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    2nd Qrt 2010 8 Page Final 2nd Qrt 2010 8 Page Final Document Transcript

    • Helping You Navigate in an Uncertain Investment World 2nd Quarter 2010 Do Stock Investors Earn More from Capital Gains or Dividends? Volume 11 Issue 2 The Answer May Surprise You Inside this issue: “In the long run, we are all dead.” tors pooled individual asset classes into broad indexes –John Maynard Keynes (think S&P 500 index fund for example) an investor could, again theoretically, create a portfolio that would achieve Do Stock Investors Earn More From Capital Gains or Dividends? Defending Cash 1 2 I F YOU HAVE BEEN INVESTING for awhile, you’ve invariably run across the conventional wisdom re- garding historical stock market returns. Over the last more consistent, higher annual returns with less “risk.” Assuming again, as noted, an investor has a long enough time-frame. Markowitz even gave us a whole 50 years or so, the mantra on Wall Street has been that new Greek alphabet soup of portfolio measures such as Inflation Adjusted Market if you hold stocks long enough, you’ll eventually earn alpha, beta, gamma, and delta to construct these more 4 Returns 1880-2010 somewhere in the neighborhood of 10% annually. The efficient portfolios and measure returns. returns breakdown along the lines of 6% annually from The final ingredient in this new magical formula, Inflation Adjust Growth of a $ 5 capital gains and 4% annually from dividends. we’re told, is we must assume that financial markets are Market Returns In times of stock market turmoil (like the last 10 efficient. That is, that the current market price of a Month End Dividend Yield for years?), Wall Street gurus and mutual fund sales depart- stock reflects everything that is known and knowable 6 about the company. This “efficient” market hypothesis the S&P 500 Index ments tell us to take a deep breath and remain calm— even while we watch our stock portfolio get summarily also applies to the market as a whole. Implied in the Equity Income Portfolio 2nd Qrt wacked 40%! Again, the key to investing success, we’re efficient market notion is the fact that, by definition, it’s 2010 Update 7 impossible for an investor to “beat” the stock market by told, is that if we just hang in there long enough, no matter what the economic or market circumstances, seeking out information other investors do not have. Deschaine & Company, L.L.C. we’ll eventually earn a decent rate of return. The undy- Over the last 50 years, Modern Portfolio Theory has become the gold standard of investing—at least for A REGISTERED INVESTMENT ADVISOR ing belief in this seemingly reliable and predictable long -term 10% annual return from stocks has been driven, at large institutions like pensions and endowments. An World Headquarters least in part, by what’s called “Modern Portfolio The- institutional investment advisor rarely gets fired for using MPT to manage institutional portfolios because if Deschaine & Company 128 South Fairway Drive ory,” or “MPT” for short. MPT began in the early 1950s by Dr. Harry M. properly implemented, MPT all but guarantees market Belleville, Illinois 62223 is an SEC registered Markowitz who wrote a series of essays on portfolio “like” investment returns. Meaning, an MPT managed Phone: (618) 397-1002 investment advisor, management theory for which he received the Nobel portfolio isn’t likely to stray too far from the returns of mark@deschaineandcompany.com managing approxi- Prize in economics.(1) Markowitz mathematically dem- the overall market index it’s trying to mimic. Further, if marnie@deschaineandcompany.com mately $70 million for onstrated that it was possible (at least theoretically) to the stock market goes down say 15%, and an MPT man- Maryville Office pensions, endowments, combine different asset classes into a portfolio that aged portfolio is down “only” 12%, the investment man- ager has “beaten” the “market.” Such superior “relative” could provide more consistent returns than one in- and individuals.Loyd Jason performance—beating the market, even though the vested in a single asset class—likes stocks. While this (618) 288-2200 seems almost intuitive today, in 1952 it was an fairly portfolio lost money—is likely to get the manager re- jason@deschaineandcompany.com warded with more assets under management. novel concept. The essential tenet behind MPT is this: Highland Office if you diversify a portfolio across different asset classes Wall Street has pushed all this highfalutin aca- such as stocks, bonds, real estate, timber, oil and so on; demic portfolio theory down to individual investors, and Matt Powers the portfolio will grow more consistently—over time— consequently, we think, instilled a false sense of statisti- (618) 654-6262 cal certainty regarding potential returns from stocks. matt@deschaineandcompany.com than one that’s concentrated in just one asset class. The operative words in the previous sentence are “over time.” Instead, what’s clear from market history is there have We’re on the Web at: A second important tenet of MPT is that if inves- (Continued on page 4) 1) Milton Friedman was un-impressed with MPT, and according to Markowitz’s himself, Friedman said, “Harry, what’s this? It’s not mathematics, it’s not economics, and it’s not finance.”
