Cio reports the-truth-about-dividends


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The Truth About Dividends

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Cio reports the-truth-about-dividends

  1. 1. CIO Reports THE MONTHLY LETTER Lisa Shalett and the Chief Investment Officer Team • DECEMBER 2012The Truth About DividendsDear Clients: The low-growth, low-yield environment is also relatively stable and thus the volatility of dividendof the post-crisis era is increasingly forcing investors streams has been one-half the typical 15-18% annualizedto look beyond the traditional investment sources volatility associated with stocks. Dividends, like equitiesof cash, Treasuries and municipal bonds for steady overall are also a better hedge to inflation than bondstreams of income. As we have been routinely noting interest as they tend to be calculated in floating nominaland discussed in last month’s CIO Monthly Letter, “A dollars. Finally, given the recent psychology in globalBond Market Bubble?” even areas like investment- markets, a dividend strategy at attractive valuations cangrade and high-yield bonds now look vulnerable to be pursued today that is highly diversified by geographyvolatility and principal risk. Despite this, and the near and sector—further reducing risks.unanimous advice from Wall Street strategists, including Two other elements are critical to the current argumentour own here at Bank of America Merrill Lynch (BofA favoring dividend paying/growing equities. The firstML) over the past two years, to embrace dividend concerns the misplaced anxiety about tax rates. Ourpaying and dividend growing equities, the asset class research suggests that tax policy on dividends, whileremains relatively cheap and unloved—as a generation certainly impacting overall after-tax outcomes forof investors wary of potential equity volatility still individual clients, actually does not tend to impactstay away. Anxious about the prospects for the global overall market outcomes and aggregate returns.economy, pending tax code changes and peak corporate The reasons are two-fold—first, dividend tax policyprofitability, many investors remain unconvinced. is almost never executed in a vacuum and is rarelyThis month we take up the argument head on, trying to isolated and discriminating versus other tax trade-demystify dividends as a steady source of investment offs investors must make regarding capital gains andincome and make the case that in the current environment ordinary income. Given potential changes to tax ratesthey may be the best risk-adjusted option investors have being discussed as part of the “fiscal cliff” negotiations,on the margin. While we refer clients to our October CIO the taxation implications for bonds might be relativelyMonthly Letter, “The Case for Equities” to discuss the broad more damaging than those proposed for stocks. Theissues of corporate profitability, the global cycle and overall second issue has to do with the fact that close tostock valuations; here we focus on the specific facts about two-thirds of all equities are owned and dividends aredividend payers and dividend growers. received in tax deferred or tax-advantaged retirement related accounts or owned through less tax awareFirst, relative valuation of dividend payers and dividend institutions like pension funds and mutual funds.growers versus bond equivalents, in particular, has rarelybeen more attractive in the last 80 years. Dividends Another factor favoring equities and dividends inhave always been a critical component of total stock particular is the current spread between the corporatereturns—comprising one-third to nearly half of aggregate cost of debt and the cost of equity. At historically wideoutcomes. Myopic to pure price returns of the S&P 500 spreads, corporate officers are incented to pursue aduring the 1982-2000 bull market, many investors cycle of balance sheet re-leveraging—an outcome thatdon’t appreciate that dividends not only cushion total favors shareholders at the expense of bond holders.drawdown but if continuously re-invested, provide a major As always, we are here to serve you and welcome youranchor to capital preservation. Corporate dividend policy questions and feedback. –Please see important disclosure information on the last page. 1
  2. 2. CIO Reports THE MONTHLY LETTER Portfolios This Month:EXHIBIT 1: Nov., Q1, Q2, Q3 and YTD Asset Class Performance (Total % Return) November was marked by a number Nov.- 2012 Q3 2012 Q2 2012 Q1 2012 YTD (through Dec. 19, 2012) Source of significant political developments, 60% S&P 500 / many of which gave markets a sense 0.41% 4.44% -0.83% 7.67% 11.60% S&P 500/Barclays US Total Bond Agg 40% Barcap US Agg of direction. The most important Cash 0.01% 0.03% 0.03% 0.01% 0.04% BAML 3 month T-Bill Index was the U.S. presidential election, where incumbent President Barack US Large Cap Equities 0.58% 6.35% -2.75% 12.59% 16.70% S&P 500 US Small Cap Equities 0.53% 5.25% -3.47% 12.44% 16.04% Russell 2000 Obama was elected for another Developed Intl Equities 2.47% 7.00% -6.93% 11.00% 18.90% MSCI EAFE term. The effects of Hurricane Emerging Markets Equities 1.27% 7.90% -8.79% 13.99% 18.15% MSCI EM Sandy caused notable devastation Global Equities 1.34% 6.98% -5.36% 12.01% 17.52% MSCI ACWI to property and disrupted economic US IG Fixed Income 0.16% 1.59% 2.06% 0.30% 3.94% Barclays US Agg activity, although the latter should US High Yield 0.74% 4.59% 1.81% 5.15% 15.56% ML High Yield Master normalize in the coming months. US Munis 1.83% 2.50% 1.96% 2.08% 6.96% ML Municipal Master However, the chief U.S. political Global Fixed Income 0.11% 3.25% 0.69% 1.07% 