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  • 1. “In the long run, we are all dead.” –John Maynard Keynes IF YOU HAVE BEEN INVESTING for awhile, you’ve invariably run across the conventional wisdom re- garding historical stock market returns. Over the last 50 years or so, the mantra on Wall Street has been that if you hold stocks long enough, you’ll eventually earn somewhere in the neighborhood of 10% annually. The returns breakdown along the lines of 6% annually from capital gains and 4% annually from dividends. In times of stock market turmoil (like the last 10 years?), Wall Street gurus and mutual fund sales depart- ments tell us to take a deep breath and remain calm— even while we watch our stock portfolio get summarily wacked 40%! Again, the key to investing success, we’re told, is that if we just hang in there long enough, no matter what the economic or market circumstances, we’ll eventually earn a decent rate of return. The undy- ing belief in this seemingly reliable and predictable long -term 10% annual return from stocks has been driven, at least in part, by what’s called “Modern Portfolio The- ory,” or “MPT” for short. MPT began in the early 1950s by Dr. Harry M. Markowitz who wrote a series of essays on portfolio management theory for which he received the Nobel Prize in economics.(1) Markowitz mathematically dem- onstrated that it was possible (at least theoretically) to combine different asset classes into a portfolio that could provide more consistent returns than one in- vested in a single asset class—likes stocks. While this seems almost intuitive today, in 1952 it was an fairly novel concept. The essential tenet behind MPT is this: if you diversify a portfolio across different asset classes such as stocks, bonds, real estate, timber, oil and so on; the portfolio will grow more consistently—over time— than one that’s concentrated in just one asset class. The operative words in the previous sentence are “over time.” A second important tenet of MPT is that if inves- tors pooled individual asset classes into broad indexes (think S&P 500 index fund for example) an investor could, again theoretically, create a portfolio that would achieve 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 new Greek alphabet soup of portfolio measures such as alpha, beta, gamma, and delta to construct these more efficient portfolios and measure returns. The final ingredient in this new magical formula, we’re told, is we must assume that financial markets are efficient. That is, that the current market price of a stock reflects everything that is known and knowable about the company. This “efficient” market hypothesis also applies to the market as a whole. Implied in the efficient market notion is the fact that, by definition, it’s impossible for an investor to “beat” the stock market by seeking out information other investors do not have. Over the last 50 years, Modern Portfolio Theory has become the gold standard of investing—at least for large institutions like pensions and endowments. An institutional investment advisor rarely gets fired for using MPT to manage institutional portfolios because if properly implemented, MPT all but guarantees market “like” investment returns. Meaning, an MPT managed portfolio isn’t likely to stray too far from the returns of the overall market index it’s trying to mimic. Further, if the stock market goes down say 15%, and an MPT man- aged portfolio is down “only” 12%, the investment man- ager has “beaten” the “market.” Such superior “relative” performance—beating the market, even though the portfolio lost money—is likely to get the manager re- warded with more assets under management. Wall Street has pushed all this highfalutin aca- demic portfolio theory down to individual investors, and consequently, we think, instilled a false sense of statisti- cal certainty regarding potential returns from stocks. Instead, what’s clear from market history is there have (Continued on page 4) 2nd Quarter 2010 Volume 11 Issue 2 Helping You Navigate in an Uncertain Investment World Inside this issue: Do Stock Investors Earn More From Capital Gains or Dividends? 1 Defending Cash 2 Inflation Adjusted Market Returns 1880-2010 4 Inflation Adjust Growth of a $ Market Returns 5 Month End Dividend Yield for the S&P 500 Index 6 Equity Income Portfolio 2nd Qrt 2010 Update 7 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.” Do Stock Investors Earn More from Capital Gains or Dividends? The Answer May Surprise You Deschaine & Company is an SEC registered investment advisor, managing approxi- mately $70 million for pensions, endowments, and individuals. WorldHeadquarters 128 South Fairway Drive Belleville, Illinois 62223 Phone: (618) 397-1002 MaryvilleOffice Jason Loyd (618) 288-2200 HighlandOffice Matt Powers (618) 654-6262 We’re on the Web at: Deschaine&Company,L.L.C. A REGISTERED INVESTMENT ADVISOR
  • 2. Page 2 WITH SHORT-TERM INTEREST RATES near zero, investors are stressed about where to invest idle cash. Investors’ angst over low cash yields only grew more acute as they watched global stock markets post double digit returns over the last year. The S&P 500 Index, for example, was up 79% from March 9th, 2009 through April 23, 2010. Comparing a 79% return on stocks to a paltry ½ percent or less in money mar- ket funds will ruffle most investors’ feathers—including ours, we’ll admit. Still, I’m here to tell you, it’s pre- cisely this lethal combination of impatience and yearning for better returns that time and again leads investors to take on extra risk (usually without knowing it) in search of marginally higher yields. It’s called “reaching for yield.” The flaw in investors’ decision making process is that it is almost always based on past returns. As VIEWPOINT readers know, we’ve advocated holding relatively high levels of cash (an average of 20% ) for much of the last 10 years primarily as protection against the secular bear mar- ket. And as Chart 3 shows, it’s been a good strategy—even with low yields. We continue to recommend hold- ing a relatively large cash position be- cause we remain bearish on the long- term outlook for the stock market. His- tory tells us the stock market makes a long-term market bottom when divi- dend yields are somewhere north of 6.0% and Price/Earnings ratios are between seven and ten times earnings. With a dividend yield on the S&P 500 about 2.2% and a P/E ratio of 18, the market’s a long way from a secular bear market bottom. You math whizzes out there will quickly calculate that for the stock market to yield 6.0% requires either a drop in stock prices of about 60% from current levels, or a tripling of the cash dividend, or some combination of the two. Before you concern yourself with the prospects of a sudden or steep drop in stock prices, let me assure you that secular bear market bottoms are usually reached after a long and bumpy ride for stocks rather than any dramatic or sharp plunge in share prices. Small consolation to many of you, I’m sure, but that’s what stock market history tells us. After more than 10 years since the stock mar- ket peaked in March 2000, I’d suggest the bear market’s right on schedule.