    • Page 2 2nd Quarter 2010 Viewpoint VIEW FROM THE FRONT SEAT by Mark J. Deschaine In Defense of Cash: In a risky world, cash is the least risky investment. W ITH SHORT-TERM INTEREST RATES near zero, investors are stressed about where to invest idle cash. Chart 1: Depression Era Cash & Stock Returns $1.10 S&P 500’s dividend yield will increase from it’s current $1.11 $1.20 $1.30 $1.00 Investors’ angst over low cash yields $0.90 yield of about 2.2% only grew more acute as they watched $0.80 to over 6.0%, while $0.70 global stock markets post double digit $0.60 our EQUITY IN- returns over the last year. The S&P 500 $0.50 COME Portfolio’s yield (currently about Index, for example, was up 79% from $0.40 6.0%) could rise to over 10%. I know that $0.30 March 9th, 2009 through April 23, 2010. Cumulative Returns for 10-Year Treasury Notes $0.20 sounds crazy, especially when we’re Comparing a 79 % return on stocks to a compared to the S&P 500, October1929 to July 1932. $0.20 $0.10 staring at near zero short-term interest paltry ½ percent or less in money mar- $0.00 rates, but again, that’s what stock mar- 1929‐09 1929‐11 1930‐01 1930‐03 1930‐05 1930‐07 1930‐09 1930‐11 1931‐01 1931‐03 1931‐05 1931‐07 1931‐09 1931‐11 1932‐01 1932‐03 1932‐05 1932‐07 ket funds will ruffle most investors’ ket history tells us. feathers—including ours, we’ll admit. In fact, since I was lucky enough Still, I’m here to tell you, it’s pre- to begin my career in April 1979, I cisely this lethal combination of impatience and yearning for better experienced firsthand the last high dividend yield cycle which occurred returns that time and again leads investors to take on extra risk (usually roughly from 1978 to 1985. During that period, investors could’ve without knowing it) in search of marginally higher yields. It’s called bought stocks with dividend yields in the high single digits across a “reaching for yield.” The flaw in investors’ decision making process is whole range of quality companies. that it is almost always based on past returns. Back to the issue of holding cash in a low-yield environment. It’s As VIEWPOINT readers know, easy to lament earning meager yields we’ve advocated holding relatively high $3.00 Chart 2: 1966-1982 Bear Market Cash & Stock Returns on your cash as you look at your ac- levels of cash (an average of 20%) for $2.49 count statement each month. It’s much much of the last 10 years primarily as $2.50 Cumulative Returns for 90-day Treasury Bills harder to accept that even with low protection against the secular bear mar- $2.00 compared to the S&P 500, December 1966 to July 1982. yields, over a long-term bear market, ket. And as Chart 3 shows, it’s been a cash is usually a winning strategy. Let’s good strategy—even with low yields. $1.50 compare the three most significant bear We continue to recommend hold- market—cash verses stock returns—of ing a relatively large cash position be- $1.00 $1.14 the last 80 years. cause we remain bearish on the long- $0.50 term outlook for the stock market. His- The 1929-1933 Deflationary Experience tory tells us the stock market makes a $0.00 In the Great Depression, from 1929 to 1933, the stock market dropped a whop- Apr‐72 Apr‐77 Sep‐72 Feb‐73 Sep‐77 Feb‐78 Jun‐71 Jul‐73 Jun‐76 Jul‐78 Jun‐81 Dec‐68 Mar‐70 Dec‐73 Mar‐75 Dec‐78 Mar‐80 Oct‐69 Aug‐70 Oct‐74 Aug‐75 Oct‐79 Aug‐80 Jan‐71 Nov‐71 Jan‐76 Nov‐76 Jan‐81 May‐69 May‐74 May‐79 long-term market bottom when divi- dend yields are somewhere north of 6.0% ping 89% as economic activity dropped and Price/Earnings ratios are between seven and ten times earnings. over 30% from a complete collapse of With a dividend yield on the S&P 500 about 2.2% and a P/E ratio of 18, international trade. Such a precipitous drop in economic actively the market’s a long way from a secular bear market bottom. caused prices to drop over 25% as deflationary forces kicked in. Over You math whizzes out there will quickly calculate that for the the same period, 10-Year Treasury Notes(3) produced what by today’s stock market to yield 6.0% requires either a drop in stock prices of standards would likely be considered a relatively meager 3.65% annual about 60% from current levels, or a tripling of the cash dividend, or return. Yet, an investor smart enough (or lucky?) to have pulled all their some combination of the two. Before you concern yourself with the money out of the stock market in the fall of 1929 and plunked it into 10 prospects of a sudden or steep drop in stock prices, let me assure you -year treasuries would’ve not only successfully preserve their wealth that secular bear market bottoms are usually reached after a long and they would’ve had valuable capital to accumulate stocks at less then 20 bumpy ride for stocks rather than any dramatic or sharp plunge in cents on the dollar in 1933. (See Chart 1) share prices. Small consolation to many of you, I’m sure, but that’s Legend has it that Joe Kennedy, patriarch to the Kennedy political what stock market history tells us. After dynasty, did just that after a shoe shine more than 10 years since the stock mar- $1.30 Chart 3: 2000-2010 Bear Market Cash & Stock Returns $1.24 boy, supposedly gave him a stock “tip” ket peaked in March 2000, I’d suggest $1.20 in September 1929. Figuring that if the bear market’s right on schedule.(2) shoe shine boys were now investing in $1.10 An investor looking to build future the stock market it had to be getting income by capturing higher yields $1.00 near a peak, so Joe proceeded to sell all should consider the relentless share $0.90 his stocks and buy U.S. Treasury secu- price declines that occur in bear mar- $0.80 $0.82 rities complete sidestepping the stock Cumulative Returns for kets a huge bonus. Such an environment $0.70 market crash. Joe than began to buy 90-day Treasury Bills results in higher yields for companies $0.60 compared to the S&P 500, stocks in 1933 and 1934, building the with a history of raising their divi- $0.50 December 2000 to May 2010. family fortune in the process. dends—in both good times and bad. $0.40 If stock market history plays out as Dec‐00 Dec‐01 Dec‐02 Dec‐03 Dec‐04 Dec‐05 Dec‐06 Dec‐07 Dec‐08 Dec‐09 Aug‐01 Aug‐02 Aug‐03 Aug‐04 Aug‐05 Aug‐06 Aug‐07 Aug‐08 Aug‐09 Apr‐01 Apr‐02 Apr‐03 Apr‐04 Apr‐05 Apr‐06 Apr‐07 Apr‐08 Apr‐09 Apr‐10 we expect over the next decade, the (Continued on page 3) 2) And I’m not trying to be flip. It just seems to me it is right on schedule. 3) I used the 10-year Treasury Note in this example for two reasons. First, I was unable to find 90-day Treasury bill data for the 1929-1933, and second, in a deflationary period, owning the highest quality, intermediate maturity fixed income security is probably as good an investment strategy as we could suggest.