5.22% ML Global Fixed Income Markets Index driver of global markets was Hedge Fund Strategies 0.41% 1.45% -1.86% 3.14% 3.35% HFRX Global Hedge Fund Index debate about the U.S. “fiscal cliff” Real Estate -0.66% 1.80% 4.50% 10.41% 18.58% FTSE NAREIT All Reits (taxation and expenditure changes Commodities 0.05% 9.69% -4.55% 0.89% -0.72% DJ UBS Commodity scheduled to begin on January 1, Gold -0.34% 10.94% -4.25% 6.69% 6.62% Bloomberg 2013). U.S. housing data continued Private Equity 0.70% 9.72% -6.11% 17.80% 28.72% LPX 50 TR USD Index to strengthen, with one measure ofSource: Bloomberg and ML GWM Investment Management & Guidance. YTD data as of Dec. 19, 2012. All returns are Total Returns and in USD. house prices reaching its highest level since 2006. In Europe, policymakers came to an agreement toward month-end regarding aid for Greece. A total of €34.4 billion is to be disbursed in December to meet Greek funding needs. Core European economic data showed signs of stabilization, with German and French gross domestic product (GDP) figures for the third quarter in line with expectations and activity indicators holding steady. In the UK, GDP showed a 1.0% quarter-on-quarter rise in the third quarter (signaling an end to the technical recession). However, this was driven by exceptional boosts to growth such as the Olympic and Paralympic Games. A more challenged growth outlook for the fourth quarter will likely weigh on public finance data, which suggests that the Chancellor’s £120 billion fiscal deficit target may be overshot in 2012. In Asian markets, China’s leadership transition transpired as expected, with Xi Jinping taking the top job of General Party Secretary. The administration is expected to engage in a program of gradual but sustained reforms, which should support the recovery in Chinese economic growth borne out by November data, notably the HSBC Flash China Purchasing Managers’ Index, which hit a 13-month high. The rising likelihood of a new, highly accommodative prime minister (Shinzo Abe) in Japan saw the Japanese yen weaken and local equities perform strongly toward the end of the month. In the U.S., equities rose 0.7% paced by technology stocks, although financials fell 0.8% in November, somewhat bucking their year-to-date return, which is market leading and remains in excess of 20%. Global equity markets rose 1.3% in U.S. dollar terms over November after a shaky start, with developed markets and Emerging Markets performing in line (see Exhibit 1). European ex-UK equities were the best geographically at +3.3%. Globally, the strongest and 2
  3. 3. CIO Reports THE MONTHLY LETTERweakest sectors were, respectively, consumer discretionary (+3.6%) and utilities (-2.6%). Bystyle and size, U.S. small cap value strategies outperformed both value and growth large capstrategies. Fifty-two percent of active managers outperformed the Russell 1000 with the successrate best in growth style with 77% of those managers besting their benchmark.In fixed income, municipals were up 1.8% and Emerging Market sovereigns were up 1.4%. U.S.Treasuries rallied in the month around political uncertainty, up 1.2% in the month. Investment-grade corporate, the favorite of investors measured by fund flows were flattish in November.European assets outperformed their U.S. counterparts in core government bonds (+1.9% versus+0.6%), investment grade (+1.3% versus -0.1%) and high-yield bonds (+2.2% versus +0.7%) inU.S. dollar terms. Significantly, Italian and Spanish government bonds rallied over Novemberas progress around Spain’s banking system and concerns around Greece abated in the wake ofEuropean policy action.The DJ UBS Commodity Index (Total Return) was flat in U.S. dollar terms over November.Improved expectations for the South American harvest led to falls in the price of agriculturalproducts (-2.8%). Gold prices fell 0.3% in November, ending the month above $1,700 and uproughly 10% year to date. Offsetting these moves was a rally in oil with Brent Crude and WestTexas Intermediate (WTI) up 2.4% and 3.1%, respectively. Within other alternatives, the BofAML Investable Diversified Hedge Fund Index was up marginally in November. Convertiblearbitrage, equity long/short and event-driven strategies were most successful, while strictlyshort strategies underperformed.Our Current Outlook and AdviceWe believe that we are in the early innings of the “Great Rotation” to equities and as a resultrecently upgraded our weighting to global equities versus long-term strategic benchmarks today.(See October’s CIO Monthly Letter, The Case for Equities and November’s, A Bond Market Bubble?)The fundamental catalyst for our call is that the huge uncertainty and set of risks dominatingthe markets for the last five years (U.S. housing/jobs/election and “fiscal cliff”, the Eurozonedebt crisis and a China hard landing) are gradually resolving themselves, paving the way forglobal reflation. We believe that as 2013 unfolds, “fear” will meet the “facts” of corporate profitresilience and incredible balance sheet strength.After several years of dysfunction, policymakers at the central banks and politicians appearto be focused on crisis resolution. And yet, most investors are still very defensively positioned,creating opportunities for those who are patient and willing to be early. Equities are reasonablyvalued based on historic price earnings multiples (13.7 times versus 17.5 times long run); areincredibly attractive on a dividend yield basis at 2.1% and growing at double digits and relative toTreasuries with an equity risk premium of 650 basis points (bps) versus a long-run average of350-400 bps.In moving to the overweight position, we would be funding the positions from sidelined cash,U.S. Treasuries and other sovereign-based and perceived “safe haven” debt, including trimsto investment-grade corporate—a move that in aggregate neutralizes our weighting globalbonds—where the “search for yield” theme appears in its final innings. Within global equitieswe achieve our overweight by increasing positions in international developed equities—no longereschewing Europe—and looking to broaden our global “best-of-breed” position to include some 3