(2) An investor looking to build future income by capturing higher yields should consider the relentless share price declines that occur in bear mar- kets a huge bonus. Such an environment results in higher yields for companies with a history of raising their divi- dends—in both good times and bad. If stock market history plays out as we expect over the next decade, the S&P 500’s dividend yield will increase from it’s current yield of about 2.2% to over 6.0%, while our EQUITY IN- COME Portfolio’s yield (currently about 6.0% ) could rise to over 10%. I know that sounds crazy, especially when we’re staring at near zero short-term interest rates, but again, that’s what stock mar- ket history tells us. In fact, since I was lucky enough to begin my career in April 1979, I experienced firsthand the last high dividend yield cycle which occurred roughly from 1978 to 1985. During that period, investors could’ve bought stocks with dividend yields in the high single digits across a whole range of quality companies. Back to the issue of holding cash in a low-yield environment. It’s easy to lament earning meager yields on your cash as you look at your ac- count statement each month. It’s much harder to accept that even with low yields, over a long-term bear market, cash is usually a winning strategy. Let’s compare the three most significant bear market—cash verses stock returns—of the last 80 years. The 1929-1933 Deflationary Experience In the Great Depression, from 1929 to 1933, the stock market dropped a whop- ping 89% as economic activity dropped over 30% from a complete collapse of international trade. Such a precipitous drop in economic actively caused prices to drop over 25% as deflationary forces kicked in. Over the same period, 10-Year Treasury Notes(3) produced what by today’s standards would likely be considered a relatively meager 3.65% annual return. Yet, an investor smart enough (or lucky?) to have pulled all their money out of the stock market in the fall of 1929 and plunked it into 10 -year treasuries would’ve not only successfully preserve their wealth they would’ve had valuable capital to accumulate stocks at less then 20 cents on the dollar in 1933. (See Chart 1) Legend has it that Joe Kennedy, patriarch to the Kennedy political dynasty, did just that after a shoe shine boy, supposedly gave him a stock “tip” in September 1929. Figuring that if shoe shine boys were now investing in the stock market it had to be getting near a peak, so Joe proceeded to sell all his stocks and buy U.S. Treasury secu- rities complete sidestepping the stock market crash. Joe than began to buy stocks in 1933 and 1934, building the family fortune in the process. (Continued on page 3) 2nd Quarter 2010 Viewpoint 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. VIEW FROM THE FRONT SEAT by Mark J. Deschaine In Defense of Cash: In a risky world, cash is the least risky investment. $1.11 $0.20 $0.00 $0.10 $0.20 $0.30 $0.40 $0.50 $0.60 $0.70 $0.80 $0.90 $1.00 $1.10 $1.20 $1.30 1932‐07 1932‐05 1932‐03 1932‐01 1931‐11 1931‐09 1931‐07 1931‐05 1931‐03 1931‐01 1930‐11 1930‐09 1930‐07 1930‐05 1930‐03 1930‐01 1929‐11 1929‐09 Cumulative Returns for 10-Year Treasury Notes compared to the S&P 500, October1929 to July 1932. Chart 1: Depression Era Cash & Stock Returns $2.49 $1.14 $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 Dec‐68 May‐69 Oct‐69 Mar‐70 Aug‐70 Jan‐71 Jun‐71 Nov‐71 Apr‐72 Sep‐72 Feb‐73 Jul‐73 Dec‐73 May‐74 Oct‐74 Mar‐75 Aug‐75 Jan‐76 Jun‐76 Nov‐76 Apr‐77 Sep‐77 Feb‐78 Jul‐78 Dec‐78 May‐79 Oct‐79 Mar‐80 Aug‐80 Jan‐81 Jun‐81 Cumulative Returns for 90-day Treasury Bills compared to the S&P 500, December 1966 to July 1982. Chart 2: 1966-1982 Bear Market Cash & Stock Returns $1.24 $0.82 $0.40 $0.50 $0.60 $0.70 $0.80 $0.90 $1.00 $1.10 $1.20 $1.30 Dec‐00 Apr‐01 Aug‐01 Dec‐01 Apr‐02 Aug‐02 Dec‐02 Apr‐03 Aug‐03 Dec‐03 Apr‐04 Aug‐04 Dec‐04 Apr‐05 Aug‐05 Dec‐05 Apr‐06 Aug‐06 Dec‐06 Apr‐07 Aug‐07 Dec‐07 Apr‐08 Aug‐08 Dec‐08 Apr‐09 Aug‐09 Dec‐09 Apr‐10 Cumulative Returns for 90-day Treasury Bills compared to the S&P 500, December 2000 to May 2010. Chart 3: 2000-2010 Bear Market Cash & Stock Returns
  • 3. Deschaine & Company, L.L.C. Clearly, cash, or in this case 10-Year Treasury Notes, was the investment of choice during the 1929-1933 bear market period. The 1966 to 1982 Inflationary Experience Almost the exact opposite investor experience occurred during the 1966 to 1982 bear market. Rather than a steep stock market plunge driven by a sharp, deflationary economic con- traction, the 1966 to 1982 bear market was a slow, methodical inflationary grind on inves- tors. Over the sixteen year period, inflation slowly yet relentlessly inched up causing an inflation-adjusted drop in stock prices of over 30%, from 1966 to the market bottom in 1982. The worst stock market performance period since the Great Depression. Over the same period, 90-day treasuries returned a healthy 7.5% per year. Which sounds good, and cer- tainly is good when compared to the devastat- ing capital losses posted by stocks during the period, yet inflation during the period aver- aged 6.8%. Consequently, cash actually earned a meager annual return of about 1% after ad- justing for inflation. Even with such paltry real returns, cash was again the hands down winning investment strategy during the 1966-1982 