    • Page 3 Deschaine & Company, L.L.C. (Front Page continued from page 2) Notes during deflationary periods holds pur- Comparing Annual Returns for Stocks With chasing power as prices decline. Once prices “Cash” During Three Long-Term Bear Markets Clearly, cash, or in this case 10-Year Treasury stabilize, you’ll have buying power to accumu- Notes, was the investment of choice during the Period Stocks Cash late all sorts of assets—from stocks to real 1929-1933 bear market period. 1929-1933 - 42.48 3.65 estate to that large boat you’ve always wanted. 1966-1982 -2.78 7.47 All at bargain prices. Assuming, that is, you The 1966 to 1982 Inflationary Experience 2000-2010 -2.07 2.29 didn’t get antsy and invest your cash in some Almost the exact opposite investor experience risky investment looking for an extra ½ in occurred during the 1966 to 1982 bear market. increases relative to the supply of goods in an yield just before it plunged. Rather than a steep stock market plunge economy, inflation is the result. Given the It’s times like these that its important to driven by a sharp, deflationary economic con- money growth over the last year, it wasn’t a ques- keep in mind the primary purpose of cash is to traction, the 1966 to 1982 bear market was a tion of “if” inflation would kick in, but “when.” preserve your capital—not to make you rich in slow, methodical inflationary grind on inves- However, when you look at the negative times of high risk—like now. tors. Over the sixteen year period, inflation credit data coupled with what is clearly a weak slowly yet relentlessly inched up causing an recovery, it’s not hard to construct a scenario Editor’s comment: It was pointed out to me by inflation-adjusted drop in stock prices of over where debtors continue to default, particularly my esteemed colleagues, Matt and Jason, that this 30%, from 1966 to the market bottom in 1982. in housing and commercial real estate causing issue’s Front Seat column was decidedly pro-cash The worst stock market performance period lenders to completely shut down lending and anti-stock. Or as Matt noted eloquently: “it since the Great Depression. Over the same (doing all they can to keep from going bankrupt appears you are telling the reader to stay away period, 90-day treasuries returned a healthy themselves) and in turn causing a contraction in from the stock market.” However, that was cer- 7.5% per year. Which sounds good, and cer- credit for the first time since the early 1930s. tainly not what I intended. tainly is good when compared to the devastat- Each dollar of credit written off in a de- The objective of the article was to note two ing capital losses posted by stocks during the period, yet inflation during the period aver- Interest Rates During the Long-Term Bear Markets things. One: that even in a low yield environment, cash serves an important purpose in protecting a aged 6.8%. Consequently, cash actually earned Period Beginning Middle End portfolio from an indiscriminate and uncaring a meager annual return of about 1% after ad- 1929-1932 3.39 3.37 3.50 stock market. And two, cash provides readily justing for inflation. 1966-1982 5.96 5.61 11.35 available buying power as the stock market peri- Even with such paltry real returns, cash was again the hands down winning investment odically offers up quality dividend stocks at at- 2000-2010 5.77 1.26 (Double digits?) strategy during the 1966-1982 inflationary tractive yields. I was attempting to point out that Note: 1929-1933 is the 10-Year U.S. Treasury Note, the holding cash, even when it may not be yielding bear market period. By the end of the 1982, 90 other two periods is the 90-Day U.S. Treasury Bill rate. much, serves an important purpose within a port- -day Treasury Bills were yielding over 12% and investors thought they were being savvy fault is a dollar that evaporates from the folio. At no time have we or would we, suggest putting a big chunk of their assets in money money supply. If loan defaults overwhelm the being completely out of the stock market. As the market funds and short-term CD’s. (See Chart 4) government’s efforts to re-inflate the econ- last year or so shows, the opportunity costs of being What most investors didn’t realize was they omy; a deflationary spiral could result. When 100% in cash can be considerable when the stock were at the bottom of the cheapest stock mar- you consider the total amount of bad debt market stages one of its random rallies. ket since the 1930s. outstanding, it’s not hard to see how deflation As readers of Viewpoint know well, we are might happen. If that happens, we need only to long-term owners of quality stocks that pay a The 2000 to 2010 Experience look to Japan’s experience since 1989. To see generous and growing dividend. Once we buy a (Inflation or Deflation?) the consequences of deflation—zero economic stock we’ll continue to own it, come what may, as The central question is: “will exploding federal growth over the last two decades. long as its dividend remains intact. We only sell a spending and money supply growth kick off Yet, whether we get inflation or deflation, stock if the company cuts the dividend—regardless inflation? Or will mortgage defaults, unem- as history shows, one investment strategy is at of reason—0r if the stock gets way over valued.(5) ployment and slack consumer spending bring least part of the answer—hold cash. Hold cash Over the next ten years, our objective is to on lower prices and by definition, “deflation.” during an inflationary period to capture higher accumulate as many shares as possible by reinvest- I’ll be honest, I don’t know. After spend- interest rates as short-term interest rates rise ing dividends and by investing the portfolio’s cash ing most of the last two years trying to get a in response to inflation. Investing in quality reserves in the most attractive stocks that are handle on the credit crisis, and the govern- investments like U.S. Treasury Bills and available each time we buy. ment’s and Federal Reserve’s 16.30  If we do our job well, by the 17.00  reaction to it, my initial expecta- 16.00  Chart 4: Monthly Yield for 90-day Treasury Bills 15.20  end of the decade, our portfolios tion was that inflation was the 15.00  from December 1966 to July 1982, compared to should be fully invested in dividend logical result of an unparalleled 14.00  the period of December 2000 to May 2010. 13.00  stocks with a yield on invested capi- growth of the money supply we 12.00  Are interest rates going higher? tal of over 10%!(6) From there, all we charted in our “Year End Eco- 10.00  11.00  11.35  nomic and Financial Market Out- 9.00  have to do is kick back, find a quiet look.” (4) After all, as Milton 8.00  spot on the beach and watch our Freidman noted, “inflation is 6.00  7.00  7.07  dividend income roll in. always and everywhere a mone- 5.00  To achieve that requires tary phenomenon.” Put another 4.00  being invested in quality dividend 3.00  way, inflation is defined as: “too 2.00  stocks and buying more with each much money chasing too few 1.00  0.15  dividend as the bear market winds ‐ goods.” If the supply of money down! Apr‐72 Apr‐77 Apr‐82 Sep‐72 Feb‐73 Sep‐77 Feb‐78 Jun‐71 Jul‐73 Jun‐76 Jul‐78 Jun‐81 Dec‐68 Mar‐70 Dec‐73 Mar‐75 Dec‐78 Mar‐80 Oct‐69 Aug‐70 Oct‐74 Aug‐75 Oct‐79 Aug‐80 Jan‐71 Nov‐71 Jan‐76 Nov‐76 Jan‐81 Nov‐81 May‐69 May‐74 May‐79 4) Available on deschaineandcompany.com. 5) On occasion, a stock’s share price will rise to a level (and subsequently its dividend yield will drop) that is so far out of whack with it’s historical averages that it no longer justifies holding onto the stock. 6)“Yield on invested capital,” is the current dollar dividend at an annual rate divided by our total cost of the position.