  4. 4. CIO Reports THE MONTHLY LETTERcyclical exporters that will benefit as China rebounds. As we also recently noted and echoedthoughts from global investment strategist Michael Hartnett in his report dated November 8,2012, Japanese equities also deserve some exposure. As a result, we are now tiptoeing backinto Japanese stocks on extreme valuation and selectively choosing high-dividend growers andexporters that are likely to benefit by a relative weakening in the yen.Emerging Markets also remain preferred as the cyclical and secular forces remain mostattractive in the longer term. In essence, we are rebalancing our global exposure, which giventhe huge relative outperformance of the U.S. this year, has us trimming there and more broadlydistributing our geographic wagers versus the 2012 bar-bell to U.S. and Emerging Markets.Overall, large cap dividend growers are our preference in global stock selection.Within fixed income, improvements in the housing markets and especially the mortgage-backedmarkets, benefit bank net margins and balance sheets—the biggest sector in high gradecorporate and one of the areas of investment grade we continue to like. In addition, the risk/reward in high yield remains compelling with duration-adjusted spreads still very favorable.Highly rated municipals, while short on supply, are also strongly preferred. Emerging Marketsovereign debt is still a solid source for income and strengthening currencies suggest locallydenominated bonds are now advised.However, mortgage-backed securities (MBS)—the huge beneficiaries of Federal Reserve (Fed)intervention—are beginning to look rich and we have begun to be cautious here. The searchfor yield has caused the Barclays MBS Index to fall to 2.1% yield versus a duration matchedTreasury portfolio that yields about 0.45%. This spread is about average for the last decade,including the boom period in the early 2000s. On an options-adjusted basis, spreads are now onestandard deviation* below average.Among alternative asset types, we recently upgraded our weightings to real assets to overweightwith a desire to also fund from cash and Treasuries. We are buyers of gold, believing thatdeflationary forces will be tamed with money printing and see oil regaining some momentumby year end as China rebounds. Other real assets, especially direct ownership of real estatecontinue, to gain our attention given trends in rents and low financing costs. We would fundinvestments in real estate from cash and Treasuries as a way to turn negative real returnspositive. We believe that U.S. housing is bottoming and that price stabilization is takingroot, albeit slowly. Among hedged strategies, in the very short term we want to focus on non-directional approaches as a trading range bound market is better played with absolute returnvehicles like market neutral, merger arbitrage, relative value and global macro approaches. Thatsaid, once reflation takes hold by mid-2013 we anticipate wanting to position more favorablytoward equity long-short strategies and managed futures.Tactically, we would use expected volatility through year end opportunistically to slowlyleg in. As always, we maintain a total return perspective and remain focused on drawingincome from the best priced sources, which are increasingly equities. Tax managementalso remains a key concern as we anticipate some changes in 2013. Harvesting excessgains this year as we rebalance is advised.* A statistical measurement of how much variation or dispersion exists from the average. 4
  5. 5. CIO Reports THE MONTHLY LETTER This Month’s Feature: The Truth About Dividends It is easy to understand how the importance of dividends has faded from the forefront of investor preferences over the last 30 years. The greatest bull market ever in bonds—propelled in large part by the perfect storm of slowing global growth, falling inflation and historically low overall taxes on ordinary income—has meant that income investors have not had to look hard for the combination of wealth preservation, steady coupons and total returns. The most recent post-crisis era where historic central bank intervention has anchored interest rates across the curve has provided further assurances and a skew to the typical supply/demand relationships. Investor flows to bonds have almost completely mirrored the outflows to equities, suggesting that the “reach for yield” has created its own self- sustaining complacency. Even bond sectors once relegatedEXHIBIT 2: U.S. Treasuries Below 10 Year Maturities Provide No Real Returns Today... to professional investors like high yield and Emerging20.0% Market debt have benefited from the exuberance.18.0%16.0% As we have recently noted in our weekly CIO Views and our14.0%12.0% last month’s CIO Monthly Letter, A Bond Market Bubble?,10.0% we believe that we are approaching the final innings of 8.0% 6.0% this perfect storm for bonds. Reference Treasuries, and by 4.0% extension, credit and spread priced bonds are at historically 2.0% 0.0% low yields, providing virtually no after inflation return (see Exhibit 2). The recent announcement by the Fed to 40 45 50 55 60 65 70 75 80 85 90 95 00 05 10 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 10 Year Treasury Yield Federal Funds Rate 3 Month Treasury Yield shift its forward interest guidance to being driven by theSource: Bloomberg, Robert Shiller and ML GWM Investment Management & Guidance. unemployment rate and the two-year forward inflationData as of Dec. 18, 2012. expectations from a peg to the calendar (2015) is likely to be a catalyst to higher bond volatility. As investors begin to re-experience mediocre total after-tax returns from bonds,EXHIBIT 3: S&P 500 Dividend Yield Now Higher than the 10 Year Treasury for the First Time in Over 50 Years which our BofA ML Global Research team is forecasting 15 for 2013, they will search for the alternatives provided by 10 dividend paying stocks. 