Tuesday, March 24, 2015

Why Stock Charts Are Misleading for Dividend Investors?


As a dividend investor, I do not really look at stock price charts. The things I look for are trends in earnings and dividends, catalysts for further earnings growth, and whether the security is cheap relative to the other investment opportunities within my opportunity set. In other words, if I expect PepsiCo (PEP) to deliver the same growth as Johnson & Johnson (JNJ), but Johnson & Johnson is available at a cheaper valuation, I would buy Johnson & Johnson (JNJ). It won’t matter whether Johnson & Johnson is selling at a 52 week high, or 52 week low.

However, I know that for a lot of investors, they look at stock price charts for whatever reason. I believe that focusing only on stock price history is misleading, because it doesn’t show you everything you need to know about a security.

The missing link of course are dividends. One of the biggest lies told to investors is that stocks , as measured by S&P 500 or Dow Jones Industrial Average, went nowhere between 1929 – 1954 and 1966 - 1982. It might be true that stock prices were volatile but mostly flat, however dividends provided for a handsome return to those patiently reinvesting them through thick or thin.

For example, if let's look at the annual price performance of the S&P 500 between 1929 and 1954. The price in 1929 was 24.86 points, which was not reached again until some time in 1953. Based on looking at price alone, someone could incorrectly assume that stocks did not provide any returns to shareholders for a quarter of a century.

However, if you add in dividends, and reinvest them, you can see that someone who put money in 1929 broke even by sometime in 1937. This is a very interesting finding, because it shows that even during a period where unemployment was at 25%, industrial and agricultural production fell, GDP fell stocks in the US did well for the long-term shareholder who was not afraid.  In fact, during that 25 year period, the whole return on US equities came from reinvested dividends. Over that period from 1929 to 1953, a $1000 investment quadrupled in value.


Let's also look at the 1966 - 1982 period for US stock prices. Again, I used historical annual data for the S&P 500. You can see that between 1966 and 1982, the S&P 500 increased from $93.32 to $117.28. If you look at reinvested dividends however, you can see that a $1000 investment at the end of 1966 pretty much doubled in value during that period.



Dividends usually accounted for 40% of average annual total returns. They are always positive, and more stable than capital gains, which makes them as a reliable source of income in retirement. Interestingly enough, prior to 1994, the yield on US Stocks was averaging around 4%. Incidentally, a researcher found that it is “safe” to "withdraw" 4% of your portfolio in retirement. I say incidentally, because it is clear that this researcher inadvertently makes the case that the safe 4% average annual spending comes entirely from dividends and the high interest income that was prevalent at the times. For those in the accumulation stage, the thing to remember is that reinvested dividends have accounted for 97% of stock market gains since 1871.

The shortcoming of stock charts is also evident when looking at individual companies returns over time.  Another thing stock price charts miss is spin-offs. Altria (MO) is a prime example of this, if you look at historical charts on Yahoo Finance. To anyone who only looks at the chart, and ignores everything else, it looks like Altria has done pretty badly since 2007. In reality, the chart fails to account for the fact that Altria (MO) spin-off Kraft in 2007 and Phillip Morris International in 2008.


Those two spin-offs actually have confused a lot of institutions. For example, despite the fact that Altria had a record of consistently increasing dividends for over a quarter of a century, it was booted off the S&P Dividend Aristocrats index in 2007. Anyone who blindly followed the index, likely also sold their shares. In reality, Altria (MO) never cut dividends. Anyone who purchased Altria in early 2007, has been receiving growing annual dividends ever since. The only issue is that those dividends were generated from shares of Altria (MO), Phillip Morris International (PM) and Kraft Foods (KRFT) ( and later Mondelez (MDLZ) as well). This is why I am very skeptical about blindly following indexes - there could be lapses of judgment that stem from mechanical application of rules, without really giving much thought to the reality and facts involved.  This is also why I think it is important to analyze every company I own, or expect to own in detail. Luckily, when Abbott split in two in 2013, the mighty S&P Dividend Aristocrats committee decided to keep both Abbott (ABT) and Abbvie (ABBV) in the index. Either way, I focus on the dividend champions index, which is the most complete list of US dividend growth stocks I know of.

The spin-off situation at Altria also confused a lot of "chartists" that appear on CNBC. You might want to check this article - it blatantly ignores the fact that the split from 2007 and 2008 ever happened.