inflationary bear market period. By the end of the 1982, 90 -day Treasury Bills were yielding over 12% and investors thought they were being savvy putting a big chunk of their assets in money market funds and short-term CD’s. (See Chart 4) What most investors didn’t realize was they were at the bottom of the cheapest stock mar- ket since the 1930s. The 2000 to 2010 Experience (Inflation or Deflation?) The central question is: “will exploding federal spending and money supply growth kick off inflation? Or will mortgage defaults, unem- ployment and slack consumer spending bring on lower prices and by definition, “deflation.” I’ll be honest, I don’t know. After spend- ing most of the last two years trying to get a handle on the credit crisis, and the govern- ment’s and Federal Reserve’s reaction to it, my initial expecta- tion was that inflation was the logical result of an unparalleled growth of the money supply we charted in our “Year End Eco- nomic and Financial Market Out- look.” (4) After all, as Milton Freidman noted, “inflation is always and everywhere a mone- tary phenomenon.” Put another way, inflation is defined as: “too much money chasing too few goods.” If the supply of money increases relative to the supply of goods in an economy, inflation is the result. Given the money growth over the last year, it wasn’t a ques- tion of “if” inflation would kick in, but “when.” However, when you look at the negative credit data coupled with what is clearly a weak recovery, it’s not hard to construct a scenario where debtors continue to default, particularly in housing and commercial real estate causing lenders to completely shut down lending (doing all they can to keep from going bankrupt themselves) and in turn causing a contraction in credit for the first time since the early 1930s. Each dollar of credit written off in a de- fault is a dollar that evaporates from the money supply. If loan defaults overwhelm the government’s efforts to re-inflate the econ- omy; a deflationary spiral could result. When you consider the total amount of bad debt outstanding, it’s not hard to see how deflation might happen. If that happens, we need only to look to Japan’s experience since 1989. To see the consequences of deflation—zero economic growth over the last two decades. Yet, whether we get inflation or deflation, as history shows, one investment strategy is at least part of the answer—hold cash. Hold cash during an inflationary period to capture higher interest rates as short-term interest rates rise in response to inflation. Investing in quality investments like U.S. Treasury Bills and Notes during deflationary periods holds pur- chasing power as prices decline. Once prices stabilize, you’ll have buying power to accumu- late all sorts of assets—from stocks to real estate to that large boat you’ve always wanted. All at bargain prices. Assuming, that is, you didn’t get antsy and invest your cash in some risky investment looking for an extra ½ in yield just before it plunged. It’s times like these that its important to keep in mind the primary purpose of cash is to preserve your capital—not to make you rich in times of high risk—like now. Editor’s comment: It was pointed out to me by my esteemed colleagues, Matt and Jason, that this issue’s Front Seat column was decidedly pro-cash and anti-stock. Or as Matt noted eloquently: “it appears you are telling the reader to stay away from the stock market.” However, that was cer- tainly not what I intended. The objective of the article was to note two things. One: that even in a low yield environment, cash serves an important purpose in protecting a portfolio from an indiscriminate and uncaring stock market. And two, cash provides readily available buying power as the stock market peri- odically offers up quality dividend stocks at at- tractive yields. I was attempting to point out that holding cash, even when it may not be yielding much, serves an important purpose within a port- folio. At no time have we or would we, suggest being completely out of the stock market. As the last year or so shows, the opportunity costs of being 100% in cash can be considerable when the stock market stages one of its random rallies. As readers of Viewpoint know well, we are long-term owners of quality stocks that pay a generous and growing dividend. Once we buy a stock we’ll continue to own it, come what may, as long as its dividend remains intact. We only sell a stock if the company cuts the dividend—regardless of reason—0r if the stock gets way over valued.(5) Over the next ten years, our objective is to accumulate as many shares as possible by reinvest- ing dividends and by investing the portfolio’s cash reserves in the most attractive stocks that are available each time we buy. If we do our job well, by the end of the decade, our portfolios should be fully invested in dividend stocks with a yield on invested capi- tal of over 10% !(6) From there, all we have to do is kick back, find a quiet spot on the beach and watch our dividend income roll in. To achieve that requires being invested in quality dividend stocks and buying more with each dividend as the bear market winds down! (Front Page continued from page 2) 4) Available on 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 3 Interest Rates During the Long-Term Bear Markets Period Beginning Middle End 1929-1932 3.39 3.37 3.50 1966-1982 5.96 5.61 11.35 2000-2010 5.77 1.26 (Double digits?) Note: 1929-1933 is the 10-Year U.S. Treasury Note, the other two periods is the 90-Day U.S. Treasury Bill rate. Comparing Annual Returns for Stocks With “Cash” During Three Long-Term Bear Markets Period Stocks Cash 1929-1933 - 42.48 3.65 2000-2010 -2.07 2.29 1966-1982 -2.78 7.47 15.20  7.07  16.30  11.35  0.15 ‐ 1.00  2.00  3.00  4.00  5.00  6.00  7.00  8.00  9.00  10.00  11.00  12.00  13.00  14.00  15.00  16.00  17.00  Dec‐68 May‐69 Oct‐69 Mar‐70 Aug‐70 Jan‐71 Jun‐71 Nov‐71 Apr‐72 Sep‐72 Feb‐73 Jul‐73 Dec‐73 May‐74 Oct‐74 Mar‐75 Aug‐75 Jan‐76 Jun‐76 Nov‐76 Apr‐77 Sep‐77 Feb‐78 Jul‐78 Dec‐78 May‐79 Oct‐79 Mar‐80 Aug‐80 Jan‐81 Jun‐81 Nov‐81 Apr‐82 Chart 4: Monthly Yield for 90-day Treasury Bills from December 1966 to July 1982, compared to the period of December 2000 to May 2010. Are interest rates going higher?