5 0 Dividends: A Strong Option for Income -5-10 Investors-15 Conventional wisdom in investing is that falling interest 1900 1920 1940 1960 1980 2000 rates are generally positive for stocks, as long as the falling Div Yield - Bond YieldSource: Robert Shiller and ML GWM Investment Management & Guidance. rates are not the result of recessionary growth or deflation. While this maxim has broadly been true in the five years since the 2007 financial crisis, the persistent fears andEXHIBIT 4: …And Comparable to the Investment Grade Yield safe haven flows to bonds have meant that bond yields 9% 8% have fallen much more than stock prices have risen. The 7% 6% implication for dividend-paying equities is that today they 5% 4% are about as cheap as they ever have been versus bonds. 3% 2% 1% On the one hand, we can look at the dividend yield on the 0% 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 S&P 500 Index, which is now higher than the yield on 10- Credit Yield - Div Yield year U.S. Treasury bonds, after 50 years of the reverseSource: FactSet and ML GWM Investment Management & Guidance. (see Exhibit 3). In the 1940s and 1950s this condition 5
  6. 6. CIO Reports THE MONTHLY LETTER persisted, favoring equity markets. But equally provocative EXHIBIT 5: Even Versus High Yield, Equities Are Relatively Cheap is the fact that dividend yields today are now comparable 14% 12% to investment-grade credit yields, a condition we have 10% 8% not observed since the corporate bond index was started 6% in the mid-1980s (see Exhibit 4, on the previous page). A 4% 2% similarly validating comparison that confirms that stock 0% 1986 1989 1992 1995 1998 2001 2004 2007 2010 multiples have not re-rated on the falling rates can be seen BofA ML US High Yield Master YTM - S&P 500 Earnings Yield in the comparison between the earnings yield (the inverse Source: FactSet and ML GWM Investment Management & Guidance. of the price/earnings (P/E) ratio) of the market and the current yield on the High Yield Index. Again, at historic spreads (see Exhibit 5). Said another way, if we look at the EXHIBIT 6A: Dividend Streams Are Consistently Less Volatile top decile of highest yielding dividend stocks in the S&P Than Earnings... 100% 500 Index, the mean and median credit rating of these 47 80% stocks today (three do not have rating) is BBB, with an 60% average yield of 5.07%. Consider the comparability of credit: % Growth YoY 40% 20% 0% the BofA Merrill Lynch U.S. BBB Index has a current yield -20% -40% of 3.5%, over 1.5 percentage points less than the equities. -60% -80% Within the credit space, investors would have to go to the -100% BB-B rating to receive a yield of over 5%. Essentially today, 1940 1950 1960 1970 1980 1990 2000 2011 S&P 500 Dividends Per Share (DPS) S&P 500 Earnings Per Share (EPS) through a dividend yield strategy, investors are receiving Note: The period December 2009 - June 2010 saw EPS growth between 200% to 800%. Past higher yields than comparable fixed income securities performance does not guarantee future results. It is not possible to invest in an index. Source: RBC Capital Markets Quantitative Research, Robert Shiller via Eaton Vance, and with better credit quality. A second factor supporting the use of dividends in an EXHIBIT 6B: And They Have Been a Quarter as Volatile in the Last 12 Years… income portfolio has to do with de-bunking myths about 50% 44.7% 45.6% volatility. In fact, as we illustrate in Exhibits 6A and 6B, 40% dividends per share have been roughly half as volatile 28.3% 30% as earnings over the last 80 years and a quarter of the 19.9% 18.0% 20% 14.9% 17.2% volatility in the last 12 years. In addition, returns from 9.6% 10.6% 10.4% 10% 4.2% 3.3% dividends have been consistent, with much more resilience 0% 1900-1919 1920-1939 1940-1959 1960-1979 1980-1999 2000-2012 to the economic cycle and GDP than many perceive (see Dividends Volatility Earnings Volatility Exhibit 6C). Equally important is that dividends are a Source: Robert Shiller and ML GWM Investment Management & Guidance. much better inflation hedge than fixed-coupon bonds. EXHIBIT 6C: Dividend Returns Are Resilient Versus GDP Growth Because dividend streams have grown on average almost 30% 9% (Compound Annual Growth Rate (CAGR)) over the last Negative and lowerS&P 500 Returns 20% growth environment 3% eight decades and have grown even more quickly in the 10% 4% 0% 4% 4% 3% 3% last three—averaging 25% per year; they easily outpace -10% inflation. Furthermore, dividend growth tends to accelerate -20% with inflation, in large part because companies often have -30% the power to pass on input price increases in a way that % 1% 3% 5% 6% 5% -1 4. 7. <= <= <= <= consumers and bondholders cannot (see Exhibit 7A and <= <= % 1% 5% -1 3% 6% 4. > > > > > Average dividend return (YoY) Average price return (YoY) Exhibit 7B, on the following page). U.S. Real GDP Growth Notes: Data from 1950, GDP = US real GDP growth lagged by 12m, returns on S&P 500 Source: Schiller data, Datastream, BofA Merrill Lynch European Investment Strategy. 6
