The First Dow
Insight NewsletterIssue #11
For those of you who have talked shop with me about stocks and markets these last few years may have noticed that I was trapped in fighting the last war much of the time. I repeatedly said that stocks are not cheap, that historical valuation levels are substantially lower, and that I was apprehensive to put substantial money to work in the average assortment of S&P 500 equities.
Well, with the benefit of hindsight, these reasons seem valid, but wrong. I did get some other investment sector strategies right in a very major way (Gold and Silver), so my investment performance was very good, but the question has kept nagging at me, why was I so reluctant to embrace the bull market of corporate profits these last four years?
We’ve done a lot of research on the history of dividend paying stocks recently, and it has brought us closer to the seeming consensus view of permanently higher than normal stock and bond valuations. In this letter we are going to historical stock returns and the origins of dividend paying stocks. We conclude with describing what this means for your portfolios.
“Historical Valuations” as an expression has many problems, mainly, it not precise. When did they ring the bell? Many studies site average returns on common stocks, beginning with the famous Ibbotson data which showed that common stock returns have averaged 11% annually since 1926. But is this the right starting point to measure? We could also start measuring in 1913 when the Federal Reserve was created, or 1885 when the first Dow Index was constructed, or 1896 when the Dow Industrials was separated from the Dow Rails Index.
In 1885 Charles Dow constructed the Dow Index. It was comprised of the 12 railroad companies (transports) and the industrial producers (industrials) delivering the rolling stock, railroad engines, and wooden ties to bind a nation. The Railroad was to that era, what the Internet is today, it revolutionized the way people saw the world. The railroads enabled commerce in new ways. But investors did not make money off these companies on the basis of long-term capital gains. The first Dow index had a value of 80 in 1885. In 1942 the decedents of that index stood at 92 (the Industrials) and 32 (the Transports). In other words, in 57 years, during a period of massive economic ascendancy common stocks had little if any capital gains. From 1885 to 1942 the Dow had gone up to 381 and down to 41, but there were never consistent capital gains.
So why did people ever invest you ask? Simple, they bought common stocks in order to receive an income stream, a dividend. Dividends on good stocks used to 6% yield. If you were rich, you needed to put your money somewhere, and many didn’t trust the banks (for good reason – 2400 banks failed in 1933). So the passive-investing public either bought bonds paying a few percent, or stocks paying 6% dividends.
Fast forward 65 years. Over the often quoted 80-year history of common stocks averaging 11% returns, the role of the dividend has been largely forgotten. Historically dividends made up more than 40% of the total 11% returns. And as shown above, dividends made up nearly ALL the return in the 40 years before common tracking of the 1926 Ibbotson numbers. But today, despite similar inflation rates, common stocks yield only 2%. Why so much less?
Well, since the post World War II bull market began in 1949, capital gains on common stocks have averaged more than 10% annually. Investors have stopped expecting companies to pay out more than half their earnings in dividend payments. Before this capital gains boom, common stocks were considered worthless, uninvestable, if they didn’t pay a dividend. The question of the day was “what does it pay”. Common stocks were not a part of your grandparents and great grandparent’s retirement savings plan. IRAs and 401ks didn’t exist. Most capital was put to work the old fashioned way, by putting it into your own business.
In order to attract investors, corporations that issued common needed a hook, to allure a constituency of stock holders. The hook was simple, pay a dividend. Dividends of good stocks tended to pay about 6% and common stockholders bought stocks in order to park their money in an income producing securities. The pre-WW2 generations of investors required dividends because they did not expect capital gains. The specter of inflationary and deflationary busts were higher than today, the dividend was a shareholder’s only protection.
The dividends of common stock today are lower than they were in the historical past eras for a number of legitimate reasons. The cyclicality of the business cycle is dramatically lower, and global growth opportunities are higher. A less legitimate but all too real reason is the excess of savings from Asia that flow’s into the capital markets of the developed world. The global economy has reduced the uncertainty, lowering perceived risk and corresponding risk premium. In a world awash in liquidity, the biggest danger to stock and bond prices is inflation. As long as inflation remains tamed, asset values seem pretty secure. It’s a stable equilibrium that maintains the permanent higher plateau of stock and bond valuations.
Another foundation supporting equity prices is the demand for stocks that is created by the burgeoning community of senior citizens from Tokyo to Berlin. Financing the retirement income of the developed world’s 200 million senior citizens means that more money than ever will be invested in common stocks in the coming years. I am convinced that today’s historically above average valuations are becoming more normal each passing year because of the persistent demand for equities by the wealth holding retirees of Japan the US, Western Europe and the oil producing states.
What does this history of dividend payments have to do with Barnes Capital?
Our confidence level in the durability of a non-inflationary environment has increased. With the acknowledged fear that our reduced caution on equities valuation may indicate that a market top is at hand (its said that all great money managers panic at market bottoms, and the inverse is usually also true), we are making some adjustments to our portfolios.
We are making large capitalization dividend paying stocks the focus on the equity portion of client portfolios. High quality dividend paying stocks have just 50% of the downside of the S&P 500 Index in bear markets. Besides reduced risks, we will in our next letter analyze the other long-term benefits of owning shares of companies that regularly increase the size of their dividends. Our next letter will come out in early February.
Blessings,
Daniel Barnes, CFA