Why Reinvested Dividends Are Crucial Investments in the Next Ten Years

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Like we pointed out yesterday, life goes on. The economic environment – widespread deleveraging – is going to favour some businesses over others. And in general, it will probably favour regular income (dividends) over capital gains. That’s about what you’d expect in a low-growth/no-growth environment. Investors will demand a higher yield to compensate for lower capital growth.

Even this is a return to cyclical norms. The good folks at Tweedy Browne in the States published some research a few years ago which shows that, “a market-oriented portfolio, which included reinvested dividends, would have generated nearly 85 times the wealth generated by the same portfolio relying solely on capital gains.”

It’s the sort of boring fact that the investment industry doesn’t generally alert you to. And to be fair, it’s not very exciting. At all. But it does appear to be true, at least up to about 2003, that reinvested dividends massively increase your total return in common stocks over time.

In fact, in normal times (without the benefit of a credit boom) reinvested dividends may be far more important to the performance of your common stocks than capital gains. The chart below from the 2002 book, Triumph of the Optimists, certainly makes that point clearly. It shows that for a one hundred year period, total returns in US and UK stocks with reinvested dividends are twice the returns of stocks with capital gains only.

How reinvested dividends can double your return in stocks over time

How reinvested dividends can double your return in stocks over time

Source: Triumph of the Optimists

You’ll note the chart ends in 2000. It includes the Internet boom in the markets, but not the bust. And of course, in the 11 years since then, markets have been heavily influenced by lower interest rates, central bank intervention, and quantitative easing. Globally low interest rates also made it less imperative for companies to pay dividends to shareholders. Companies could borrow cheaply and lever up to grow earnings. It was a market for chasing capital gains in a global boom.

But in the scheme of things, it’s the last 10 years that are anomalous, not the previous 100. That means we’re returning to a market where dividends will be far more important to your total return than they have been in the last 10 years. As financial analyst Robert Arnott wrote in 2003, “Unless corporate managers can provide sharply higher real growth in earnings, dividends are the main source of the real return we expect from stocks.”

This is encouraging news. It means the return of genuine security analysis is now on the horizon – after the great deleveraging. Investors will again have to assess which corporate managers do the most with your money. In technical terms, you’re looking for managers who generate consistently high returns on equity.

Naturally, we rang Sound Money. Sound Investments editor Greg Canavan to discuss this point. Greg pointed out that for really well-run companies, shareholders might be better off seeing the company reinvest its earnings in more growth instead of paying them out as dividends. This issue came up earlier in the year for BHP Billiton, with some shareholders clamouring for a cash payout while others wanted the earnings reinvested in new projects.

There are two last points we’ll make on this idea. First, the chart above shows returns from the US and UK markets over the last 100 years. It’s possible that the total returns in the Aussie market deviate. But we don’t have that data in front of us at the moment, so we can’t say.

What we CAN say is that in terms of capital management, Aussie firms are probably less culturally greedy than US firms. Ever since executive compensation has been tied to quarterly earnings performance in the US, US corporate managers have borrowed heavily to lever up the balance sheet and deliver quarter-over-quarter earnings growth. They were more interested in delivering earnings surprises to push the share price higher because that directly influenced their yearly pay packet.

You could make a pretty hefty argument that this mis-aligned the incentives of shareholders and corporate managers. The capital management of US firms became short-sighted, short-term, and dominated by growing quarterly earnings by any means necessary. This was particularly true, for example, for firms like Fannie Mae and Freddie Mac.

Shareholders, to the extent, they cared at all, decided to chase capital gains and leave the valuation game to the dinosaurs like Buffett and Canavan (just kidding Greg). But we may now be swinging back to a market where capital management matters again to investment returns. That’s what happens when you take away the balance-sheet boosting powers of easy money and credit.

The last point is probably the most important one: timing. You HAVE to be a market timer today in order to put these observations to use. First off, it’s of no use understanding the next big trend in financial markets if the current trend (the other side of the hurricane) wipes your capital out. The only real goal you should have in a bear market is to not lose money. And we’re still in a bear market.

But this is the encouraging thing. As the Austrian economists point out, the recession is the correction to the credit excess. The recession IS the healing to the economy, inasmuch as bad investments are liquidated and imbalances corrected. Eventually, market forces will over-run political and monetary intervention and return asset prices to a level commensurate with their power to generate real earnings in a real economy.

We are in the middle of the creative destruction right now. We’re closer to the end than the beginning. But we’re not there yet. But when we do get there, if you have your capital intact, it will be the last best chance of your investment lifetime to buy a portfolio of solid businesses. Then, you can let the magic of time compound your returns and reinvest your dividends.

Our suspicion is that for anyone planning to retire in the next 10 years, the next cycle of growth is probably too far away to matter. Baby Boomers need to preserve their capital now and make it generate enough income to live off of for the next 20 years. Losing another 20-30% in capital is not an option, even if it means the end of the correction.

If we’re right about markets reverting to the mean and dividends reasserting themselves as the most important factor in your total portfolio returns, then the main beneficiaries will be your children and grandchildren. They have time on their side, as long as they don’t rush in and lose all their money now. More on this next week.

Dan Denning,
for The Daily Reckoning Australia

The Daily Reckoning
The Daily Reckoning offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, The Daily Reckoning delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors. Founded in 1999, The Daily Reckoning is published in 7 countries with a worldwide readership of almost 1 million people.
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Dan
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Why is it this kind of sense isn’t wide spread?

How do we change the corporate culture to reflect this kind of prudent thinking?

Thanks for your continued thoughful musings Dan. While I don’t always agree with some of your philosophy, I do generally agree with the intent.

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