  7. 7. CIO Reports THE MONTHLY LETTEREXHIBIT 7A: Dividends Have Outpaced Overall Inflation EXHIBIT 7B: ...And Dividend Growth Accelerates During Higher 4,600 Inflation Regimes S&P 500 4,100 Div per Share 10%Inflation Indexed to 100 3,600 +30 Fold ‘03 Tax Cut on 5% 3,100 in Dec. 1946 Dividends & 2,600 Cap Gains 0% 2,100 1,600 Inflation -5% +10 Fold 1,100 -10% 600 100 -15% 1946 1953 1960 1967 1974 1981 1988 1995 2003 2011 -20% S&P 500 Dividends Per Share (DPS) -20 to -15 to -10 -10 to -5 -5 to 0 0 to 5 5 to 10 10 to 15 15 to 20 Greater S&P 500 Earnings Per Share (EPS) -15 than 20 Average Dividend Per Share GrowthNote: Based on the S&P 500 Index versus the Consumer Producer Index, a widely used measureof U.S. inflation. It is not possible to invest in an index. As of Dec. 31, 2011.Source: Strategas Partners via Eaton Vance, Source: Robert Shiller and ML GWM Investment Management & Guidance. Dividends: A Historical PerspectiveEXHIBIT 8: Dividends Have Always Been a Major Source of Total Equity Returns on Performance Dividends Although it is convenient to suggest that the Price Percentage Percentage Dividend of Total Average case for dividend strategies is particularly Decade/Year Change Contribution Total Return Return Payout Ratio compelling today, the truth is that focusing 1930s -41.9% 56.0% 14.1% N/A 90.1% on dividend yield has always been an 1940s 34.8% 100.3% 135.0% 74.3% 59.4% advantageous strategy for investors who have 1950s 256.7% 180.0% 436.7% 41.2% 54.6% decided to take some risk. Dividend yield has 1960s 53.7% 54.2% 107.9% 50.2% 56.0% been a critical driver of wealth preservation 1970s 17.2% 59.1% 76.4% 77.4% 45.5% and wealth accumulation for equity owners. 1980s 227.4% 143.1% 370.5% 38.6% 48.6% 1990s 315.7% 117.1% 432.4% 27.0% 47.6% We illustrate just how significant dividends 2000s -24.1% 15.0% -9.1% N/A 35.3% are to equity returns in Exhibit 8. Avg. 104.9% 90.6% 195.5% 51.5% 54.6% Since 1926, dividends have contributed nearly 2011 0.00% 2.1% 2.1% 100% 26.9% half of the return on the S&P 500 Index. InNote: Past performance does not guarantee future results. It is not possible to invest in an index. Dividends’ percentageof total return is represented by “N/A” in class of either a negative total return or a negative input to total return. many decades, dividends were the differenceSource: Strategas Partners via Eaton Vance, between positive and negative total returns. Consider for example the 2000s. Over thisEXHIBIT 9: And Dividend Reinvestment Has Been a Multiplier to period, investors would have lost nearly one-quarter of their Total Total Returns and Wealth Accumulation investment in price terms. However, including the dividend $8,000 component, investors would have lost less than 10%. Equally $6,000 compelling is the power of dividends when reinvested $5,478 where their growth is compounded. For example, excluding $4,000 dividends, $1,000 invested in the S&P 500 in 1960 would be $2,000 $1,479 worth just over $22,000 today (or nearly $3,000 in real terms). $600 Including the reinvestment of dividends, that same $1,000 $0 1946 1953 1960 1967 1974 1981 1988 1995 2003 2011 invested in 1960 would be worth over $110,000 today (or over S&P 500 Index Total Return $14,000 in real, purchasing power, terms). Exhibit 9 illustrates S&P 500 Index w/o Dividends Inflation the point since 1970 using just $100 as a starting investmentNote: Inflation is represented by Consumer Price Index (CPI). Past performance does not guarantee where the dividend reinvestment strategy yielded 3.5 times thefuture results. As of Dec. 31, 2011.Source: Factset, Zephyr via Eaton Vance, wealth accumulation or a price return only strategy. 7
  8. 8. CIO Reports THE MONTHLY LETTER Over the longer term, dividend policy has also beenEXHIBIT 10A: Dividend Yield is an Effective Stock Selection Tool... an effective stock selection strategy. In fact, much of $1,000,000 value style investing and models such as the “dividend $100,000 discount model” are premised on this view. Using data $10,000 from academic economist Kenneth French, it can be seen $1,000 that higher yielding companies (Quintiles 4 and 5) have $100 outperformed (in total return terms with reinvesting $10 dividends) lower yielding companies (Quintiles 1 and 2). $1 Non-dividend paying companies are the clear laggard 19 7 19 2 19 7 19 2 19 7 19 2 19 7 19 2 67 19 2 19 7 19 2 19 7 19 2 20 7 20 2 20 7 12 2 3 3 4 4 5 5 6 7 7 8 8 9 9 0 0 in performance terms (see Exhibit 10A). This additional 19 19 Non Dividend Paying Quintile 2 Quintile 4 Quintile 1 Quintile 3 Quintile 5 return was achieved with lower risk too, resulting in far superior risk-adjusted returns (i.e., investors in the higherSource: Fama & French Database and ML GWM Investment Management & Guidance. quintiles are being better compensated for each unit of risk. (See Exhibit 10B).EXHIBIT 10B: …And Highest Yielders Have Often Achieved Superior Risk-Adjusted Returns When considering Non equities for income, the S&P 500 Dividend Price Index Paying Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5 natural preference is Compound annual return 9.50% 8.27% 8.73% 9.59% 9.48% 11.51% 10.76% to focus on the highest Value of $100 $220,418 $84,456 $120,996 $237,247 $216,318 $1,033,956 $583,803 yielding stocks in Standard deviation 15.97% 30.28% 20.74% 18.48% 18.83% 18.88% 21.16% the index. While this Sharpe ratio 25.70% 9.49% 16.06% 22.72% 21.66% 32.39% 25.37% has been a profitableSource: Fama and French, and ML GWM Investment Management & Guidance. strategy historically (as shown above), we can also highlight the importance of focusing on dividendEXHIBIT 11A: But Dividend Growth is Really the Most Lucrative growth. Strategy for Stock Selection...10% 9.4% 8.6% Consider for example a company currently yielding 3%. If 8% 8% 7.0% 7.0% 7.0% 7.0% 6% this company continued to grow its dividends at an annual 6% 4% 4% 1.4% rate of 10% for five years and had no change in price, its 2% 2% 0% -0.9% 1.4% dividend yield in five years’ time would be 4.8%. Using data -0.9% 0%-2% from the quantitative research firm Ned Davis Research, Dividend All Dividend- All Dividend Dividend Non-Dividend- S&P 500-2% & Initiators Dividend Paying Stocks All Dividend- Payers w/No All Dividend Cutters or Dividend Paying Stocks Non-Dividend- Index S&P 500 and looking over the last 40 years, the total return on Change in Eliminators & Initiators Paying Stocks Payers w/No Dividends Change in Cutters or Eliminators Paying Stocks Index “dividend growers and initiators” has significantly Dividends outperformed not only the broad S&P 500 Index butNote: Past performance does not guarantee future results. It is not possible to invest in an index.Note: Past performance does via Eaton Vance, www.eatonvance.comSource: Ned Davis Research not guarantee future results. It is not possible to invest in an index. “growers and initiators” beat the no-growth payers bySource: Ned Davis Research via Eaton Vance, close to 2.4 percentage points per year (see Exhibit 11A).EXHIBIT 11B: ...and Like the High Payers, the High Growers Are Better on a Risk-Adjusted Basis As can be seen in Exhibit 11B, the outperformance by Long “dividend growers and initiators” has also been true on a Term Long Long risk-adjusted basis, with the Sharpe Ratio on this section of Ann. Long Term Term Earnings Basket Total Term Sharpe Average Per the index being double the broad S&P 500 Index. Investors (1972 - 2012) Retun Volatility Ratio Yield Share have also not had to sacrifice yield pursuing a growth Dividend Growers & Initiators 9.5% 16.3% 0.31 3.2% 12.9% strategy as the long-term average yield on the “Growers All Dividend and Initiators” was higher than the broad index. 8.7% 17.1% 0.25 3.3% 10.1% Paying Stocks S&P 500 Total 6.9% 18.1% 0.14 2.9% 10.9% Return IndexSource: Ned Davis Research. 8
  9. 9. CIO Reports THE MONTHLY LETTER Dividends: The Outlook is Bright for GrowthEXHIBIT 12A: Currently High Dividend Yield Stocks are Very Expensive… Although much of our discussion thus far has focused on 18 the overall attractiveness of dividend paying and growing 16 equities as an asset class, current valuation dynamics that 14 12 have favored perceived quality and safe haven factors have 10 created an especially compelling opportunity in dividend 8 6 growth stocks. This theme has been a favorite of BofA ML 4 U.S. equity strategist Savita Subramanian. As she has 1990 1993 1996 1999 2002 2005 2008 2011 Median Fwd. P/E of Top Decile by Div Yield Average noted, from a valuation perspective, currently dividendSource: BofA ML Global Research and ML GWM Investment Management & Guidance. growth is also more attractive than dividend yield (seeEXHIBIT 12B: …While Dividend Growers are About as Cheap as Exhibit 12A). At present, the 12-month forward P/E of the They Have Been in 10 Years top decile of highest dividend yielding stocks on the S&P 24 500 Index are trading above their long-term average (see 22 20 Exhibit 12B), whereas the top decile of highest dividend 18 16 growing stocks are trading at nearly their cheapest in 10 14 years. The implication is that on a relative spread basis, the 12 10 discount on dividend growers is extreme. (See Exhibit 13). 8 1990 1993 1996 1999 2002 2005 2008 2011 And the prospects for further dividend growth ahead are Median Fwd. P/E of Top Decile by Div Growth Average quite solid given the huge cash hoards, the relatively weakSource: BofA ML Global Research and ML GWM Investment Management & Guidance.EXHIBIT 13: ...the Implication is that the Relative Spread Between EXHIBIT 14: Payout Ratios are Low… “High Payers” and “Growers” is Now Extreme 160% 40% 30% 140% 20% 120% 10% 100% 0% 80% -10% -20% 60% -30% 40% -40% 20% -50% 0% -60% 19 0 19 5 19 0 19 5 19 0 19 5 19 0 19 5 19 0 19 5 19 0 19 5 19 0 19 5 19 0 19 5 19 0 19 5 19 0 20 5 20 0 20 5 10 0 0 1 1 2 2 3 3 4 4 5 5 6 6 7 7 8 8 9 9 0 0 1990 1993 1996 1999 2002 2005 2008 2011 19 Premium of Div Yield to Div Growth Average S&P 500 Dividend Payout Ratio AverageSource: BofA ML Global Research and ML GWM Investment Management & Guidance. Source: BofA ML Global Research and ML GWM Investment Management & Guidance.EXHIBIT 15: ...and Free Cash Flow is Ample capital spending trends and the peak corporate profitability. $80 $70 As we have routinely noted, current payout ratios are at a $60 historically low level, running at 28% versus the long-run $50 history of about 50% (see Exhibit 14) and free cashflow is $40 ample (see Exhibit 15). In fact, year to date, 107 companies $30 in the S&P 500 have declared special dividends. But what $20 currently gives us the most confidence that dividends per $10 share will exhibit above-average growth ahead are the $0 growing prospects for corporate balance sheet re-leveraging. 19 5 19 6 19 7 19 8 19 9 19 0 19 1 19 2 19 3 19 4 19 5 19 6 19 7 19 8 20 9 20 0 20 1 20 2 20 3 20 4 20 5 20 6 20 7 20 8 20 9 20 0 11 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 0 0 1 19 S&P 500 Ex Financials Free Cash Flow Per Share One of the most noteworthy features of the post-crisis eraSource: BofA ML Global Research, FactSet, and ML GWM Investment Management & Guidance. has been the pristine quality of corporate balance sheets. 9
