Several Camelback Fund investors emailed me this week about an Op-Ed piece in the Wall Street Journal by Jeremy Siegel and Jeremy Schwartz (link to bios) that reiterates their feelings that Treasury bonds are in a bubble, and suggests that dividend-paying stocks are the answer to a Treasury bond market that they feel is dangerous.

I try to read whatever I can by Jeremy Siegel, and I did see this piece, but I very much appreciate when investors and other interested parties share these kinds of things with me.

It should be noted that one of the primary points of the article is the authors' acknowledgment that a subset of investors has avoided dividend-paying companies because the big banks and related financial companies pretty much all cut their dividends in 2008.  Their share prices also crashed.  With few exceptions, they haven't returned to pre-crash levels.  Siegel and Schwartz don't think financials will have the same impact if we see a repeat performance, as they now make up only 16% of all dividends in the S&P 500, and dividend-paying companies in every other sector have rebounded nicely.  They point out that, aside from financial companies, dividends for other stock sectors actually grew in the period from 2007-2009.  While it felt to many like the stock market was imploding, investors in non-bank dividend-paying companies were able to bide their time and actually see an increase in cash flows if they simply stuck to their strategy.

Some other highlights from the piece:

• Corporations are more profitable than ever, and those that pay dividends are generally better able to pay them than they've been in a long time.  The average payout ratio of less than 30% provides a "huge cushion" for companies to continue paying their dividends even if a double dip recession materializes.  
• The dividend yield for S&P 500 companies is now more than 2%.  That means that simply investing in a decent S&P 500 index fund will provide exposure to capital appreciation as well income that stacks up very nicely against Treasuries.  Of course, a more focused strategy will pay considerably more than that.
• Dividends for S&P 500 companies have grown at a faster pace than inflation over the past 50 years, in periods of low inflation as well as high inflation.  A lot of people are flocking to gold to protect against impending inflation.  (Others don't actually know why they're flocking there, except that it has been going up lately).  In fact, it's hard to say when we're going to see higher broad-based inflation.  Dividends will outpace it if we do, and they'll outpace it if we don't see it any time soon, based on the historical record.
• Dividends in the S&P 500 have grown by 10% over the last 2 years, as corporations are holding record amounts of cash, and many are "rightly" returning some of it to shareholders.  One of the key points that seems to have been forgotten in the recent market turmoil is the fact corporations have been turning in record profits, and those profits have generated record cash hoards.  More and more companies are choosing to return to the old ways by distributing at least some of this cash to its owners.

No, for several reasons.

First, our investment management clients are charged the same flat rate for that service as are investors in the Camelback Fund. Consequently, Foothills Financial Planning has no financial incentive to choose the Camelback Fund over competing investments. Additionally, for the typical financial planning client we develop an asset allocation plan prior to selecting any specific investments. The investments from Camelback Fund will only draw from a couple of asset classes. By design, much of an investment plan we create will require investment options that cannot be fulfilled via the Camelback Fund. Finally, and perhaps most importantly, the Camelback Fund is a Spoke Fund®, which means that a significant percentage of my family’s liquid assets are invested in the fund. That can be considered a conflict, certainly, but I consider it a conflict that an investor should welcome.

For more questions and answers on the Camelback Fund, please see our Camelback Q&A page.

There are several obvious cases that would cause us to sell. The easy one is that we'll almost certainly sell if a company suspends its dividend. That would cause the holding to unequivocally violate our fundamental requirement for ownership. Similarly, we'd be very likely to sell if a company cuts its dividend, as we'd consider that to be a very ominous sign. Another catalyst that could go hand in hand with a negative dividend change would be a material breakdown in the business case that motivated us to buy the company. This could mean that we simply were wrong and have finally come around to that position, or that there was a material change. An example of such a change would be BP's recent oil spill troubles. Certainly, there are arguments for and against investing in BP over the last few months; what is inarguable is that the financial picture for the company changed drastically in a short period of time. That would clearly be cause for re-evaluation on our part.

