Rediscovering Dividends – July 2002

July 20, 2002

Dow Jones Average:8,019
S&P 500 Index:848


Rediscovering Dividends


Cash dividends paid out by companies to shareholders have been an important part of investment returns over the past one hundred years. A dividend return amounting to three percent of the stock value was the minimum expectation investors had for well established companies. It was assumed that reliable, trustworthy companies would return some of the shareholders’ money in the form of dividends. The stock market routinely peaked and fell back whenever stock prices ran too far ahead of dividend pay out rates.

The entire relationship between stock prices, earnings and dividends changed in the last few years of the twentieth century. Stock prices sprinted forward at a 20 percent annual rate from 1995 through 1999, while dividends barely budged. Dividends became a miniscule part of overall investment returns and were written off as irrelevant by most investors. By the time the market peaked in early 2000, the average company was paying
shareholders less than one percent per year in dividends. As corporate earnings swelled in the late 1990’s, many companies elected to use extra profits for stock buybacks rather than paying more out in cash dividends. The massive amounts spent on stock repurchase programs drove stock prices higher than they otherwise would have gone, weakened company balance sheets, and put little actual cash in the pockets of long term shareholders. The temporary boost to stock prices did enrich company executives who were cashing in stock options. The interests of company management became disconnected from the interests of shareholders. But as long as stock prices were rising briskly few complained about policies that wasted billions of dollars of shareholder equity.

It has taken over two years for most investors to realize that the robust markets of recent years were an expensive illusion. Dishonest accounting of earnings, a manipulated new issues market, and aggressive stock buybacks helped create the impression that stock price increases were inevitable and unlimited. Throughout this entire crazy period one thing that remained relatively constant was the cash dividends paid out by companies. While reported earnings boomed for the 500 companies in the S&P 500 Index during 1999 and 2000, the level of dividends paid out by the 500 companies remained the same as in 1997. Dividends are often a reliable indicator of the sustainable, real earnings stream at a company. It is interesting that after rising sharply in 1998 and 1999, the S&P 500 index is now back to its 1997 level.

In recent months companies that pay larger dividends have been favored over companies that pay small or no dividends. It seems that investors want companies to show them some real money. After all the accounting scandals and high profile bankruptcies, investors are fed up corporate managements and brokerage firm recommendations. The old desire for a decent dividend return is returning. If the market remains choppy, flat or down for years, dividends may once again become an important part of an investorĀ¹s return.

The average stock is now yielding about 1.5 percent, up from the .8 of one percent two years ago, but still well shy of the 3 percent that was the bare minimum expected for so many years. The major stock market averages would have to drop in half again for dividends to reach the 3 percent pay out level.

Current Strategy

In my previous strategy update (April 2002) I was unequivocally bearish on the stock market, seeing no sectors that could lead the market higher. The S&P 500 Index was 1125 at that time, it is now some 25 percent lower at 848. The cyclical stocks such as autos and housing are falling as anticipated. Medical, technology, and telecom stocks continue to erode in price. The decline of so many industry sectors and widely owned stocks has finally broken the bullish mindset of most investors. The media is full of bearish commentary echoing the very sour mood of most listeners. Given such negative sentiment and widespread selling, it is not surprising that some stocks are starting to score better on our stock evaluation system.

Even though we are seeing some decent companies selling at realistic prices, we do not think a bottom in the markets has been reached. When a market trend is firmly in place, the indices go to extremes in both directions. The two year downtrend in stocks is taking a heavy toll on investor psychology. The penalty for the ludicrous highs of 1999 will
probably be lows beyond reason. As price to earnings ratios decline and dividend yields improve the market will find stability. It may take years for such a low to develop, triggered by unforseen events. In the meantime we are finding some stocks that are reasonable buys in the current economic\interest rate environment.

Capital preservation is still our number one priority. The value of cash relative to shares of stock becomes more apparent with each passing week. Cash has already doubled in value relative to the major companies in the S&P 500 index. It is entirely conceivable that cash could double in value once again before the bottom is reached. We are examining ways to enhance the return on cash reserve holdings. We will not move money into bonds that could lose significant value, because that would defeat the goal of capital preservation.

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