  10. 10. CIO Reports THE MONTHLY LETTER As we illustrate in Exhibit 16, non-financial debt levelsEXHIBIT 16: Corporate Balance Sheets are Underleveraged... remain broadly below average, despite the explosion in 34% the corporate bond flows. As BofA ML credit strategist 29% Hans Mikkelsen has pointed out, this huge demand from 24% investors has not been met with much net new issuance—a key factor driving spreads and overall yields way down. 19% The implication is that the current spread between the cost 14% 1994 1998 2002 2006 2010 of debt and the cost of equity for companies has become S&P 500 ex Financials Net Debt/Market Cap Average provocative, providing an incentive to re-leverage theSource: S&P, BofA Merrill Lynch US Equity & US Quant Strategy and ML GWM Investment balance sheet for the benefit of equity shareholders at the Management & Guidance. expense of bondholders (see Exhibit 17). Re-leveraging, where it takes the form of direct dividend increases or shareEXHIBIT 17: ...and the Spread in the Cost of Debt and Equity is Now repurchases, which reduces the share count, is likely to Provocative for Shareholder Friendly Re-Leveraging 10 2.5 positively support dividend per share growth. 9 8 2.0 Dividends: Don’t Worry About Tax Policy 7 6 One of the key objections we hear from clients over the last 1.5 5 six months is that they worry that tax rates on dividends 4 1.0 3 will rise—not only hurting after-tax returns but hurting the 2 0.5 overall attractiveness of the asset class. Our perspective is 1 0 0.0 that these concerns are overblown. Specifically, our work suggests that while changes to the tax code may have real 19 0 19 1 19 2 19 3 19 4 19 5 19 6 19 7 19 8 20 9 20 0 20 1 20 2 20 3 20 4 20 5 20 6 20 7 20 8 20 9 20 0 20 1 12 9 9 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 0 0 1 1 19 Cost of equity (x) % of Equity consequences at an individual level that prompt explicit Cost of Debt (x) % of Debt Ratio of kd/ke, rhs tactical decisions (and we would point to our 2012 Tax GuideSource: BofA ML Global Research and ML GWM Investment Management & Guidance. for suggestions); medium-term macroeconomic impacts and thus implications for the capital markets are basically non-existent. Warren Buffett’s common-sensical perspective from his November 25, 2012 New York Times op- ed makes the point that market conditions, cost of capital and valuations dictate capital market outcomes much more than tax rates. And on this score, history is a terrific empirical guide. To illustrate the impotence of tax policy to drive capital market outcomes, we can first point to the period between January 2003 and today—the era of the Bush tax cuts when marginal rates have been among the lowest in history. In addition, dividend tax rates have been at a 70-year low rate of 15%. In both instances, for overall stocks and dividend payers, total returns have been the most disappointing in the post-World War II era. During the last episode of fundamental tax reform—the Reagan tax cuts—marginal rates declined but capital gains and dividend tax increased to roughly 25-28%—not far off from some potential scenarios for the current fiscal cliff negotiations. At that time, stocks were accelerating into their fourth year of what would prove to be the longestEXHIBIT 18: Higher Tax Rates on Dividends Didn’t Inhibit Returns bull market in U.S. history. Finally, when we look at the in the Clinton Era or Help Them in the Bush Era Clinton era—a period when both marginal rates and S&P Index Annual Highest Yielders dividend tax rates were nearly double today’s level—it is Returns Annual Return notable that not only did the market soar, but in fact the Clinton Era (1993 - 2003) 10.0% 13.3% highest yielding quartile of stocks outperformed the broad Bush Era (2003 - present) 6.5% 6.3% market by more than four percentage points (see ExhibitSource: Bloomberg and ML GWM Investment Management & Guidance. 18). Not only that, but work by academic economists Eugene 10
  11. 11. CIO Reports THE MONTHLY LETTER Fama and Kenneth French recently confirmed that after-EXHIBIT 19: …and Simultaneous Tax Hikes Didn’t Hurt Either tax equity returns for the highest dividend payers in the Total Returns Before & After 1990 Dividend Tax Increase Clinton era were two times those most recently experienced -3M -1M +1M +3M in the era of Bush tax cuts. Looking at 1990 and 1993, Dividend Aristocrats** -4.6% 3.3% 7.1% 15.2% periods where ordinary income rates and dividend tax S&P 500 -7.8% 1.3% 5.3% 12.7% rates increased simultaneously as may be the case in Aristocrats Rel S&P 3.2% 2.0% 1.8% 2.5% 2013, we can also see that post the tax increase, dividend Total Returns Before & After 1993 Dividend Tax Increase “aristocrats”** outperformed the broad (see Exhibit 19). -3M -1M +1M +3M Another argument of the tax hysterics is that it is warping Dividend Aristocrats** -1.1% -0.1% 3.2% 4.0% corporate behavior. While media like the Wall Street Journal S&P 500 2.2% 0.5% 3.0% 3.9% have hyped the fact that 103 companies in the S&P 500 have Aristocrats Rel S&P -3.3% -0.6% 0.2% 0.1%Source: Strategas Research Partners declared special dividends in front of the likely tax hikes— we think this has as much to do with the fact that American companies today are drowning in excess cash as it suggests that they are so worried about tax policy. To this point, recent work published by Yale University Professor Robert Shiller suggested that dividend growth rates—or the rate at which corporations increase their dividend—were also completely independent of tax policy, with overall growth, margin levels and cost of capital much bigger drivers of corporate decision making. Why are these policies so irrelevant at a macro level? In large part because of market structure. As we continue to note, less than 35% of all stock market capitalization is directly owned by individual investors. Most capital is held in tax deferred accounts, beneficial institutional accounts or by relatively tax insensitive mutual funds. PREVIOUS CIO MONTHLY REPORTSDATE TITLE TOPIC WHAT WE ARE BUYINGNov. 