The final reason that we would consider selling a significant position is a run up in the price of the stock. This is a pretty standard consideration in straight value investing: if a stock is trading for considerably more than one's calculated intrinsic value, it may be time to pare down the position. Many value investors bail out at or even prior to the point when market prices match intrinsic value. We view things a bit differently in the case of the Camelback Fund. If we've been able to buy a strong, dividend-paying company for a lot less than its intrinsic value, and the market has subsequently recognized the mispricing and closed the gap, we'll probably hold on a bit longer than a strict value investor because we like fortified companies that pay a healthy dividend. However, there comes a time when the prospect of a significant price decline and the likelihood of more attractive investment opportunities make a sell decision obvious. An example of this is a fertilizer company that dropped approximately 45% between March and June, when I bought it for myself and earmarked it for the Camelback Fund. Before the fund launched, it had already gained back more than 50%, and was right around intrinsic value. It consequently didn't make it into the fund's portfolio, but would now be a candidate for sale if it had.

Recently, I ran across an article from the May issue of Kiplinger Personal Finance discussing the wisdom of investing in dividend-paying stocks.  The information in the article is pretty well-covered territory at Foothills Financial Planning, but a sub-article covering Why Dividends Matter almost sounded like an advertisement for the Camelback Fund, so I decided to summarize the high points.


The article points to five reasons to favor dividend paying companies, using Procter & Gamble as a representative stock.  For purposes of full disclosure, P&G is not currently a holding of the Camelback Fund, but it is a significant holding in Warren Buffett’s Berkshire Hathaway portfolio, and it has a lot of the characteristics we look for in evaluating candidates for the Camelback Fund.

The high points:

Dividends are big drivers of stock returns

Although the S&P 500 is currently yielding less than 2%, dividends have accounted for 43% of the market’s long-term return of nearly 10% annually.  At the time of the article the yield for the S&P 500 was 1.9%, and we’re not far off of that right now.

Dividends can grow

Many companies make it a practice to increase their dividend on a regular basis, typically annually or every other year.  Owning these shares on a long-term basis not only ensures that the investor receives the dividend income he or she signed up for, but also that the income will grow over time as the dividend grows.  In contrast, the interest payment on bonds - which are another place income-seekers look for a steady paycheck - will never increase.  This is a particularly important issue when inflation is factored into the equation.  The fact that P&G has raised its dividend an average of 10% per year for a very long time provides reassurance that the income provided from such an investment will outpace inflation in most economic environments.

Dividend-paying stocks enjoy a tax advantage

At least through the end of 2010, dividends are taxed at a 15% rate for taxpayers in most tax brackets, while ordinary income can be taxed at a rate as high as 39.6%.  Those in the 10% and 15% brackets pay no tax on qualified dividends.

To be clear, the current favorable tax treatment for dividends is set to expire at the end of 2010.  Lately, there has been a lot more indication that they may be extended for a year or two, at least for most taxpayers, but that is far from a done deal.  If the tax treatment does expire, rates will return to the rates paid on ordinary income.

It’s worth noting that the out-performance that has been attributed to dividend stocks has mostly occurred during times when they were taxed at ordinary income rates, rather than the current lower dividend rate.  Nonetheless, the more that goes to taxes, the less the investor keeps.

Dividend-paying stocks tend to be less volatile than non-dividend stocks

While the stock market as a whole has been very volatile in recent times, and dividend payers have not been entirely exempt from that volatility, they tend to move up and down less than the overall market.  One backward-looking measure of volatility is beta, which in this case typically refers to how closely a stock tracks with the S&P 500.  The article points out that dividend-paying stocks as a whole (i.e. those that pay dividends, big or small) tracked pretty closely over the past 5 years, with a beta of .98.  However, Proctor and Gamble’s beta was only .55.

Bad markets treat dividend-paying stocks more kindly

Dividend-paying stocks tend to maintain their value in down markets more than their non-dividend paying brethren.  Perhaps the most eye-opening bit of data offered in the article is the fact that dividend-paying stocks lost only 10.9% in 2002, just after the bursting of the dot com bubble.  By contrast, non-payers dropped 30.3%!  In fact, P&G actually gained 9.4% in 2002.  

Yesterday's MarketBeat blog in the Wall Street Journal featured an entry titled Drumbeat for Dividends Grows, which highlights the fact that more and more analysts are calling for companies to raise their dividends in light of the historically low payout rates that current exist.  While we at Foothills Financial Planning and the Camelback Fund are pretty loathe to be aligned with what is trendy in the world of investing, we're not at all surprised that the world has woken up to the fact that many dividend companies are good values right now.  The fact that payout rates are relatively low underscores the fact that many dividend payors are perfectly capable of covering their dividends long into the future.

Also, note the recent performance of the S&P 500 companies whose dividend yields exceed the average yield on 10-year corporate debt.  Per the post, they have outperformed their S&P 500 peers by 700 basis points since April.

Wow.