To summarize, stock price charts only show one part of return that investors would have received. However, without taking into accounts dividends, and the power of dividend reinvestment, you cannot understand what the total returns on an investment really are. It pays to research every investment in detail, before putting hard earned money to work there. In addition, it pays to own investments that regularly shower their investors with cash, in order to reduce the risk of outliving money in retirement. As we was above, stock prices can remain flat for extended periods of time - anywhere from 16 to 25 years. If you only rely of capital gains to bail you out, you might be in for some nasty surprises if you happen to invest during one of those periods. An investor who expects to live off the dividend stream generated from their portfolio can afford to ignore stock price fluctuations, and enjoy the retirement that they have worked so hard to achieve. An investor who wants to sell of portions of their portfolio will be in real trouble if that portfolio doesn't pay dividends and share prices fail to increase.

Full Disclosure:

Relevant Articles:

Altria Group (MO): A Smoking Hot Dividend Champion
S&P Dividend Aristocrats Index – An Incomplete List for Dividend Investors
S&P 8000 – The power of reinvested dividends in action
Dow 370,000
The case for dividend investing in retirement

12 comments:

  1. Your point is well taken vis-à-vis price only charts. I believe the 1966 - 1982 period was so awful due to the ravages of inflation. Even with dividends reinvested, the real return was lousy. I'm not sure that the return doubled in real terms.

    ReplyDelete
  2. Wow, that CNBC article, Philip Morris trading at 1x earnings 15 years ago?

    I did some searching and found this article from 2001, which seems way more realistic. http://www.thestreet.com/story/1223892/1/will-philip-morris-be-smokin-in-2001.html

    "Big Tobacco weighs in with a market cap in the heavyweight realm of $90.2 billion. Add in the figures of a low $40 range share price and a price-to-earnings ratio of 12.3, and you have a sum total to watch next year."

    ReplyDelete
  3. Great advice DGI. If you are in the market for the long haul there is only one type of stock to own.

    ReplyDelete
  4. Sound advice again DGI! I do look at charts from time to time, but never to blindly rely on them. Any investor needs to go further into its analysis to make a clear opinion on a stock. Great examples you brought it, will probably share this article with my readers! ;-)

    ReplyDelete
  5. Sir I have owned MAT for some time and I planned on holding it for at lest 20 more years but I have seen some recent articles about it cutting the dividend. Should I sell now and take my loss or hold on and see if it really does cut the dividend? I have not got confirmation of cut from MAT yet.

    ReplyDelete
    Replies
    1. Any company paying a dividend yield over 6% and has lousy earnings and lousy growth is at risk of a dividend cut. Stocks that have "accidental high yields" better be able to recover, or in a special situation, or the dividend will be cut. That doesn't necessarily mean the stock will drop precipitously. That cut may already be priced in. Just don't think your 6% is safe.

      Delete
  6. Ty Anonymous great info. I bought MAT a long time ago I am seriously thinking it may be time to sell. I have my eye on 3 other companies I would like to own. I called the company and got quite a runaround before I got the truth. They are freezing the dividend for 2015 and reevaluating it in 2016,

    ReplyDelete
  7. Yes, price charts are not useful for examining the total return of a security. Morningstar's "Growth of $10k" charts are much better, since they incorporate reinvested dividends. Unfortunately you have to jump through a slight hoop to use them for individual stocks: first enter a mutual fund (such as VTSAX) to get a "Growth of $10k" chart rather than a price chart, and then you can add stock symbols to that chart and it will show their total, dividend-reinvested return. They're really the only sensible thing to use for analyzing past performance.

    The 4% Safe Withdrawal Rate research had absolutely no connection to dividends. It used total-return numbers for the stock market, and was agnostic on whether that return came from dividends or capital appreciation. In a parallel universe where all companies throughout history had used share buybacks to return earnings to shareholders, and no one had ever paid a single dividend, the research would have come up with the exact same SWR, 4%.

    It is not true to say that "reinvested dividends have accounted for 97% of stock market gains since 1871". Yes, if you ignored dividends over that period, your return would have been 97% lower. But that doesn't mean that capital gains account for only 3% of the return; if you ignored capital gains, your return would have been 99% lower! If dividends are responsible for 40% of the return on average like you said a few lines earlier, then that's their contribution to the return over a long time period too. The "97%/99%" thing is just the nature of exponential functions. If you remove *any* component (either dividends or capital gains) from a rate of return, it will result in a dramatically lower total return over a long time period.

    ReplyDelete
  8. Sky,

    Morningstar has great historical charts showing how an investment evolved over time. You can see performance of the first mutual funds from 1920s - fascinating stuff if you like looking at stock market history.

    If you look at the data behind 4% rule, and you understand that dividends are more stable than capital gains, you will make the connection that the past success of this rule was a byproduct of higher dividend yields. ( and even bond yields). In recent years, as yields have fallen on stocks, that 4% rule has been modified to a 3% rule now. If you look objectively at the data, you will understand my point.