  • 4. 2nd Quarter 2010 ViewpointPage 4 0.92% 4.87% ‐2.00% ‐1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00% 2010 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 1970 1968 1966 1964 1962 1960 1958 1956 1954 1952 1950 1948 1946 1944 1942 1940 1938 1936 1934 1932 1930 1928 1926 1924 1922 1920 1918 1916 1914 1912 1910 1908 1906 1904 1902 1900 1898 1896 1894 1892 1890 1888 1886 1884 been long periods where the stock market did not grow at all, let alone 10 percent. An Inefficient, “Efficient” Stock Market Consider too, that while the MPT driven notion of “relative” performance may be okay for institu- tional investors who can wait to years recoup loses, an individual investor, particularly one in or getting close to retirement, can’t incur signifi- cant capital loses and doesn’t have the luxury of waiting years for his portfolio to recover. For MPT to work it requires giving it time—lots of time. Decades in fact. How many of you are willing (or able) to wait for a mutual fund that’s been going down for several years in a row, like many technology funds were in the early part of the decade, to make a comeback? Nevertheless, mutual fund managers will always tell you now is a good time to buy, just as they probably did six months ago, a year ago and even ten years ago. In the fund manager’s mind, it’s never time to sell. Every dip is just a prelude to a new high. Modern Portfolio Theory says so, again, if you just give it enough time. However, had you put your money in a technology or Internet mutual fund in March 2000, you’re not only underwater, its likely you’ll never ever see a positive return from that invest- ment. In addition, as we’ve documented, in detail here in VIEWPOINT, the stock market’s not been a friend to investors over the last ten years. Re- member, the NASDAQ composite index is still down more than 55% from its 2000 high. Doing What Works-In time Paradoxically, most academic studies of individ- ual investor behavior contend most investors do not give their investment program enough time. We would argue the problem may be that indi- vidual investors have a different time frame than the extremely long one required to achieve the annual returns implied under MPT theory. Not only that, but such an abstract investment con- cept becomes increasingly less relevant to indi- vidual investors as they get closer to retirement. C o n s i d e r , that in a long- term, secular bear market, like the one we’ve been in since 2000, a retired investor cannot possibly win at the stock market game if they’re following a strategy, such as espoused by MPT, that requires a 25-40 year time frame. Put an- other way, investing one’s portfolio on a long- term bet that the stock market will always earn 10%—assuming you wait long enough—is nei- ther practical nor rational—if your time horizon isn’t 25-40 years. Especially if your retirement happens to correspond with the beginning of a secular bear market. Doing What Works in Generating Returns “Business is taking a pile of cash, doing something with it, to get a bigger pile of cash in the end.” —Leonard P. Shaykin Often lost in the academic world of MPT invest- ing, is the notion that a stock represents the frac- tional ownership of an ongoing, operating “business.” And just as any owner of any busi- ness, a stock investor is looking to get his hands on the cash the business produces. Because you see it’s the “cash” the business produces that ultimately determines your investment returns. The question is, “how does the owner get his (or her) hands on the cash and when?” The “how” is either in the form of cash dividends and/or capi- tal returns from selling shares—ideally after they’ve appreciated in value. The “when,” of course, is “the sooner, the better.” All things being equal, an owner or inves- tors prefers a busi- ness that: a) pro- duces more cash rather than less; b) produces cash that’s available to be distributed to the owners/ shareholders, sooner rather than later; and c) produces cash that is “predictable” rather then unpredictable, or even “unknown.” In all three cases, the present value of quar- terly cash dividends is worth more (a lot more) to an owner than the uncertainty of any cash they may received from capital sales (or again, even losses?) at some unspecified point in the future. Given such economic realities, it should be obvious that stocks that pay a steady and grow- ing quarterly dividend have more economic value to investors (i.e. owners) than stocks (or businesses) that rely solely on capital returns. Not only has this been confirmed by numerous academic stud- ies which show that dividend-paying stocks con- sistently outperform the average stock, but that stocks with a rising dividend have, in most stock market periods, rank among the highest perform- ers. When you think about it, all the academic studies are really doing is confirming the present value of discounted cash flows from dividends compared to capital returns. In other words, the (Continued from page 1) (Continued on page 5) “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn’t ... pays it.” — Albert Einstein 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. Chart 5: Inflation Adjusted Accumulative Annual Returns for the S&P 500 Index by Dividend and Capital (5) 1880 to 2010 Data Source: Standard & Poor’s and Robert Shiller. Chart Deschaine & Company Research