    • Page 4 2nd Quarter 2010 Viewpoint 10.00% Chart 5: Inflation Adjusted Accumulative Annual Returns for the S&P 500 Index by Dividend and Capital (5) 1880 to 2010 9.00% 8.00% Data Source: Standard & Poor’s and Robert Shiller. Chart Deschaine & Company Research 7.00% 6.00% 4.87% 5.00% 4.00% 3.00% 2.00% 0.92% 1.00% 0.00% 1884 1886 1888 1890 1892 1894 1896 1898 1900 1902 1904 1906 1908 1910 1912 1914 1916 1918 1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 1942 1944 1946 1948 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 ‐1.00% ‐2.00% (Continued from page 1) ual investor behavior contend most investors do ultimately determines your investment returns. been long periods where the stock market did not not give their investment program enough time. The question is, “how does the owner get his (or grow at all, let alone 10 percent. We would argue the problem may be that indi- her) hands on the cash and when?” The “how” is vidual investors have a different time frame than either in the form of cash dividends and/or capi- An Inefficient, “Efficient” Stock Market the extremely long one required to achieve the tal returns from selling shares—ideally after Consider too, that while the MPT driven notion annual returns implied under MPT theory. Not they’ve appreciated in value. The “when,” of of “relative” performance may be okay for institu- only that, but such an abstract investment con- course, is “the sooner, the better.” tional investors who can wait to years recoup cept becomes increasingly less relevant to indi- All things being equal, an owner or inves- loses, an individual investor, particularly one in vidual investors as tors prefers a busi- or getting close to retirement, can’t incur signifi- they get closer to “Compound interest is the eighth wonder of the ness that: a) pro- cant capital loses and doesn’t have the luxury of retirement. world. He who understands it, earns it ... duces more cash waiting years for his portfolio to recover. Consider, he who doesn’t ... pays it.” — Albert Einstein rather than less; b) For MPT to work it requires giving it that in a long- produces cash time—lots of time. Decades in fact. How many of term, secular bear market, like the one we’ve that’s available to be distributed to the owners/ you are willing (or able) to wait for a mutual fund been in since 2000, a retired investor cannot shareholders, sooner rather than later; and c) that’s been going down for several years in a possibly win at the stock market game if they’re produces cash that is “predictable” rather then row, like many technology funds were in the following a strategy, such as espoused by MPT, unpredictable, or even “unknown.” early part of the decade, to make a comeback? that requires a 25-40 year time frame. Put an- In all three cases, the present value of quar- Nevertheless, mutual fund managers will always other way, investing one’s portfolio on a long- terly cash dividends is worth more (a lot more) to tell you now is a good time to buy, just as they term bet that the stock market will always earn an owner than the uncertainty of any cash they probably did six months ago, a year ago and even 10%—assuming you wait long enough—is nei- may received from capital sales (or again, even ten years ago. In the fund manager’s mind, it’s ther practical nor rational—if your time horizon losses?) at some unspecified point in the future. never time to sell. Every dip is just a prelude to a isn’t 25-40 years. Especially if your retirement Given such economic realities, it should be new high. Modern Portfolio Theory says so, happens to correspond with the beginning of a obvious that stocks that pay a steady and grow- again, if you just give it enough time. secular bear market. ing quarterly dividend have more economic value However, had you put your money in a to investors (i.e. owners) than stocks (or businesses) technology or Internet mutual fund in March Doing What Works in Generating Returns that rely solely on capital returns. Not only has 2000, you’re not only underwater, its likely you’ll “Business is taking a pile of cash, doing something this been confirmed by numerous academic stud- never ever see a positive return from that invest- with it, to get a bigger pile of cash in the end.” ies which show that dividend-paying stocks con- ment. In addition, as we’ve documented, in detail —Leonard P. Shaykin sistently outperform the average stock, but that here in VIEWPOINT, the stock market’s not been stocks with a rising dividend have, in most stock a friend to investors over the last ten years. Re- Often lost in the academic world of MPT invest- market periods, rank among the highest perform- member, the NASDAQ composite index is still ing, is the notion that a stock represents the frac- ers. When you think about it, all the academic down more than 55% from its 2000 high. tional ownership of an ongoing, operating studies are really doing is confirming the present “business.” And just as any owner of any busi- value of discounted cash flows from dividends Doing What Works-In time ness, a stock investor is looking to get his hands compared to capital returns. In other words, the Paradoxically, most academic studies of individ- on the cash the business produces. Because you see it’s the “cash” the business produces that (Continued on page 5) 5) Since the long-term superior performance of stocks over bonds is almost a given, its a wonder why dividend investing ever fell out of favor with investors? XX) The chart shows the accumulated annualized returns for dividends and capital returns for the S&P 500 going back to 1880. For example, from 1880 through June 30, 2010, total return for the S&P is just under 6%, about 1.5% annually from capital and 4.5% from dividends. See the bar to the far right of the chart. If we add the average annual inflation rate for the 130 year period the annual returns get close to the historical 10% average discussed in the history books.