    As for dividends vs share buyback - share buybacks can be canceled at any moment. Dividends impose discipline on the company. Most companies usually do buybacks when they are flush with cash, and stop them when times are tough. This is the opposite of what intelligent capital allocation should be. Just check how the amount spent on buybacks during the 2007 - 2009 crisis collapsed relative to the amounts before 2007 or after 2010. Compare that to dollars spent on dividends. In theory, theory and reality are same. In reality, they are not.

    Also valuation matters with buybacks - when you have too much cash your stock might be expensive. So buybacks would not be the best capital allocation strategy, and has not been in some cases like General Electric.

    Plus, a buyback has a higher hurdle than dividends - you spent money, but then the stock market has to realize that value of buyback. Just because you repurchased 2% of shares, that doesn’t mean shares will increase by 2%. A dividend is a return that is not dependent on fickle nature of Mr Market. Again, in theory, theory and reality are same. In reality, they are not.

    ReplyDelete
    Replies
    1. I've looked quite thoroughly at the data behind the 4% rule, and I understand that dividends (for US stocks) are more stable than capital gains. But there is still no causal connection between the past success of the 4% rule and dividends.

      In recent years, yes, some people have said they feel unsafe with a 4% WR, and would feel more comfortable with a 3% WR. #1: this doubt comes because they expect a historically-low *total return* going forward, not because dividend yields are lower than they once were. #2: This doubt has nothing to do with the 4% SWR research. The same math that was used in 1994, but updated to include today's data, still results in a 4% SWR. Anyone advocating a 3% SWR simply believes "the next 30 years will be worse than any 30-year period in the last 130 years". And they may be right! But low dividend yields will not be the cause of those poor returns.

      Regardless of whether you think it's a good idea or not, companies have made a huge shift towards buybacks when choosing how to return cash to shareholders. Total shareholder yield (dividend yield+buyback yield) is not at all "low" these days. It has remained fairly constant (buybacks have increased over time as dividends have fallen), and shows that ignoring buyback yield in stock analysis is just as misleading as looking only a price chart.

      Delete
    2. You said: “I've looked quite thoroughly at the data behind the 4% rule, and I understand that dividends (for US stocks) are more stable than capital gains. But there is still no causal connection between the past success of the 4% rule and dividends.

      In recent years, yes, some people have said they feel unsafe with a 4% WR, and would feel more comfortable with a 3% WR. #1: this doubt comes because they expect a historically-low *total return* going forward, not because dividend yields are lower than they once were. #2: This doubt has nothing to do with the 4% SWR research. The same math that was used in 1994, but updated to include today's data, still results in a 4% SWR. Anyone advocating a 3% SWR simply believes "the next 30 years will be worse than any 30-year period in the last 130 years". And they may be right! But low dividend yields will not be the cause of those poor returns.”

      A dividend is more stable than cap gains. It makes living off nest egg much easier - no subject to vagaries of Mr Market. When you have small dividend, or no dividend, you are more subject to sequence of return risks. Your return is more susceptible to perception of the market. The stability of the dividend payments are the reason why portfolios can withstand pressure in terms of price depreciation, and the retiree can remain retired, if they spend only dividends. You can choose to ignore this fact, or choose to disagree. That’s fine by me.

      Low dividends yields are a fairly recent phenomenon. An analysis of the 4% rule and a 30 yr retirement would end with periods that start in 1980s - when yields were higher. Your starting valuation amounts and yield are important.

      You Said: “Regardless of whether you think it's a good idea or not, companies have made a huge shift towards buybacks when choosing how to return cash to shareholders. Total shareholder yield (dividend yield+buyback yield) is not at all "low" these days. It has remained fairly constant (buybacks have increased over time as dividends have fallen), and shows that ignoring buyback yield in stock analysis is just as misleading as looking only a price chart.”
      Please read my comment above. Noone is telling you that buybacks are low today or that dividends are low. I am telling you that companies’ use of buybacks is dumb – they stop them when prices are low, and initiate them and maintain them when prices are high. This is not smart capital allocation. Check any independent source if you don’t believe me – I like to look at Fact Set Research quarterly.

      Delete
  9. SkyRefuge

    You are making an assumption of what it could be. However, stock pay dividends, so u don’t actually have data to support thesis of what world will be like if no dividends paid by all companies. Without data to support, the model is just that - a highly theoretical model, whose real world application is very suspect. Thus you cannot say 4% rule will work if companies never paid dividends. For all we have in terms of data, the 4% rule doesn't work well when dividend yields are low and we don’t have price gains - such as period since 2000 - 2012. If you were living off assets, that was a tough time.

    ReplyDelete

Questions or comments? You can reach out to me at my website address name at gmail dot com.

Popular Posts