"I'm seeing people treating stocks like baseball cards. They're buying pack after pack of baseball cards trying to find the Mickey Mantle rookie year card, and there's this annoying piece of gum that they throw away. When in reality the only thing of value in that pack of baseball cards is the piece of gum. And people are completely disregarding dividends in the same matter."
He was right, and probably more so than he realizes. For when it gets down to it, the only thing that drives the value of a stock, the only thing that gives a stock its value is dividends, not earnings.
The reason why is that the shareholder never sees all the earnings, only the dividends. The corporation may reinvest profits and only pay out a fraction of that in dividends, but that still doesn't change the fact the only cash flow is dividends.
Now some will argue, "Yeah, but when I sell the stock, I get a capital gains, it's worth more than what I bought it for."
True, but that doesn't change the fact dividends are still what's driving the value of that stock. Whoever buys it from you, is not buying it now in hopes of selling it for more later, they're buying a future string of dividends. In other words, if you held onto the stock, in truth the only thing giving it value is its future dividends.
The only time there is a "genuine" capital gain is when the company is bought out by another. Otherwise the firm either dissolves or goes bankrupt and you have no capital gain. Thus, the entire history and value of a stock is not what profits it made, but what dividends it meted out to its shareholders.
Sadly though, and perhaps through the goggles of retirement planning and 401k's we look at stocks as purely capital gain investments. We rarely care about dividends and presume we'll be able to sell stocks for more when we retire.
There's just one minor problem. The true driver of value for stocks is going down, relative to the price you have to pay. In other words, you have to pay more in stock price to get the same paltry amount of dividends. This is measured by what's called the "dividend yield."
The dividend yield is dividends divided by price. In other words what percent return will you realize from investing in a stock given its price and the dividends it pays.
Roughly the dividend yield has averaged around 5%, meaning you could expect to receive a 5% return in the form of a dividend. Not terribly much, but it was a little more than inflation. But with stock prices being driven by retirement money and less by earnings and even less by dividends, the dividend yield has been driven down below 2% and has been there for the past decade. Even with the stock market crash in 2000 and even with our significant correct today, it's still below 2%.
The reason again is not that dividends have gone down, but prices have gone up so much driving the ratio down. Sadly this little tidbit of data is making me ever more convinced that stocks are going to be coming down like housing once the boomers retire.
While I agree with your general premise, that most people are unaware of the value of their stocks, I disagree with the thought that dividends are the only driver of value. If a company has positive net present value projects with internal rates of return (IRR) exceeding their cost of capital, management's choice to proceed with these projects in lieu of dividends can be reasonable. As an investor, I can choose to invest in companies that pay no dividends when I believe that management will make sound decisions and where my expected rate of return on the stock (based on positive IRR projects) is greater than my other investment opportunities. Without belaboring the point, I believe that properly invested retained earnings will drive the stock's value. A subsequent investor may decide to purchase my shares based upon those same criteria. Without judging the merits of Growth investment strategies, that is a reasonable reflection on how that has worked over the years.
ReplyDeleteI completely agree with you, and properly invested retained earnings should and will drive up the value of the stock. However, the inevitable fruits of the reinvested labor are not realized by the shareholders until they are paid out via dividends. My primary concern is how much prices have increased over dividends suggesting something other than dividends are driving prices now.
ReplyDeleteWell, looking at the time frame of this shift in dividend yield, one could conjecture that the S&P 500 has shifted more toward technology during that same time. Technology firms, while possibly overvalued at many points throughout said time frame, tend to retain their earnings for growth and not pay any dividends. This could account for a large portion of the shift. In the end, however, I believe that the reasonable idea that retained earnings drive value has taken over. You might say that this is just a "greater fools" theory of investment, where others may rightly prefer a good investment to reinvest its earnings so that they are not forced to pay taxes on dividends and reinvest the remaining cash themselves.
ReplyDeleteHmm, perhaps I've misunderstood your point. I think you and I look at this from opposite points of view: you're the economist, I'm the investor, and I don't fully agree with your post.
ReplyDeleteFirst, by "the value of a stock" I assume you mean embedded/intrinsic value. This is the value of a company taking into account all of its tangible and intangible assets (machinery, land, people, intellectual property, trademarks etc). This value is what drives the market price - all things being equal, all knowledge of a company is embedded within its current price. When a new piece of knowledge enters the market, the price of a share moves to reflect that. If it's a subprime loss, it'll go down. If it's regulatory approval for a drug, it'll go up. You get my general point.
This is totally and completely separate to the dividend. The dividend, assuming it's covered by a reasonable earnings multiple, is the "attractive compensation" an investor gets for placing their money in a share. That's why stable shares with low growth potential traditionally pay high dividends (another generalisation): holders are being compensated for sacrificing the higher growth they may get elsewhere. There are other reasons for dividends (for example, as an offset to risk) but let's leave those aside for the moment.
Dividends and value are linked, but they're not the same. Dividends don't drive the value of a share, they contribute to the market's assessment of fair price for it.
The other thing to remember is that not only are dividends and "value" different, "value" is also different to "price". It's quite common to see share prices trading well below their embedded value, especially when the market over-reacts.
Investing for growth and investing for income - two different but equally valid strategies.