  • 5. Page 5 Deschaine & Company, L.L.C. 6) Of course, the contribution of interest income to total return for bonds over the long term is 100%. 1.65  0.53  2.75  0.53  0.74  0.89  4.53  1.71  4.63  13.08  6.96  11.21  5.42  7.68  ‐ 1.00  2.00  3.00  4.00  5.00  6.00  7.00  8.00  9.00  10.00  11.00  12.00  13.00  14.00  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 stock market clearly prefers the relative cer- tainty of cash dividends over the uncertainty of unknown future capital returns. Why would anyone argue with that? Employing What Works Given our expectations that the next decade will be a continuation of the past decade, which is to say, a period of low, and highly uncertain capital returns from stocks, we don’t think it’s prudent that investors rely solely or largely on capital returns to fund one’s retirement. To substantiate this, take a look at Chart 6 above, which is the inflation adjusted growth of a dollar for the S&P 500 going back to 1880. Note that from 1880 to 1954, or 73 years, the index showed a negative inflation adjusted capital return! Also note that capital returns were negative for most of the last 60 years with the exception of the 1954 to 1966 bull market and the 1982 to 1999 bull market. So rather than rely on the uncertainty of capital returns, doesn’t it makes more sense to focus at least part of your stock portfolio on real cash returns from dividends and dividend growth to produce income? Initially, such a strategy provides growing dividend income for reinvestment to maximize compounding and later it provides a steady and growing income stream to fund a comfortable retirement. Additionally, a high-yield, dividend growth strategy is relevant in today’s low interest rate environment which makes investing in long bonds—regardless of quality—an extremely risky proposition. A Further Look Into What Works Sungard strategist Gail Dudak noted in 2002, after one of the many accounting scandals; “Only companies with real cash flow and real earnings are able to consistently pay dividends to investors. Divi- dends are a financial commitment from a company. They can’t be paid with smoke and mirrors.” Dudak went on to tabulate over 200 years of returns from stocks and showed that in 13 of the 20 decades, reinvesting dividends represent on average 57% of the total return from stocks in each decade. She noted an important benefit of high-yield stocks is the protection the dividend provides in weak stock market environments. While Dudak was correct about the per- centage of returns attributable to dividends and the reinvestment of dividends for each decade, she didn’t go far enough in crediting the impact of cash flows from dividends on total stock re- turns, which is; “the longer the time period, the greater the impact of reinvested dividends on total stock market returns due to compounding.” In a 2004 study in Plan Sponsor Magazine, William Raver, revisited the seminal work of Roger Ibbotson on long-term stock market returns and confirmed that: “the current income from both equity and fixed income securities, when reinvested, forms the predominant share of long-term reported returns.” Raver also showed that on average, after ten years, the percentage of return attributable to dividend income and its reinvestment is greater than 50%; and that the value of rein- vested dividend income after ten years usually exceeds the value of all the cumulated capital returns for equities in a given portfolio. He also confirmed that after 78 years—the period of the Ibbotson study—the proportion of return attrib- uted to reinvesting dividends represents 96.2% of total return from common stocks.(6) Raver talks about the difficulty investment managers have in delivering value-added invest- ment performance. He points out that the typical equity portfolio has a current dividend yield that is well below the dividend yield on the bench- mark being used to measure a manager’s per- formance. This effectively raises the perform- ance hurdle for the manager—often by as much as 2-3% annually in an environment where three and five year expected excess returns is often less than 1.5% to 2.0%. “ “Why active equity managers tend to handicap themselves relative to their perform- ance benchmark has always puzzled me, espe- cially given the long-term importance of com- pounding dividend income to total return.” Raver, lamented. We agree and we think the same handicap often applies to individual investors and their investment advisors. Using MPT driven asset allocation studies and colorful presentations filled with MPT driven expected returns, inves- tors are told they must sprinkle in some growth, some value, some large cap, some small cap in some statically-justified portfolio brew which only serves to gives investors a false sense of certainty regarding future expected returns. If stock market history’s taught us anything, it’s that various stock market subsets are much more closely correlated than previously believed. When one goes down, they all go down. It’s only when we dig deep into market history do we see that investing to maximize the compounding of income—not style, not sector, (Continued from page 4) (Continued on page 6) 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 that for long-term capital returns? With the exception of the 1920s bull market, an in- vestor had to wait until the late 1960s to see any significant capital returns from stocks. Or a modest 80 years! Prior to the 1920s stocks were considered the “income” investment because of their generous dividends. Bonds were the risky alternative. Chart 6: Inflation Adjust Growth of a Dollar Invested in the S&P 500 Index 1880 to 2010 Data Source: Standard & Poor’s and Robert Shiller. Chart Deschaine & Company Research Positive Capital Positive CapitalNegative Negative Capital
