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Essay on Investment Theory: Continued

The Value of Dividends

Yields For A Boston Capitalist

John Perkins Cushing, a Boston capitalist who lived during the first half of the nineteenth century, owned a portfolio of stocks.

Like other stockholders of his time, he expected high dividends.

Average annual cash returns on Cushing's portfolio during the years 1836 to 1851 were as follows :

'Casebook in American Business History',

N.S.B. Gras and Henrietta M. Larson, F.S. Crofts & Co. 1939, New York

This was a time when cash from dividends could be exchanged for gold or silver.

There were no income taxes.

To compare these figures to present-day yields, we would need to adjust for inflation and taxes.

Effective dividend yields in Mr. Cushing's day were at least ten times current rates.

The Prudent Man Rule

In 1830, Harvard College sued a trustee – a Mr. Amory – for having invested its funds in common stock.

The outcome of this case was the 'prudent man rule' and the idea that a diversified and carefully selected portfolio of common stock could be a wise investment.

Nevertheless, for the next one hundred years, investors still preferred bonds.

It took generations for investors to overlook the stigma of risk that burdened stocks and to accept equities as long-term investments, suitable for conservative institutions and the public.

It was only after the Great Depression and the retreat from the gold standard that risk of inflation and the threat of communism motivated a shift from bonds to equities.

Common Stock Risk Premium

For over one hundred and fifty years, the dividend yield on common stock was usually higher than the yield on investment grade bonds.

In the mid-sixties, the Life Insurance Associations of America studied the portfolios of insurance companies and found that over three decades, the weighted average cash dividend yield of common stock was 5.79%, compared with 3.17% cash return on bonds.

Adding capital gains, common stocks showed a return of 7.56%, compared with 3.27% for bonds.

These figures confirmed other studies showing superior returns on common stock.

Most importantly, the insurance study revealed that three quarters of historical returns on common stock came from cash dividends, and only one-fourth of total return came from an increase in market value.

Value in a Dividend World

Theories of common stock investment were developed during the first half of the twentieth century, a time when stocks had higher cash yields than bonds and when investment flowed in the traditional direction – from shareholders to corporations.

In 1912, Professor Irving Fisher, considered by some to be one of America's greatest economists, pointed out that common stocks offered a shield against inflation.

In 1937, Benjamin Graham and David Dodd, the founding fathers of conservative investment research, published 'Securities Analysis', describing a technique for selecting stocks based on intrinsic value and common sense.

In 1938, John Burr Williams wrote 'Evaluation of the Rule of Present Worth', explaining how the discounted present value of dividends could be used to determine the worth of equities.

John Burr Williams stressed the importance of cash dividends with a bit of doggerel that reminded the reader that just as milk, eggs, and honey were important to the farmer, cash dividends were the reason investors bought stock.

Although dividend yields were high, market risks were a concern in 1952 when Harry Markowitz published 'Portfolio Selection,' establishing the basis for Modern Portfolio Theory.

Merton Miller and Franco Modigliani, later to become Nobel laureates, wrote 'Dividend Policy, Growth, and the Valuation of Shares' in 1961 – well before the era of stock buybacks and vanishing dividend yields.

The Petersburg Paradox

As long as dividend yields on common stock exceeded yields on investment grade bonds, appraisal of equities based on present worth of future dividends was to some degree practical and sensible.

However, present value formulas developed during the 1930s give absurd results when projected dividend growth exceeds the investor's discount rate.

The theoretical value in such cases becomes infinite, resulting in what David Durand called 'The Petersburg Paradox.'

What this means is that if one assumes that corporate dividends are increasing faster than the investor's interest rate, it is possible to justify whatever stock value that suits one's fancy.

Intrinsic value becomes indeterminate and investment in such stocks is pure speculation.

A Shortage Of Equities

Those who worked to bring democratic capitalism to America were patriotic and well intentioned.

They never imagined that one day there might not be enough stocks to supply a mass market.

However, this is what happened.