2012 A Bond Market Bubble? Bond Market SemiconductorsOct. 2012 The Case for Equities Equities Japanese EquitiesSept. 2012 Rethinking Emerging Market Portfolios Emerging Markets U.S. FinancialsJul. 2012 G-Zero and the Borderless Portfolio: A Roadmap for the Next Decade A leaderless G-Zero world (Selling) Sovereign BondsJun. 2012 Election 2012 and the “Fiscal Cliff”: Playing Possum U.S. election and the fiscal cliff GoldMay 2012 The Unsung Hero: Corporate Profits Corporate profits Select German equitiesApr. 2012 Here Come the Judge(s) Healthcare costs EnergyMar. 2012 (Energy) Shock Absorbers Rising oil prices Dividend growersFeb. 2012 A Look at U.S. Housing: Curing What Ails Us U.S. housing market U.S. technologyJan. 2012 2012: China’s Year of the Water Dragon Growth in China Municipals ** The S&P 500® Dividend Aristocrats Index measures the performance of large cap, blue chip companies within the S&P 500 that have followed a policy of increasing dividends every year for at least 25 consecutive years. 11
  12. 12. CIO Reports THE MONTHLY LETTER THE CIO TEAM Lisa Shalett, GWIM CIO and Head of Investment Management & Guidance • 212-449-0544Spencer Boggess, Tom Latta, Anil Suri, Chris Wolfe,CIO, Alternative Investments Global Head, Traditional Manager Due Diligence CIO, Multi-Asset Class Modeled Solutions CIO, PBIG and Ultra-High Net Worth Customized212-449-3043 201-557-0258 212-449-3385 Solutions 212-236-3159Jim Russell, Rick Galiardo, Bill O’Neill, Victoria Ip,CIO, Portfolio Construction and Multi-Manager Global Head, Advice, Guidance and Marketing CIO, EMEA Chief Investment Strategist, Asia-Pacific RimSolutions Strategy 44-20-79955745 852-3508-5305201-557-0079 212-449-3348GWM Investment Management & Guidance (IMG) provides industry-leading investment solutions, portfolio construction advice and wealth management guidance.This information and any discussion should not be construed as a personalized and individual client recommendation, which should be based on each client’s investmentobjectives, risk tolerance, and financial situation and needs. This information and any discussion also is not intended as a specific offer by Merrill Lynch, its affiliates,or any related entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service. Investments and opinions aresubject to change due to market conditions and the opinions and guidance may not be profitable or realized. Any information presented in connection with BofA MerrillLynch Global Research is general in nature and is not intended to provide personal investment advice. The information does not take into account the specific investmentobjectives, financial situation and particular needs of any specific person who may receive it. Investors should understand that statements regarding future prospects maynot be realized.Asset allocation and diversification do not assure a profit or protect against a loss during declining markets.The investments discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to eventsspecific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks. Investmentsin high-yield bonds may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher rated categories. Investments in foreign securitiesinvolve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified forinvestments made in emerging markets. Investments in a certain industry or sector may pose additional risk due to lack of diversification and sector concentration. Investments in realestate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and riskrelated to renting properties, such as rental defaults. Market-Linked investments have varying payout characteristics, risks and reward, investors need to understand the characteristicof each specific investment, as well as those of the linked asset. There are special risks associated with an investment in commodities, including market price fluctuations, regulatorychanges, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors.Alternative Investments are speculative and subject to a high degree of risk. Although risk management policies and procedures can be effective in reducing or mitigating the effects ofcertain risks, no risk management policy can completely eliminate the possibility of sudden and severe losses, illiquidity and the occurrence of other material adverse effects. Some or allalternative investment programs may not be suitable for certain investors. Many alternative investment products, specifically private equity and most hedge funds, require purchasers tobe “qualified purchasers” within the meaning of the federal securities laws (generally, individuals who own at least $5 million in “investments” and institutional investors who own at least$25 million in “investments,” as such term is defined in the federal securities laws). No assurance can be given that any alternative investment’s investment objectives will be achieved.In addition to certain general risks, each product will be subject to its own specific risks, including strategy and market risk.Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S) and other subsidiaries of Bank ofAmerica Corporation.Investment products offered through MLPF&S: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value© 2012 Bank of America Corporation. All rights reserved. ARD0AE9E 12