    • Page 5 Deschaine & Company, L.L.C. 14.00  13.00  Chart 6: Inflation Adjust Growth of a Dollar Invested in the S&P 500 Index 13.08  1880 to 2010 12.00  11.21  11.00  Data Source: Standard & Poor’s and Robert Shiller. Chart Deschaine & Company Research 10.00  9.00  From 1880 to the early 1960’s the S&P 500 index produced little in the way of capital returns. A dollar invested in 1880 was worth 89 cents after adjusting for inflation. How’s 8.00  that for long-term capital returns? With the exception of the 1920s bull market, an in- 7.00  vestor had to wait until the late 1960s to see any significant capital returns from stocks. 7.68  Or a modest 80 years! Prior to the 1920s stocks were considered the “income” investment 6.96  6.00  because of their generous dividends. Bonds were the risky alternative. 5.00  4.53  5.42  4.63  4.00  2.75  3.00  2.00  1.65  1.71  1.00  0.74  0.89  Positive Capital Negative Positive Capital Negative Capital 0.53  0.53  ‐ 1881 1882 1884 1885 1887 1888 1890 1892 1893 1895 1896 1898 1900 1901 1903 1904 1906 1907 1909 1911 1912 1914 1915 1917 1919 1920 1922 1923 1925 1926 1928 1930 1931 1933 1934 1936 1938 1939 1941 1942 1944 1945 1947 1949 1950 1952 1953 1955 1957 1958 1960 1961 1963 1964 1966 1968 1969 1971 1972 1974 1976 1977 1979 1980 1982 1983 1985 1987 1988 1990 1991 1993 1995 1996 1998 1999 2001 2002 2004 2006 2007 2009 2010 2012 2014 2015 (Continued from page 4) A Further Look Into What Works Ibbotson study—the proportion of return attrib- stock market clearly prefers the relative cer- Sungard strategist Gail Dudak noted in 2002, uted to reinvesting dividends represents 96.2% of tainty of cash dividends over the uncertainty of after one of the many accounting scandals; “Only total return from common stocks.(6) unknown future capital returns. Why would companies with real cash flow and real earnings are Raver talks about the difficulty investment anyone argue with that? able to consistently pay dividends to investors. Divi- managers have in delivering value-added invest- dends are a financial commitment from a company. ment performance. He points out that the typical equity portfolio has a current dividend yield that Employing What Works They can’t be paid with smoke and mirrors.” Dudak went on to tabulate over 200 years is well below the dividend yield on the bench- Given our expectations that the next decade will of returns from stocks and showed that in 13 of mark being used to measure a manager’s per- be a continuation of the past decade, which is to the 20 decades, reinvesting dividends represent formance. This effectively raises the perform- say, a period of low, and highly uncertain capital on average 57% of the total return from stocks in ance hurdle for the manager—often by as much returns from stocks, we don’t think it’s prudent each decade. She noted an important benefit of as 2-3% annually in an environment where three that investors rely solely or largely on capital high-yield stocks is the protection the dividend and five year expected excess returns is often returns to fund one’s retirement. To substantiate provides in weak stock market environments. less than 1.5% to 2.0%. “ this, take a look at Chart 6 above, which is the While Dudak was correct about the per- “Why active equity managers tend to inflation adjusted growth of a dollar for the S&P centage of returns attributable to dividends and handicap themselves relative to their perform- 500 going back to 1880. Note that from 1880 to the reinvestment of dividends for each decade, ance benchmark has always puzzled me, espe- 1954, or 73 years, the index showed a negative she didn’t go far enough in crediting the impact cially given the long-term importance of com- inflation adjusted capital return! Also note that of cash flows from dividends on total stock re- pounding dividend income to total return.” capital returns were negative for most of the last turns, which is; “the longer the time period, the Raver, lamented. 60 years with the exception of the 1954 to 1966 greater the impact of reinvested dividends on total We agree and we think the same handicap bull market and the 1982 to 1999 bull market. stock market returns due to compounding.” often applies to individual investors and their So rather than rely on the uncertainty of In a 2004 study in Plan Sponsor Magazine, investment advisors. Using MPT driven asset capital returns, doesn’t it makes more sense to William Raver, revisited the seminal work of allocation studies and colorful presentations focus at least part of your stock portfolio on real Roger Ibbotson on long-term stock market filled with MPT driven expected returns, inves- cash returns from dividends and dividend returns and confirmed that: “the current income tors are told they must sprinkle in some growth, growth to produce income? Initially, such a from both equity and fixed income securities, when some value, some large cap, some small cap in strategy provides growing dividend income for reinvested, forms the predominant share of long-term some statically-justified portfolio brew which reinvestment to maximize compounding and only serves to gives investors a false sense of later it provides a steady and growing income reported returns.” certainty regarding future expected returns. If stream to fund a comfortable retirement. Raver also showed that on average, after stock market history’s taught us anything, it’s Additionally, a high-yield, dividend growth ten years, the percentage of return attributable that various stock market subsets are much strategy is relevant in today’s low interest rate to dividend income and its reinvestment is more closely correlated than previously believed. environment which makes investing in long greater than 50%; and that the value of rein- When one goes down, they all go down. bonds—regardless of quality—an extremely vested dividend income after ten years usually It’s only when we dig deep into market risky proposition. exceeds the value of all the cumulated capital history do we see that investing to maximize the returns for equities in a given portfolio. He also compounding of income—not style, not sector, confirmed that after 78 years—the period of the (Continued on page 6) 6) Of course, the contribution of interest income to total return for bonds over the long term is 100%.