  • 6. Page 6 2nd Quarter 2010 Viewpoint 6.14  1.85  1.11  2.61  6.24  2.67  7.44  3.66  8.67  7.79  3.36  13.84  10.15  7.04  6.13  7.17  3.013.03 ‐ 1  2  3  4  5  6  7  8  9  10  11  12  13  14  15  2021 2019 2017 2015 2013 2011 2008 2006 2004 2002 2000 1998 1995 1993 1991 1989 1987 1985 1982 1980 1978 1976 1974 1972 1969 1967 1965 1963 1961 1959 1956 1954 1952 1950 1948 1946 1943 1941 1939 1937 1935 1933 1930 1928 1926 1924 1922 1920 1917 1915 1913 1911 1909 1907 1904 1902 1900 1898 1896 1894 1891 1889 1887 1885 1883 1881 not asset classes, but income—is the real driver of long-term total stock market returns. At the end of the day, regardless of whether you need in- come in retirement or to offset poor capital re- turns in secular bear markets, investing for growing dividend income to maximize the power of money to compound is the one proven way to build wealth in both good and bad economic and financial periods. History tells us so. Other Notable & Quotable WSJ: June 26 2010. Verizon CEO and Business Roundtable Chairman Ivan Seidenberg speaking at the Economic club of Washington, June 22, 2010 THE COMPANIES OF THE Business Roundta- ble have a huge stake in the success of the American economy. We create jobs all along the (economic) food chain. We manufacture and sell the things consumers need. And we have the technology, expertise and capital capacity to play a huge role in contributing to our nation’s eco- nomic growth. The BRT has accepted our responsibility as partners in moving the country forward. My colleagues and I have worked closely with policy makers across the political spectrum on matters from health care to trade and tax policy to en- ergy and climate change. But frankly, we have become somewhat troubled by a growing discon- nect between Washington and the business com- munity that is harming our ability to expand the economy and grow private-sector jobs in the U.S. We see a host of laws, regulations and other policies being enacted that impose a government prescription of how individual industries ought to be structured, rather that produce an environ- ment in which the private sector can innovate, invest and create jobs in this global economy. In our judgment, we have reached a point where the negative effects of these policies are simply too significant to ignore. In the search for short-term revenue fixes, we’re doing long-term damage to economic growth. By reaching into virtually every sector of economic life, government is injecting uncer- tainty into the market place and making it harder to raise capital and create new businesses. The Riddle of the Roth IRA By: Roger M. Shorr, From Barron’s June 28, 2010 issue PAY THE TAX MAN NOW, or pay him later? Millions of upper-income households be- came eligible this year to convert their traditional Individual Retirement Accounts to Roth IRAs. Before 2010, those with modified adjusted gross income in excess of $100,000 couldn’t make such conversions. Confusion exists about the advantages and disadvantages of Roth conversions. But if inves- tors don’t solve the conversion riddle, the result could be hazardous to their wealth. Switching to a Roth usually means paying income taxes up front, based on the taxable value of a traditional IRA, instead of paying taxes on retirement income from the IRA. After convert- ing, investors who are at least age 59 1/2 will have a tax-free source of retirement income un- der most circumstances. Investors trying to maximize net income from their IRAs in retirement should focus on their effective tax rates resulting from two very different situations: Taking money from tradi- tional IRAs in retirement, or converting those IRAs to Roth IRAs now. The Effective Tax Rate rule compares the ETR on a Roth IRA conversion to that on money taken from a traditional IRA in retire- ment. The rule assumes that the IRAs are in- vested the same way, that Roth withdrawals are tax-free and that the same percentage of with- drawals are taken from the IRAs and spent. For example, if a $100,000 traditional IRA is converted to a Roth IRA and creates $30,000 of tax, the conversion ETR is 30%. If 10 years of $10,000 withdrawals from a traditional IRA in retirement are expected to create $20,000 of tax, the ETR on money taken is 20%. Investors may pay conversion taxes from 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 produces significantly better results. When using individual Retirement Account money to pay the conversion tax, the ETR rule determines which IRA will produce more retire- ment income. The Roth wins if the conversion rate is lower than the effective tax rate on retire- ment withdrawals. The traditional IRA wins if the opposite is true. (The rule assumes that the taxes are withdrawn from the account at the time of conversion. In fact, results may differ if the value of the assets changes between the time the taxes accrue and the time they are withdrawn.) If a saver uses non-IRA money to pay the conversion tax, the ETR rule functions a bit differently. For this comparison, we must assume that when not converting, a separate fund, equal to the taxes saved, is invested and distributed (Continued from page 5) (Continued on page 8) Data Source: Standard & Poor’s and Robert Shiller. Chart Deschaine & Company Research Month End Dividend Yield for the S&P 500 Index 1880 to 2010 (Dividend Forecast to 2021?) The Future of Dividend Yields?
