For the vast majority of common stocks, the dividend record and prospects have been the most important factor controlling invest­ment quality and value—Benjamin Graham, Security Analysis

In a recession, the best thing to own is a good business—Warren Buf­fett, Berkshire Hathaway 2009 Annual Meeting

Global Corporations are the new sovereign credits—Unknown

Dividends account for 43% of the returns from equities but only get 1% of the attention—William Andersen

With the world economy facing bigger than usual challenges, in­vestors face difficult choices in making decisions. In mid 2011, eq­uity markets have corrected the severe undervaluation which fol­lowed the financial crisis. The yields on high quality fixed income instruments are low and are likely to rise at some point. Yields on medium to lower quality debt offer substantially lower premiums than they did a short time ago. On the positive side, of course, there has been a modest economic recovery in the developed economies and a much more substantial one in many developing ones.

This dilemma comes at the same time that a huge demo­graphic group is retiring. Today’s retirees have a longer life ex­pectancy than any group before them. They are also less likely to be covered by a traditional “defined benefit” retirement plan. For them, funding their retirement will be accomplished through a combination of portfolio income, social security, working until a later age, and whatever pension benefit they may have.

For investors with income needs and long life expectancies, dividend income has many advantages. Dividend payments tend to be predictable and to grow at a steady pace. There is sub­stantial research to support this trend, but the general finding is that companies are very reluctant to reduce dividends, and therefore are very careful to set them at levels where they can be maintained and increased. One need only look at the long-term dividend records of many high quality companies to see this.

Dividends also provide investors with substantial protec­tion against inflation. Because they represent a share of the earnings from a corporation, they may be expected to grow as a company’s earnings grow. In general, higher inflation will lead companies to raise prices which will lead to increased dividends. Contrast this to the coupon payments on a bond, which remain constant over the life of the instrument. In real dollars those coupons shrink in value each year by the amount of inflation. This may not seem like much, but over ten or twenty years it adds up.

Dividends also are currently favored by U.S. tax policy, which imposed a 15% rate on them compared to the 30% plus rate imposed on coupon payments from bonds.

None of this would matter if dividend paying shares didn’t prove to be a sound investment. They have. Studies have shown that shares of companies which pay dividends have substan­tially outperformed non-dividend paying shares over the long-term. This analysis is particularly interesting given that small company shares also outperform over time, yet there is a large cap bias to dividend paying shares. The corollary might be that investors should be very concerned about large cap companies that don’t pay a dividend!

Another significant factor in thinking about dividends is the payout ratio. Interestingly, this number seems to vary from country to country. U.S. companies are notoriously stingy in paying out dividends. There are various explanations offered for this behavior. One is that the tax code has historically dis­criminated against dividends by taxing them both at the cor­porate and individual level. This is less true today as dividends are currently taxed at the lower capital gains rate of 15%. In the U.S., share buybacks have been very popular as a way of using earnings to benefit shareholders. Unfortunately there are nu­merous cases of companies which have spent billions of dollars on buybacks only to see their shares drop in value. It is hard to see how this benefitted shareholders. Another theory is that American managements may prefer to retain earnings as a way to grow their business and their own compensation. Others (in­cluding notably Ralph Wanger) have argued that investors (es­pecially institutional investors) have not been diligent enough in demanding that companies share more of their earnings with shareholders.

What are the most attractive ways for investors to seek out dividend paying companies? There are, of course, the usual choices. There are numerous mutual funds available in the “eq­uity income” category. While some of these are excellent, this route may be an expensive way to access the asset class. If a fund invests in quality companies with yields in the 3% range, a fund with an expense ratio of 1 to 1 and a half percent may not work out as well after fees. There are also ETFs which invest in this asset class. The experience of 2008 shows, however, that sim­ply purchasing a passive portfolio of companies with dividends isn’t a good strategy as many companies with supposedly secure dividends cut them during the crisis.

A New Way of Looking At Equity Income

Given the importance of equity income to many investors, we think it is time to re-evaluate the approach many take to this as­set class. In this section, we propose two new themes for equity income investments, and three suggested criteria.