    • Page 6 2nd Quarter 2010 Viewpoint 15  13.84  Month End Dividend Yield for the S&P 500 Index 14  1880 to 2010 (Dividend Forecast to 2021?) 13  Data Source: Standard & Poor’s and Robert Shiller. Chart Deschaine & Company Research 12  11  10.15  10  8.67  9  7.79  7.44  The Future of 8  7.17  7.04  Dividend Yields? 7  6.13  6.24  6.14  6  5  4  3.66  3.36  3  3.03 3.01 2.67  2.61  2  1.85  1  1.11  ‐ 1881 1883 1885 1887 1889 1891 1894 1896 1898 1900 1902 1904 1907 1909 1911 1913 1915 1917 1920 1922 1924 1926 1928 1930 1933 1935 1937 1939 1941 1943 1946 1948 1950 1952 1954 1956 1959 1961 1963 1965 1967 1969 1972 1974 1976 1978 1980 1982 1985 1987 1989 1991 1993 1995 1998 2000 2002 2004 2006 2008 2011 2013 2015 2017 2019 2021 (Continued from page 5) to be structured, rather that produce an environ- different situations: Taking money from tradi- not asset classes, but income—is the real driver of ment in which the private sector can innovate, tional IRAs in retirement, or converting those long-term total stock market returns. At the end invest and create jobs in this global economy. IRAs to Roth IRAs now. of the day, regardless of whether you need in- In our judgment, we have reached a point The Effective Tax Rate rule compares the come in retirement or to offset poor capital re- where the negative effects of these policies are ETR on a Roth IRA conversion to that on turns in secular bear markets, investing for simply too significant to ignore. In the search for money taken from a traditional IRA in retire- growing dividend income to maximize the power short-term revenue fixes, we’re doing long-term ment. The rule assumes that the IRAs are in- of money to compound is the one proven way to damage to economic growth. vested the same way, that Roth withdrawals are build wealth in both good and bad economic and By reaching into virtually every sector of tax-free and that the same percentage of with- financial periods. History tells us so. economic life, government is injecting uncer- drawals are taken from the IRAs and spent. tainty into the market place and making it harder For example, if a $100,000 traditional IRA Other Notable & Quotable to raise capital and create new businesses. is converted to a Roth IRA and creates $30,000 WSJ: June 26 2010. of tax, the conversion ETR is 30%. If 10 years of Verizon CEO and Business Roundtable Chairman The Riddle of the Roth IRA $10,000 withdrawals from a traditional IRA in Ivan Seidenberg speaking at the Economic club of By: Roger M. Shorr, retirement are expected to create $20,000 of tax, Washington, June 22, 2010 From Barron’s June 28, 2010 issue the ETR on money taken is 20%. Investors may pay conversion taxes from T HE COMPANIES OF THE Business Roundta- ble have a huge stake in the success of the American economy. We create jobs all along the P AY THE TAX MAN NOW, or pay him later? Millions of upper-income households be- came eligible this year to convert their traditional the IRA itself, but for those under 59 1/2 this could cause a 10% penalty tax. Or they may pay the taxes from non-IRA money-this normally (economic) food chain. We manufacture and sell Individual Retirement Accounts to Roth IRAs. produces significantly better results. the things consumers need. And we have the Before 2010, those with modified adjusted gross When using individual Retirement Account technology, expertise and capital capacity to play income in excess of $100,000 couldn’t make such money to pay the conversion tax, the ETR rule a huge role in contributing to our nation’s eco- conversions. determines which IRA will produce more retire- nomic growth. Confusion exists about the advantages and ment income. The Roth wins if the conversion The BRT has accepted our responsibility as disadvantages of Roth conversions. But if inves- rate is lower than the effective tax rate on retire- partners in moving the country forward. My tors don’t solve the conversion riddle, the result ment withdrawals. The traditional IRA wins if colleagues and I have worked closely with policy could be hazardous to their wealth. the opposite is true. (The rule assumes that the makers across the political spectrum on matters Switching to a Roth usually means paying taxes are withdrawn from the account at the time from health care to trade and tax policy to en- income taxes up front, based on the taxable value of conversion. In fact, results may differ if the ergy and climate change. But frankly, we have of a traditional IRA, instead of paying taxes on value of the assets changes between the time the become somewhat troubled by a growing discon- retirement income from the IRA. After convert- taxes accrue and the time they are withdrawn.) nect between Washington and the business com- ing, investors who are at least age 59 1/2 will If a saver uses non-IRA money to pay the munity that is harming our ability to expand the have a tax-free source of retirement income un- conversion tax, the ETR rule functions a bit economy and grow private-sector jobs in the U.S. der most circumstances. differently. For this comparison, we must assume We see a host of laws, regulations and other Investors trying to maximize net income that when not converting, a separate fund, equal policies being enacted that impose a government from their IRAs in retirement should focus on to the taxes saved, is invested and distributed prescription of how individual industries ought their effective tax rates resulting from two very (Continued on page 8)