  • 7. Year End 2009 Viewpoint Page 7 AnnualReturns 2nd Qrt USMARKETS - 11.34 GLOBAL EX-US - 12.25 DEV MRKTS EX-US - 12.84 EMERGING MRKTS - 9.39 CORE BONDS 3.70 LT COMMODITY - 2.89 Source: Morningstar Q210 Market Com- mentary Market Summary 2nd Qrt 10 EQUITY INCOME Portfolio 2nd Quarter 2010 Update THE EQUITY INCOME Portfolio current holdings as of June 30, 2010 are shown on thetabletothe left. The second quarter of 2010wasone of thoseanomalies of stock market behavior that drives investors crazy. While a host of companies across a swath of diverse industries were reporting decent, and in some cases, excellent earnings, raising dividends at a clip no one ex- pected this soon after the credit meltdown and hording record amounts of cash, the S&P 500 went down 11.43% for the quar- ter. That put the S&P 500 down 6.65% for the six months ending June 30, 2010. But hey, that’s the stock market for you, just when you think it’s safe to go into thewater,etc. The good news so far in 2010 is the strong growth in dividends. We anticipated com- panies would boost dividends given how much cash they’re producing and how much cash they’re holding on their balance sheet, in excess of $2 trillion at last count. And we’ve not been disappointed. So far this year , we’ve had 13 stocks increase their dividend representing a 3.2% increase for the quarter over the previous periods payout, which is a 12.8% annual rate of dividend growth forthe stocksboostingpayouts. We see dividend increases continuing throughyear-end. Equity Income Portfolio Dividend Data Update   Company  Symbol   Recent  Price    Current  Yield    Cons Div  Increases  Div 5yr  Growth   Previous  Qrtly  Amount    New  Qrtly  Amount    %  Change   Div   Paid  Since   Industries   Abbott Laboratories ABT 46.69 3.50 37.00 9.24 0.44 0.44 - 1926 Pharmaceuticals Arthur J Gallagher & Co. AJG 24.29 5.30 19.00 5.48 0.32 0.32 - 1990 Insurance 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 Black Hills Corporation BKH 28.30 5.10 38.00 4.29 0.36 0.36 - 1942 Multi-Utilities Bristol-Myers Squibb Co. BMY 25.63 5.00 - 3.54 0.32 0.32 - 1900 Pharmaceuticals Colgate-Palmolive Co CL 78.77 2.30 47.00 12.90 0.44 0.53 20.45% 1895 Household Products Clorox Company CLX 61.92 4.00 33.00 18.62 0.50 0.55 10.00% 1968 Household Products ConocoPhillips COP 49.20 4.10 9.00 14.84 0.50 0.55 10.00% 1934 Oil Gas & Consumable Fuel 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 Century Link, Inc. CTL 33.40 8.50 36.00 105.16 0.73 0.73 - 1974 Diversified Telecom Chevron Corp CVX 67.56 4.10 19.00 10.88 0.68 0.72 5.88% 1912 Oil Gas & Consumable Fuel Dominion Resources Inc. D 39.14 4.60 6.00 6.24 0.46 0.46 - 1925 Multi-Utilities DuPont de Nemours & Co. DD 34.05 4.80 - 2.97 0.41 0.41 - 1904 Chemicals Diamond Offshore Drilling Inc. DO 62.90 11.90 - 178.93 0.13 0.13 - 1997 Energy Equipment & Services ENI S.p.A. E 37.88 5.20 - 11.39 1.07 1.00 -6.54% 1996 Oil Gas & Consumable Fuel 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 Energy Transfer Partners LP ETP 46.83 7.60 - 16.34 0.89 0.89 - 1996 Oil Gas & Consumable Fuel EV Energy Partners, Units EVEP 31.70 9.50 2.00 - 0.76 0.76 0.13% 2007 Oil Gas & Consumable Fuel Federated Investors Inc FII 20.39 10.90 - 69.56 0.24 0.24 - 1998 Capital Markets Fifth Street Finance Corp. FSC 10.54 10.80 1.00 - 0.30 0.32 6.67% 2008 Capital Markets Gladstone Investment Corp GAIN 6.00 8.00 - - 0.04 0.04 - 2005 Diversified Financials General Mills Inc. GIS 35.81 2.70 6.00 9.15 0.25 0.28 14.29% 1898 Food Products 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 Glaxo Smithkline ADS GSK 34.13 5.80 - 6.61 0.46 0.46 - 2001 Pharmaceuticals Health Care REIT Inc HCN 41.28 6.60 2.00 2.37 0.68 0.68 - 1990 Real Estate Investment Trust H.J. Heinz Company HNZ 43.50 3.90 5.00 8.23 0.42 0.45 7.14% 1911 Food Products Johnson & Johnson JNJ 59.08 3.40 47.00 11.18 0.49 0.54 10.20% 1944 Pharmaceuticals Kraft Foods Inc KFT 28.25 4.10 8.00 7.26 0.29 0.29 - 2001 Food Products Kimberly-Clark Corp. KMB 60.19 4.20 35.00 8.29 0.66 0.66 - 1935 Household Products 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 Eli Lilly & Co. LLY 33.91 5.80 42.00 5.94 0.49 0.49 - 1885 Pharmaceuticals Main Street Capital Corp MAIN 15.44 9.70 2.00 - 0.13 0.13 - 2007 Capital Markets Microchip Technology Inc MCHP 27.88 4.90 7.00 48.39 0.34 0.34 0.29% 2002 Semiconductors Mercury General Corp. MCY 41.30 5.70 19.00 8.08 0.59 0.59 - 1990 Insurance Altria Group Inc MO 20.54 6.70 - 15.66 0.35 0.35 - 1928 Tobacco Middlesex Water Co. MSEX 15.67 4.60 2.00 2.71 0.18 0.18 - 1990 Water Utilities 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 Norfolk Southern Corp NSC 50.50 2.70 8.00 27.31 0.34 0.34 - 1901 Railroads Realty Income Corp O 29.33 5.80 12.00 6.57 0.14 0.14 0.21% 1994 Real Estate Investment Trust Paychex, Inc. PAYX 25.16 4.90 19.00 20.87 0.31 0.31 - 1988 IT Services Pitney Bowes Inc. PBI 22.08 6.60 19.00 3.35 0.37 0.37 - 1934 Commercial Services Plum Creek Timber Co. PCL 33.51 5.00 - 2.59 0.42 0.42 - 1989 Real Estate Investment Trust PepsiCo, Inc. PEP 61.64 3.00 38.00 14.14 0.45 0.48 6.67% 1952 Beverages 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 Pinnacle West Capital PNW 36.74 5.70 - 2.32 0.53 0.53 - 1993 Electric Utilities 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 AT&T Inc. T 24.41 6.80 19.00 5.36 0.42 0.42 - 1881 Diversified Telecom 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 Unilever PLC ADR UL 27.19 3.50 10.00 6.15 0.27 0.28 1.69% 1999 Food Products 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 Verizon Communications, Inc. VZ 26.61 6.60 5.00 4.48 0.48 0.48 - 1984 Diversified Telecom 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 QWest Communications Q 5.27 6.10 - - 0.08 0.08 - 2001 See Note Below Deschaine & Company, L.L.C.