Separately: Your note about 2% is interesting. In the most recent Investor's Chronicle (respected UK weekly mag) there's a list of the highest yielding FTSE350 companies. The vast majority are 5%+ yields, with a smattering going all the way up to a high of 13.65%.
Which company is the highest? DSG International, owner of the Dixons Group - a high street chain that sells white goods and electronics. A company with low growth prospects and not a small amount of risk due to consumer spending issues.
Also, don't forget the effects of stock buy backs. Until recently the tax advantages of buying back stock were far greater than issuing dividends. And (at least theoretically) buying back your own stock and issuing a dividend should result in exactly the same results.
ReplyDeleteit's good to see you are still up and dispensing financial justice.
ReplyDeleteit's great to be around again.
Hey hey, Mulk, where the heck have you been?
ReplyDeleteGood to have you back.
It is interesting that the 'greater fool' term was mentioned. This was my original point when I proposed the analogy to the Captain.
ReplyDeleteA significant amount of money blindly pours into equities daily. An informal survey of even the most astute co-workers has not yielded a single individual that an tell me what stocks their mutual finds hold. I'm sure many people know, but many more probably don't. I propose that there is currently an irrational excessive bias toward capital gain/stock price and earnings, rather than the actual tangible return. A stock's capital gains are not real until they are realized, i.e. the stock is sold.
Yeah, I know that is obvious, but it bears more thought. This irrational expectation is that a company can eternally reinvest earnings so as to avoid paying out those taxable dividends, and the investor will always and forever find someone who will pay more for the shares with the expectation of selling said dividend-free stock to another buyer.
Let's consider tulip bulbs for a moment. Do they pay a dividend? Sort of - if you get enjoyment from owning a particularly beautiful specimen. that is the dividend you receive. One of the precipitating events that collapsed the tulip bubble was the realization that even the wealthy who were buying the bulbs were doing so to speculate. In other words, the price of the bulbs had risen so high that everyone was buying to sell. The dividend (enjoyment of ownership) could not justify the price anymore, only potential capital gains could justify the price. Once everyone started realizing that there was no 'ultimate buyer', the price collapsed to the value supported by the dividend - personal desire to own the tulip bulb.
As long as you can pass the stock along to someone else, you can play the earnings/capital gains game.
This point gets lost on so many people, but absent real pass-through of earnings (dividends), you can only justify the sale to the next buyer. But you can never justify the sale to the ultimate buyer.
This painful lesson is being learned with respect to housing. It was always assumed that there would be a next buyer, when in fact many people realized they were the ultimate buyer. Many, if not most, of the people who are now 10-20% negative equity would not have paid the price they paid had they known that they had no next buyer to give them their 'rightful' capital gain.
And so it will likely go for stocks - expect dividend yields to be low for a protracted period, since the public clamors for stock price, just as they did for house prices, without much thought of dividends (cash from a stock or housing value provided by a property).
I fully expect a what-were-we-thinking moment in the future when many discover they were someone else's next buyer, but they are holding the bag as an ultimate buyer (of broad market holdings, not an individual stock).
In the mean time, corporations have essentially free use of your rightful dividends, often searching (with difficulty) for internal investment opportunities that will meet ROI hurdles so that they make more money for you that you will not be paid so that they can reinvest it to create more earnings you don't get.
And the market cheers this arrangement. "Reinvest it! We trust you!"
I highly recommend the Bernstein-Arnott paper on this issue, but it's heavy reading.
Capt,
ReplyDeleteDo you not think the continued flow of funds into stocks, since the boomer's began in the 1970s, will prevent a burst in stock prices once boomers retire?
I could understand your theory of an epic stock price deflation when boomers begin to retire if there were no means by which to replace the lost funds of boomers retirements. But, American society has made the shift toward the stock market, injecting the stock market with funds for three decades.
Baby Boomers represent around 1/4 of our current population, and have been among the greatest income earners; especially the older boomers. This is demographic fact, not opinion.
ReplyDeleteSecond, boomers have been the greatest users of stock-based retirement plans (mutual funds in 401Ks, IRAs). The available excess wealth in the following generations is not as great, hence there will not be a group of greater income earners coming along behind to bid stock prices higher.
It is important to remember that most stocks that people purchase are "used stocks", if you'll forgive the term. The corporations receive none of the cash from the sale. They are exposed to a liability, however, in that a low stock price affects their public image and borrowing potential. And executive stock-option bonuses. This has led to an obsession with stock price, and an unnatural dismissal of earnings as being nearly irrelevant.
A significant portion of the gain over the last hundred or so years has been from the advancement of price, in the absence of substantial dividend gains.
Through 2001, stocks had gone from 18 times dividends to 70 times dividends (almost quadrupling). Can we really expect future investors to buy our stocks out at over 270 times dividends? Hint - that's a lot less than 1% yield.
There are to many expectations attached to equities. Everyone "KNOWS" that stocks yield 8% of you hold them long enough. Until they don't.
Again, I recommend the Bernstein-Arnott paper on this topic. It explains some one-time events that have happened over the years that are a part of the long-accepted 8% gain. These one-time events can't be repeated.
In many discussions with investors, the key thing I notice is that they fell that the long-term stock market return is a fixed quantity; a law of nature (like the speed of light) and that all time and space must warp to to fit that number. Essentially they believe that the market OWES them 8% if they hold out long enough, and all other participants in the economy MUST and WILL act in such a way that ensures that return.