When the NYSE began its campaign in 1954, no one thought to ask,

'When everyone buys shares, will there be enough to go around?'

As the public began to buy equities indirectly through fiduciaries, prices rose relentlessly and dividend returns eventually fell below bond yields.

Corporate buybacks forced stock prices so high that dividends became only a small part of expected returns.

The reasons that had justified equity ownership in the 1950s were no longer valid in the 1990s.

Over generations, the Common Stock Legend had been transformed from the prudent, conservative advice of Professor Irving Fisher in 1912 to blatant hucksterism that hoodwinked ordinary investors and brought on the Great Bubble of the 1990s.

Dividend yields had exceeded bond yields until 1958, but thereafter investors became more attracted to earnings growth than cash income.

Swapping Gold For Dross

The sale of mutual funds was now big business and the trusted intermediaries had no economic incentive to tell the public that stocks had become tremendously over-valued.

During the aging bull market of the sixties, there was aggressive promotion of equity mutual funds.

The ballyhooing of growth stocks put the spotlight on capital gains.

Never again in the twentieth century did ordinary investors buy shares primarily for dividends.

Rising prices eliminated the justification for the Common Stock Legend as dividend yields fell below coupons on bonds.

By 1999, the average dividend yield on actively traded stocks was only about 1.1% – an amount so small as to disappear in the daily noise of market fluctuations and transaction costs.

As automatic dividend reinvestment became common and as most investors held stock indirectly through mutual funds, fewer people paid attention to when dividends were paid or reduced.

Capital gains now commanded center stage.

Dividends are a legal right representing obligations of the issuers of stock; unrealized capital gains are only a hope of eventual profit from sales to other shareholders.

By abandoning dividends for unrealized capital gains, stockholders changed from investors into speculators.

Without realizing what was happening, they swapped gold for dross.

The Era Of Dividends Ends

The next graph shows the relationship between stock yields and bond yields over one hundred thirty one years.

Until the 1970s, stock yields averaged between ten and twenty percent higher than the yields of investment grade bonds.

By the end of the century, dividend yields were eighty percent below bond yields – a historic low.

(Click to enlarge)

Part of the reason for this was the 'shareholder democracy' movement that started with the New York Stock Exchange's 'Own Your Share of America' campaign in 1954 and increased the number of American shareholders from seven million to seventy-five million by the year 2000.

The graph serves to put in context two turning points in U.S. investment history.

• Benjamin Graham Retires: In 1956, the juncture at which the blue line on the graph dipped below the level at which stock yields equaled bond yields for the last time, Benjamin Graham lost interest in digging up bargain stocks and closed his investment management business to retire in California and teach at UCLA.
• In the same year, Graham's star disciple, Warren Buffett, started a money management business for a small circle of friends and neighbors in Omaha, Nebraska.
• Buffett used Graham's techniques to uncover cheap stocks, but he had to work many times harder at it.
• Warren Buffett Closes His Partnerships: By 1968, Buffett was one of the most successful private investment managers in America.
• He realized that because of the inflation of equity values, it was becoming increasingly difficult to find under-valued equities using Ben Graham's methods.
• Buffett closed the partnerships he was managing, returning his partners' money with handsome profits and turned his attention to long-term direct investing, using Berkshire-Hathaway, an old New England textile company, as a vehicle.
• Forced by a shortage of reasonably priced stocks, Buffett moved away from concepts amenable to Mr. Dividend and adopted an approach that depended more on the kind of safety sought by Mr. Control.

The Era of Dividends was over.

A Long Ways Down

In 2002, even after two years of falling markets, stock prices were still much higher than the prudent judgment of our forefathers would allow.

In mid-2002, investment grade bonds were yielding about seven percent, while dividend yields on stock were less than two percent.

Using a pre-1950 basis for value, the cautious investor might expect dividend yields of about eight percent on common stock.

To achieve this, the price of stocks would have to fall seventy percent from mid-2002 levels!

This would wipe out the retirement savings of Americans and would have enormous political consequences.

