July 20, 2002
Dow Jones Average:8,019
S&P 500 Index:848
Rediscovering Dividends
Cash dividends paid out by companies to shareholders have
been an important part of investment returns over the past one hundred
years. A dividend return amounting to three percent of the stock value
was the minimum expectation investors had for well established companies.
It was assumed that reliable, trustworthy companies would return some
of the shareholders' money in the form of dividends. The stock market
routinely peaked and fell back whenever stock prices ran too far ahead
of dividend pay out rates.
The entire relationship between stock prices, earnings and dividends
changed in the last few years of the twentieth century. Stock prices
sprinted forward at a 20 percent annual rate from 1995 through 1999,
while dividends barely budged. Dividends became a miniscule part of
overall investment returns and were written off as irrelevant by most
investors. By the time the market peaked in early 2000, the average
company was paying
shareholders less than one percent per year in dividends. As corporate
earnings swelled in the late 1990's, many companies elected to use extra
profits for stock buybacks rather than paying more out in cash dividends.
The massive amounts spent on stock repurchase programs drove stock prices
higher than they otherwise would have gone, weakened company balance
sheets, and put little actual cash in the pockets of long term shareholders.
The temporary boost to stock prices did enrich company executives who
were cashing in stock options. The interests of company management became
disconnected from the interests of shareholders. But as long as stock
prices were rising briskly few complained about policies that wasted
billions of dollars of shareholder equity.
It has taken over two years for most investors to realize that the
robust markets of recent years were an expensive illusion. Dishonest
accounting of earnings, a manipulated new issues market, and aggressive
stock buybacks helped create the impression that stock price increases
were inevitable and unlimited. Throughout this entire crazy period one
thing that remained relatively constant was the cash dividends paid
out by companies. While reported earnings boomed for the 500 companies
in the S&P 500 Index during 1999 and 2000, the level of dividends
paid out by the 500 companies remained the same as in 1997. Dividends
are often a reliable indicator of the sustainable, real earnings stream
at a company. It is interesting that after rising sharply in 1998 and
1999, the S&P 500 index is now back to its 1997 level.
In recent months companies that pay larger dividends have been favored
over companies that pay small or no dividends. It seems that investors
want companies to show them some real money. After all the accounting
scandals and high profile bankruptcies, investors are fed up corporate
managements and brokerage firm recommendations. The old desire for a
decent dividend return is returning. If the market remains choppy, flat
or down for years, dividends may once again become an important part
of an investor¹s return.
The average stock is now yielding about 1.5 percent, up from the .8
of one percent two years ago, but still well shy of the 3 percent that
was the bare minimum expected for so many years. The major stock market
averages would have to drop in half again for dividends to reach the
3 percent pay out level.
Current Strategy
In my previous strategy update (April 2002) I was unequivocally bearish
on the stock market, seeing no sectors that could lead the market higher.
The S&P 500 Index was 1125 at that time, it is now some 25 percent
lower at 848. The cyclical stocks such as autos and housing are falling
as anticipated. Medical, technology, and telecom stocks continue to
erode in price. The decline of so many industry sectors and widely owned
stocks has finally broken the bullish mindset of most investors. The
media is full of bearish commentary echoing the very sour mood of most
listeners. Given such negative sentiment and widespread selling, it
is not surprising that some stocks are starting to score better on our
stock evaluation system.
Even though we are seeing some decent companies selling at realistic
prices, we do not think a bottom in the markets has been reached. When
a market trend is firmly in place, the indices go to extremes in both
directions. The two year downtrend in stocks is taking a heavy toll
on investor psychology. The penalty for the ludicrous highs of 1999
will
probably be lows beyond reason. As price to earnings ratios decline
and dividend yields improve the market will find stability. It may take
years for such a low to develop, triggered by unforseen events. In the
meantime we are finding some stocks that are reasonable buys in the
current economic\interest rate environment.
Capital preservation is still our number one priority. The value of
cash relative to shares of stock becomes more apparent with each passing
week. Cash has already doubled in value relative to the major companies
in the S&P 500 index. It is entirely conceivable that cash could
double in value once again before the bottom is reached. We are examining
ways to enhance the return on cash reserve holdings. We will not move
money into bonds that could lose significant value, because that would
defeat the goal of capital preservation.
