“Earnings are an opinion, cash is a fact”
Courtesy Hodges Capital, North Dallas LIVING WELL Magazine
“Earnings are an opinion, cash is a fact” is an old adage in the investment world that was first recorded in the early 1890s. Today, we believe the wisdom behind this adage should be an important consideration for all investors, especially those focused on income generation. This article seeks to discuss the idea that equity income investing represents significant advantages for most long-term investors.
Why Dividends Matter
Over time, equity returns are made up of three factors: the change in share price, dividends, and the compounding of dividends. According to Standard & Poor’s (S&P 500 Index), dividends were responsible for 44% of the total return on the S&P 500 Index over the past 80 years.
Often investors focus primarily on the share appreciation portion of the total return equation and overlook the important role that dividends play over the long-term. While capital appreciation is mostly a function of growth, the dividend contribution to total equity returns is often associated with companies that have steady cash flow and a fair amount of economic visibility. As a result, stocks with the highest regular dividend payouts have traditionally been fairly mature businesses with predictable cash flows, such as utilities, consumer staples, and REITs. Therefore, the dividend contribution to stock market returns becomes even more important during periods of low economic growth or market uncertainty.
In addition to making up an important component of historical stock market returns, cash dividend payments are often an important measure of the underlying health of a public company. One reason is that reported earnings can often be influenced by accounting tricks; while dividends offer shareholders a direct gauge of a company’s ability to generate free cash flow. As fundamental investors, we believe that stock prices over the long-term are theoretically the present value of future cash flow, which reported earnings are designed to measure. However, earnings can be influenced over the short-term by different accounting methodologies that vary across companies and industries. Cash flow and dividend payments are generally less influenced by accounting methods.
We acknowledge that tax disadvantages related to dividends exist. In many cases, the tax code allows corporations to receive a deduction for dividends to prevent double taxation. Individual investors are not afforded this deduction and are at somewhat of a disadvantage when it comes to the taxation of dividends. Such a disadvantage arises from the deferral opportunity afforded by capital gains. Prevailing tax policies also impact the after-tax return on stock dividends. However, investors should also consider that dividends may signal a stable financial condition and solid future prospects. As a result, higher expected future pre-tax returns may partly compensate individual investors for the tax disadvantages related to dividends.
Equity Income vs. Corporate Bonds
Corporate bonds may play an integral role in a well-diversified portfolio, but tend to underperform the broader equity market (as measured by the S&P 500). Over the long-term, lower returns in corporate bonds are functions of their more conservative risk profile.
Over the past 40 years ending in 2009, high-grade, long-term corporate bonds have produced annual returns averaging 8.87%, while the S&P 500 (with dividend reinvestment) has produced annual returns averaging 11.47%. While a few percentage points difference in average returns might not seem like a large disparity, consider this: a $1,000 investment in a generic, high-grade, long-term corporate bond index in the year 1970 would’ve grown to approximately $29,992 by the end of 2009. Conversely, the same $1,000 invested in the S&P 500 (with dividends reinvested) during the same time frame would have grown to approximately $76,997. During the aforementioned timeframe, many different market and economic environments were present and the results are clear: the initial, passive equity income investment outperformed the passive corporate bond investment by 156.72%. On a side note, during the same 1970-2009 period, cash returned an average 5.55% and an initial $1,000 investment would have grown to approximately $5,056 by December 31, 2009.
Dividends and Inflation
During periods of inflation, bonds tend to experience stagnant (and often negative) real returns leaving investors in a financial quagmire. Fixed income securities are subject to various risks including: interest rate risk, downgrade and/or default risk, liquidity risk and inflation risk. Many will agree that inflation can be one of the most corrosive of all fixed income risks. During inflationary environments, the real worth of fixed income investments erodes as the value of the initial investment, or principal, falls. The higher the inflation rate climbs, the more real value of principal investment falls. This loss in principal purchasing power is a drawback to bond investors.
For the duration of the period 1970 through 2009, the correlation between the S&P 500 Index (with dividend reinvestment) and the Consumer Price Index (a closely followed inflation metric) was 0.84. Over the same period, the correlation between the S&P 500 Index (without dividend reinvestment) and the Consumer Price Index (CPI) was 0.81.
While inflation is the enemy of most financial assets, equities tend to fare much better than fixed income securities in such an environment. During inflationary periods, investors are better off seeking return in the form of equity income rather than fixed income because the principal investment made in an equity instrument is more likely to gain during times of increasing inflation. This gain is often attributed to the appreciation experienced by the underlying assets of the company, and the subsequent pass-through effect that is eventually reflected in the company’s earnings per share. There is often an increase in corporate earnings due to the aforementioned gain in value of a company’s assets, as well as the pricing-power that allows the company to raise the price of its goods and services. Pricing-power allows the company to adjust its earnings to inflation on a real-time basis. Most fixed income investments do not have this ability. The increase in corporate earnings is made available to equity investors in the form of higher share prices and increased dividends. In short, we contend that equity income is a more positively-responsive vehicle to long-term inflation than corporate fixed incomes securities.
In our opinion, current market valuations favor dividend stocks over the bond market. While we believe investors are best served to focus on the relative underlying values of individual securities, the valuation of the broader equity market can be measured by comparing the current spread between the 10-year treasury yield at around 3.0% with earnings yield on the S&P 500 Index of more than 7.0%. Over time, the relationship between each of these yields has been closely correlated. The idea that money will go where it can find the best return is the justification for the close historical correlation between the fixed income yield. However, we believe that investor uncertainty and fear have resulted in panic-buying of bonds, especially treasuries, and have left many areas of the equity market artificially undervalued. Although it is difficult to predict when the relationship between the earnings yields and bond yields may revert to their historical mean, we believe the current environment offers investors a unique risk/reward in seeking income returns in the equity markets.
We acknowledge that there are many ways to achieve long-term investment objectives, but also contend that equity income should be an important consideration for most long-term portfolios. In addition, dividends have proven to play an important role in total equity returns over time and can also signal positive underlying fundamentals within an enterprise. As a result, we would suggest rephrasing the old investment adage that we referenced earlier to “Earnings are an opinion, cash dividends are a fact.”
Today we find equity markets trading below the levels of a decade ago, PE multiples well below their historical averages, and the investing public flocking at large to the bond market at the lowest bond yields in a generation. In conclusion, we view the current landscape as a unique opportunity for investors to put capital to work in dividend paying stocks.
The information contained in this article are the opinions of Hodges Capital and is subject to change. It is not intended to be a forecast of future events, a guarantee of future results and should not be considered a recommendation to buy or sell any security. The S&P 500 Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general. You cannot invest directly in an index.