However, as the long decline in the price of Japanese equities suggests, overvalued assets may indeed fall in price as commonsense creeps into the marketplace.

Wisdom of Dividend-Based Value

For generations before the 1970s, investors looked for dividend yields that averaged about twenty percent higher than yields on investment grade bonds.

Using this simple rule-of-thumb, we may derive an index of what stock prices would have been, using corporate dividends shown in the Federal Reserve flow of fund accounts as a starting point.

Wall Street's marketing of democratic capitalism since mid-century has been the major factor in the inflation of stock prices.

By the millennium, stock values were four times higher than they would have been if prices had continued to be bound by dividend and bond yields.

The graph below suggests how stocks might have performed if investors had continued to buy stocks on the basis of dividends, compared to what actually happened after the shift to non-dividend pricing, as shown in the S&P 500 index.

[The dividend-based hypothetical price index was derived from Moody's AAA 10-year bond yields and total corporate dividends from the Federal Reserve Flow of Fund accounts on a quarterly basis, so that in each quarter the current dividend yield was 120% of the indicated bond yield at that time.]

The chart shows that after the 1970s, the S&P 500 index rose much faster than stock values would have risen if based on the one-hundred-twenty-percent-of-bond-yield rule.

At first glance, this seems to suggest that the shift from dividends to capital gains worked to investors' advantage.

However, when cash dividends are added to capital gains, the total return comparison indicates that investors made the wrong choice in disregarding dividends.

Although the S&P 500 index outpaced the values that stocks would have had under the old-fashioned bond-yield multiplier, focusing on capital gains was not to the advantage of investors.

The table shows that investors would have had higher total return and better downside protection if market prices during the last four decades of the century had continued to be based on a premium over investment grade bond yields as had been the practice during the preceding one hundred years.

Even considering lower taxes on capital gains, investors would be better off acquiring stocks with pricing based on a multiple of bond yields.

In the example, using a tax rate of thirty-three percent on dividend income and twenty-five percent on capital gains, annual total returns on S&P 500 stocks would have been 9%, compared to 12.3% using the hypothetical returns derived from prices based on a dividend yield multiplier of one-hundred-twenty percent of investment grade bond yields.

Again, we see that Mr. Lesser Fool is the twin of Mr. Greater Fool, muddled in his thinking by the seeming 'bargain' of lower capital gains taxes and the speculative lure of an unlimited market upside.

The lower capital gains tax argument is even less persuasive when we realize that millions of American investors saved through Keogh accounts, IRAs, and 401(k) plans – accounts that were not subject to taxation until funds were withdrawn and then with no fiscal distinction between principal, capital gains, or dividend income.

Will Rational Investing Return?

An investor who receives more than fifty percent of total return as cash from issuers has greater safety than the investor who gets less than a third in cash and depends on other players to provide capital gains to beat the yield on bonds.

The commonsense rule of demanding a cash dividend premium over bond yields was the basis for the Common Stock Legend.

Although, at times, stock prices might be volatile as dividends and bond prices vary, with the older pricing methods, investors had a comfortable cushion of cash and handsome cash yields to ease the pain of down markets.

Will rational investing, based on dividends, ever return?

At the new millennium, even after the crash, prices would have to fall considerably for dividend yields to exceed bond yields again.

Corporations would have to stop buying back their own stocks, increasing dividends instead.

Investors would have to wake up from the dream of the Common Stock Legend and start demanding cash yields.

Academic validators of equity value theories would have to renounce their love for capital gains and switch allegiance to dividends.

Wall Street would have to undergo major reforms.

Is this likely? Who can say?

Essay: End

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About dividends

For over one hundred years, common stock investors have loved dividends.

In the later half of the 20th century, investor expectations changed.

Here is the story of how dividends were used to value common stocks and why investors are poorly served by modern theories of value.

Essay reading time:

20 to 33 minutes.

(5,000 words. 2 pages)

Author

John Oswin Schroy (July 25, 2020)

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