  • 8. Page 8 Deschaine & Company, L.L.C. WorldHeadquarters 128 South Fairway Drive Belleville, Illinois 62223 Phone: (618) 397-1002 MaryvilleOffice (618) 288-2200 HighlandOffice (618) 654-6262 similarly to the IRA. It’s still true that when the conversion ETR is lower than the pro- jected rate on withdrawals from the traditional IRA, converting is nor- mally advantageous. But even when the expected tax rate is lower on tradi- tional IRA withdrawals, converting can still be beneficial. If the separate fund for taxes were itself tax-free, the ETR rule would operate virtually the same as if conversion taxes were being paid from the IRA. But since the separate fund is taxable, the advantage goes to the Roth. Another difference is that the Roth can become more advantageous over time because taxes slow the growth of the separate fund, so time be- comes a factor in the conversion decision. The longer a Roth is owned, the longer it can accumulate earnings tax-free. The ETR remains the key: the lower the rate on withdrawals, the less advantageous converting becomes. It can even become a losing proposition. How can investors know their future tax rates? They can’t. Congress makes the laws and nobody can be certain what future lawmakers will do about Roth IRAs. But everyone should know that the long-term fiscal outlook for the U.S. will require more tax revenue, pending cuts or both. A distinct minority of Americans has significant savings, and a dis- tinct majority believes in progressive taxation. This means that rich people with big individual Retirement Accounts are likely to see higher tax rates, perhaps a lot higher. Even so, some retirees live frugally on retirement incomes considerably smaller than their employment earnings. Other re- tired people may have very large deductible medical bills, or other deducti- ble expenses sufficient to offset the taxable income from withdrawals from a traditional IRA. Such expenses aren’t deductible against tax-free Roth IRA withdrawals, so the deductions could be lost. Also with years to plan, some people may find legitimate tax shelters. And they may be in a lower tax bracket, even if all brackets are raised, resulting in a lower ETR on retirement withdrawals. Some possible advantages of converting: 1) Roth IRA conversions may be especially advantageous for well- heeled people who don’t need their IRAs for retirement income. With- drawals from traditional IRAs must begin no later than April 1 of the year after one turns age 70 1/2. Roth IRAs may be held without withdrawals during the original owner’s (and spousal beneficiary’s) lifetime. This means more money could stay in the Roth, compounding income tax-free for one’s heirs. However, a Roth, like a traditional IRA, may be subject to estate tax. 2) Currently, tax-free Roth withdrawals aren’t’ considered in deter- mining if Social Security retirement benefits are taxable. And they don’t affect Medicare Part B premiums. A few possible disadvantages of converting: 1) Roth conversions creating taxable income could increase Medicare Part B premiums or cause Social Security retirement benefits to be taxed for the year of the switch or both. 2) Converting to a Roth now could cause the loss of a tax-free conver- sion in some later year. For example, a business owner experiencing losses might be able to use them to offset the taxable income created by a Roth conversion. The result could be a totally tax-free conversion and tax-free income later. A cautious investor needn’t go all the way. He can convert a portion of this traditional IRA to a Roth. This could produce a better outcome if his esti- mate of future tax rates proves to be a lot different than what materializes. One big caveat: the best-laid plans of mice and investors may go astray. Every IRA investor’s situation is different, and no one should make important financial decisions without knowing how the law applies to him individually. Seek a financial professional’s help before taking any action. The definition of “Ironic?” Every year Warren Buffett auctions off a lunch with him to the highest bidder. The money goes to charity. This year the auction raised a record $2.11 million. Obviously, Buffett’s incredible investment record attracts those looking for some special insights into his investment strategy. This year his insight should be easy: “Never pay $2.1 million, to have lunch with anyone, including me!” As always, thanks for reading. MJD (Continued from page 6) 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 and we would be happy to add you to one of our mailing lists. Deschaine&Company,L.L.C. “Most bad government has grown out of too much government.” — Thomas Jefferson. Page 8