    • Deschaine &Viewpoint L.L.C. Year End 2009 Company, Page 7 Equity Income Portfolio Dividend Data Update   EQUITY INCOME  Recent   Current   Cons Div  Div 5yr   Previous   New  Qrtly  Qrtly   %  Div   Paid  Portfolio Company  Symbol  Price   Yield   Increases  Growth  Amount   Amount   Change   Since   Industries   2nd Quarter 2010 Update Abbott Laboratories ABT 46.69 3.50 37.00 9.24 0.44 0.44 - 1926 Pharmaceuticals T Arthur J Gallagher & Co. AJG 24.29 5.30 19.00 5.48 0.32 0.32 - 1990 Insurance HE EQUITY INCOME Alliance Bern Global High Inc AWF 13.48 8.60 4.00 7.12 0.10 0.10 - 1993 High Yield Equity Fund B&G Foods, Inc. Class A BGS 10.32 6.60 - - 0.17 0.17 - 2007 Food Products Portfolio current holdings Black Hills Corporation BKH 28.30 5.10 38.00 4.29 0.36 0.36 - 1942 Multi-Utilities as of June 30, 2010 are shown Bristol-Myers Squibb Co. BMY 25.63 5.00 - 3.54 0.32 0.32 - 1900 Pharmaceuticals on the table to the left. Colgate-Palmolive Co CL 78.77 2.30 47.00 12.90 0.44 0.53 20.45% 1895 Household Products The second quarter of Clorox Company CLX 61.92 4.00 33.00 18.62 0.50 0.55 10.00% 1968 Household Products 2010 was one of those anomalies ConocoPhillips COP 49.20 4.10 9.00 14.84 0.50 0.55 10.00% 1934 Oil Gas & Consumable Fuel of stock market behavior that CPFL Energy Inc. CPL 69.31 6.20 - 101.14 1.99 2.30 15.37% 2005 Electric Utilities Computer Programs & Systems CPSI 39.71 3.60 - 18.95 0.36 0.36 - 2003 Health Care Technology drives investors crazy. While a Century Link, Inc. CTL 33.40 8.50 36.00 105.16 0.73 0.73 - 1974 Diversified Telecom host of companies across a Chevron Corp CVX 67.56 4.10 19.00 10.88 0.68 0.72 5.88% 1912 Oil Gas & Consumable Fuel swath of diverse industries were Dominion Resources Inc. D 39.14 4.60 6.00 6.24 0.46 0.46 - 1925 Multi-Utilities reporting decent, and in some DuPont de Nemours & Co. DD 34.05 4.80 - 2.97 0.41 0.41 - 1904 Chemicals cases, excellent earnings, raising Diamond Offshore Drilling Inc. DO 62.90 11.90 - 178.93 0.13 0.13 - 1997 Energy Equipment & Services dividends at a clip no one ex- ENI S.p.A. E 37.88 5.20 - 11.39 1.07 1.00 -6.54% 1996 Oil Gas & Consumable Fuel pected this soon after the credit Consolidated Edison, Inc. ED 43.62 5.40 35.00 0.87 0.60 0.60 - 1885 Multi-Utilities Elbit Systems Ltd. ESLT 49.29 2.90 4.00 11.92 0.36 0.36 - 1997 Aerospace & Defense meltdown and hording record Energy Transfer Partners LP ETP 46.83 7.60 - 16.34 0.89 0.89 - 1996 Oil Gas & Consumable Fuel amounts of cash, the S&P 500 EV Energy Partners, Units EVEP 31.70 9.50 2.00 - 0.76 0.76 0.13% 2007 Oil Gas & Consumable Fuel went down 11.43% for the quar- Federated Investors Inc FII 20.39 10.90 - 69.56 0.24 0.24 - 1998 Capital Markets ter. That put the S&P 500 down Fifth Street Finance Corp. FSC 10.54 10.80 1.00 - 0.30 0.32 6.67% 2008 Capital Markets 6.65% for the six months ending Gladstone Investment Corp GAIN 6.00 8.00 - - 0.04 0.04 - 2005 Diversified Financials June 30, 2010. But hey, that’s General Mills Inc. GIS 35.81 2.70 6.00 9.15 0.25 0.28 14.29% 1898 Food Products the stock market for you, just Great Northern Iron Ore GNI 95.65 9.60 - 0.82 2.00 2.75 37.50% 1990 Diversified Financials Genuine Parts Company GPC 39.44 4.10 53.00 5.77 0.41 0.41 - 1948 Distributors when you think it’s safe to go Glaxo Smithkline ADS GSK 34.13 5.80 - 6.61 0.46 0.46 - 2001 Pharmaceuticals into the water, etc. Health Care REIT Inc HCN 41.28 6.60 2.00 2.37 0.68 0.68 - 1990 Real Estate Investment Trust The good news so far in H.J. Heinz Company HNZ 43.50 3.90 5.00 8.23 0.42 0.45 7.14% 1911 Food Products 2010 is the strong growth in Johnson & Johnson JNJ 59.08 3.40 47.00 11.18 0.49 0.54 10.20% 1944 Pharmaceuticals dividends. We anticipated com- Kraft Foods Inc KFT 28.25 4.10 8.00 7.26 0.29 0.29 - 2001 Food Products panies would boost dividends Kimberly-Clark Corp. KMB 60.19 4.20 35.00 8.29 0.66 0.66 - 1935 Household Products given how much cash they’re Coca-Cola Company KO 50.43 3.40 47.00 9.92 0.44 0.44 - 1893 Beverages Linn Energy, LLC LINE 26.55 9.50 - - 0.63 0.63 - 2006 Oil Gas & Consumable Fuel producing and how much cash Eli Lilly & Co. LLY 33.91 5.80 42.00 5.94 0.49 0.49 - 1885 Pharmaceuticals they’re holding on their balance Main Street Capital Corp MAIN 15.44 9.70 2.00 - 0.13 0.13 - 2007 Capital Markets sheet, in excess of $2 trillion at Microchip Technology Inc MCHP 27.88 4.90 7.00 48.39 0.34 0.34 0.29% 2002 Semiconductors last count. And we’ve not been Mercury General Corp. MCY 41.30 5.70 19.00 8.08 0.59 0.59 - 1990 Insurance disappointed. Altria Group Inc MO 20.54 6.70 - 15.66 0.35 0.35 - 1928 Tobacco So far this year , we’ve had Middlesex Water Co. MSEX 15.67 4.60 2.00 2.71 0.18 0.18 - 1990 Water Utilities 13 stocks increase their dividend MLP & Strategic Equity Fund MTP 16.30 5.20 - - 0.07 0.07 - 2007 Capital Markets Maxim Integrated Products MXIM 16.75 4.80 7.00 16.65 0.20 0.20 - 2002 Semiconductors representing a 3.2% increase for Norfolk Southern Corp NSC 50.50 2.70 8.00 27.31 0.34 0.34 - 1901 Railroads the quarter over the previous Realty Income Corp O 29.33 5.80 12.00 6.57 0.14 0.14 0.21% 1994 Real Estate Investment Trust periods payout, which is a 12.8% Paychex, Inc. PAYX 25.16 4.90 19.00 20.87 0.31 0.31 - 1988 IT Services annual rate of dividend growth Pitney Bowes Inc. PBI 22.08 6.60 19.00 3.35 0.37 0.37 - 1934 Commercial Services for the stocks boosting payouts. Plum Creek Timber Co. PCL 33.51 5.00 - 2.59 0.42 0.42 - 1989 Real Estate Investment Trust We see dividend increases PepsiCo, Inc. PEP 61.64 3.00 38.00 14.14 0.45 0.48 6.67% 1952 Beverages continuing through year-end. Procter & Gamble Co. PG 59.34 3.00 56.00 12.91 0.44 0.48 9.50% 1891 Household Products Progress Energy Inc PGN 39.82 6.20 9.00 1.26 0.62 0.62 - 1937 Electric Utilities Philip Morris Intl PM 46.77 5.00 1.00 - 0.58 0.58 - 2008 Tobacco Market Summary 2nd Qrt 10 Pinnacle West Capital PNW 36.74 5.70 - 2.32 0.53 0.53 - 1993 Electric Utilities Annual Returns 2nd Qrt Reynolds American Inc RAI 53.08 6.70 - 13.81 0.90 0.90 - 2004 Tobacco Southern Company SO 33.50 5.30 8.00 4.11 0.44 0.46 4.00% 1948 Electric Utilities US MARKETS - 11.34 AT&T Inc. T 24.41 6.80 19.00 5.36 0.42 0.42 - 1881 Diversified Telecom GLOBAL EX-US - 12.25 Integrys Energy Group TEG 44.12 6.20 51.00 4.56 0.68 0.68 - 1994 Multi-Utilities UIL Holdings Corp UIL 25.23 6.80 - - 0.43 0.43 - 1900 Electric Utilities DEV MRKTS EX-US - 12.84 Unilever PLC ADR UL 27.19 3.50 10.00 6.15 0.27 0.28 1.69% 1999 Food Products EMERGING MRKTS - 9.39 Vector Group Ltd. VGR 17.30 9.20 11.00 5.10 0.40 0.40 - 1990 Tobacco Vectren Corporation VVC 23.34 5.80 34.00 2.98 0.34 0.34 - 1946 Multi-Utilities CORE BONDS 3.70 Verizon Communications, Inc. VZ 26.61 6.60 5.00 4.48 0.48 0.48 - 1984 Diversified Telecom LT COMMODITY - 2.89 Wayside Technology Group WSTG 8.65 6.90 - 5.56 0.15 0.15 - 2003 Electronic Equipment Aqua America Inc WTR 17.85 3.20 19.00 8.31 0.15 0.15 - 1939 Water Utilities Source: Morningstar Q210 Market Com- QWest Communications Q 5.27 6.10 - - 0.08 0.08 - 2001 See Note Below mentary