The first theme is that equity income investors should look globally for investments. While this may seem obvious at first, the fact is that while many investors have shifted substantial investments overseas (including some fixed income invest­ments) most dividend oriented investments remain domestic. There are several advantages to looking globally. First, as with all international investments, searching globally increases the opportunity set of potential stocks to buy. In the case of divi­dend investments, however, there are other advantages. A global equity income portfolio provides an income stream diversified by currency, which provides investors with a hedge in the case of a dollar crisis or prolonged dollar weakness. A well chosen portfolio may also concentrate on countries whose currencies have strong long term fundamentals. A further benefit of invest­ing globally is that, as noted above, in many countries the typi­cal payout ratio, or portion of earnings paid out to investors, is substantially higher than in the U. S. This may give investors the potential for higher current income without needing to make riskier investments. For example, a company in the U.S. trading at 15 times earnings with a 30% payout ratio may be compared to one in Australia with a 70% payout ratio. The two companies may appear to be similarly valued, but to the income oriented investor the Australian company is likely to be more interesting.

The second theme we’d propose is that income portfolios should be multi-class. In our view, there are a number of eq­uity income categories which are attractive from time to time depending on fundamentals and valuation. In addition to com­mon stocks, securities such as Real Estate Investment Trusts, Master Limited Partnerships, closed-end funds, convertible and preferred securities can all fit into a yield oriented portfo­lio. Many of these categories exist for non-U.S. companies as well. Investors have typically either ignored these asset classes, or participated in them through a specialist manager. This ap­proach may sound rational but investors should note it assumes that investors can identify managers with the proper skill set not only to select securities, but also to tell clients candidly when their asset class is unattractive. Our experience is that there is a limited number of managers who can do the first of these things and almost none with the combination of talent and candor to do the second. We believe a better approach is to utilize a man­ager who has access to all these categories (as well as new ones which arise) and can invest in them opportunistically based on a proven, value oriented philosophy.

We suggest four criteria when searching for income invest­ments. First, the income portion of the investment must be meaningful. By this, we mean that a substantial portion of the total expected return from the security should be income. Con­sider a stock with a 2% yield and earnings which are expected to grow at 10% annually. By one measure, the Gordon Growth model, investors could reasonably expect to earn around 12% from holding this share for a period of time. This may be a rea­sonable return, but most of the expected return is from capital gains. In our view, the income portion isn’t the determinant part of this investment. Compare this with a company growing at 5% with a 7% yield. According to the same model, the overall return could be expected to be the same, but the income portion in this case is the most important.

Secondly, income investments should be defensive. Income investors by nature are conservative, and may count on income from their investments. It makes no sense to generate income in a way which will be highly variable or subject to severe impair­ment during an economic slowdown. The year 2009 was a good test of this, as it was the worst year for dividend cuts since Stan­dard and Poor’s started keeping tabs of this in the 1950s. Yet well chosen stocks made it through this period without cutting their payouts. Many managed to maintain their dividend increases.

Thirdly, income should not be derived from financial gim­micks. We would include in this category exotic derivatives, complex options strategies, and excessive trading. We haven’t seen strategies in this category which consistently provide su­perior results to a well developed stock selection strategy. Short-term strategies also generate short-term income, which is taxed at a much higher rate than dividends. This means that such strategies must be superior to traditional strategies if they are to be comparable on an after tax basis.

The generation long bull market has led investors to ignore the income portion of equity returns. This is strange because if equity ownership is a form of business ownership, how could owners fail to ask whether the businesses they owned did or did not generate any cash return. The answer may lie in the human propensity to speculate, the interest in the financial industry in generating stories which lead to securities transactions, or any other number of factors. The fact remains that over time, divi­dends account for 43% of the total returns from equity invest­ments. Why they only attract 1% of the attention is mysterious, but it may also be an opportunity for investors who believe that it is attractive to focus their activity away from the crowd.

William Andersen, CFA, Portfolio Manager,
Wanger Income and Growth Strategy