    • Deschaine & Company,Page 8 Deschaine & Company, L.L.C. Page 8 L.L.C. World Headquarters 128 South Fairway Drive Belleville, Illinois 62223 Phone: (618) 397-1002 Maryville Office (618) 288-2200 Highland Office (618) 654-6262 “Most bad government has grown out of too much government.” — Thomas Jefferson. (Continued from page 6) drawals from traditional IRAs must begin no later than April 1 of the year similarly to the IRA. after one turns age 70 1/2. Roth IRAs may be held without withdrawals It’s still true that when the conversion ETR is lower than the pro- during the original owner’s (and spousal beneficiary’s) lifetime. This means jected rate on withdrawals from the traditional IRA, converting is nor- more money could stay in the Roth, compounding income tax-free for one’s mally advantageous. But even when the expected tax rate is lower on tradi- heirs. However, a Roth, like a traditional IRA, may be subject to estate tax. tional IRA withdrawals, converting can still be beneficial. If the separate 2) Currently, tax-free Roth withdrawals aren’t’ considered in deter- fund for taxes were itself tax-free, the ETR rule would operate virtually mining if Social Security retirement benefits are taxable. And they don’t the same as if conversion taxes were being paid from the IRA. But since the affect Medicare Part B premiums. separate fund is taxable, the advantage goes to the Roth. A few possible disadvantages of converting: Another difference is that the Roth can become more advantageous 1) Roth conversions creating taxable income could increase Medicare over time because taxes slow the growth of the separate fund, so time be- Part B premiums or cause Social Security retirement benefits to be taxed comes a factor in the conversion decision. The longer a Roth is owned, the for the year of the switch or both. longer it can accumulate earnings tax-free. The ETR remains the key: the 2) Converting to a Roth now could cause the loss of a tax-free conver- lower the rate on withdrawals, the less advantageous converting becomes. sion in some later year. For example, a business owner experiencing losses It can even become a losing proposition. might be able to use them to offset the taxable income created by a Roth How can investors know their future tax rates? They can’t. Congress conversion. The result could be a totally tax-free conversion and tax-free makes the laws and nobody can be certain what future lawmakers will do income later. about Roth IRAs. But everyone should know that the long-term fiscal A cautious investor needn’t go all the way. He can convert a portion of this outlook for the U.S. will require more tax revenue, pending cuts or both. traditional IRA to a Roth. This could produce a better outcome if his esti- A distinct minority of Americans has significant savings, and a dis- mate of future tax rates proves to be a lot different than what materializes. tinct majority believes in progressive taxation. This means that rich people One big caveat: the best-laid plans of mice and investors may go with big individual Retirement Accounts are likely to see higher tax rates, astray. Every IRA investor’s situation is different, and no one should make perhaps a lot higher. Even so, some retirees live frugally on retirement important financial decisions without knowing how the law applies to him incomes considerably smaller than their employment earnings. Other re- individually. Seek a financial professional’s help before taking any action. tired people may have very large deductible medical bills, or other deducti- ble expenses sufficient to offset the taxable income from withdrawals from The definition of “Ironic?” a traditional IRA. Such expenses aren’t deductible against tax-free Roth Every year Warren Buffett auctions off a lunch with him to the highest IRA withdrawals, so the deductions could be lost. Also with years to plan, bidder. The money goes to charity. This year the auction raised a record some people may find legitimate tax shelters. And they may be in a lower $2.11 million. Obviously, Buffett’s incredible investment record attracts tax bracket, even if all brackets are raised, resulting in a lower ETR on those looking for some special insights into his investment strategy. This retirement withdrawals. year his insight should be easy: “Never pay $2.1 million, to have lunch with Some possible advantages of converting: anyone, including me!” 1) Roth IRA conversions may be especially advantageous for well- heeled people who don’t need their IRAs for retirement income. With- As always, thanks for reading. MJD PUBLISHER: MARK J. DESCHAINE EDITOR: JOHN H. DESCHAINE CONTRIBUTING EDITOR: TOM O’HARA STAFF CONTRIBUTORS: MATT POWERS, JASON LOYD COPY EDITOR: MARNIE E. DESCHAINE TECHNICAL ADVISOR: Joseph M. Deschaine. VIEWPOINT is a complementary publication of Deschaine & Company, L.L.C. a registered investment advisor in Belleville, Illinois. This information has been prepared from sources deemed reliable, but its accuracy is not guaranteed. It should not be assumed that any securities discussed will be profitable or will equal past performance, or is it an offer to buy or sell any security mentioned. Deschaine & Company and/or one or more of its clients, employees, family or friends may have a position in the securities dis- cussed herein. © 2010. All rights reserved. Reproduction of this publication is strictly forbidden without written consent from Deschaine & Company. This issue was published on July 20, 2010. If you would like to receive a complementary copy each quarterly, simply send us your address and the preferred method of delivery: snail-mail or email, to: 128 South Fairway Drive, Belleville, IL 62223 Or email us at mdeschaine@charter.net and we would be happy to add you to one of our mailing lists.