By Kenneth N. Green, CPA, MBA
We would like to sound a wake-up call to retirees and conservative investors who may be waiting for much better rates of interest on certificates of deposit (CD’s) and government securities. Those rates may not arrive for a long time, perhaps not in this decade and maybe even longer. Today, the 10-year Treasury note yields 1.64% and may not go much higher this year. The high bond prices (commensurate with low yields) represent elevated capital risk for intermediate-long term bonds, in addition to the low income return. Still, for open minded investors, there are viable options to earn good income.
Globally, central banks have been competing with private investors for the available supply of bonds this past year as a result of the Covid-19 induced liquidity injections. Further, the industrialized world is rapidly aging, putting additional pressure on the demand side. And, many institutions and fiduciaries are required to own “investment grade” bonds. Hence, low yields will be with us for some time to come.
From December 31, 1980 to December 31, 2020, the annualized return of the Bloomberg Barclay’s U.S. Bond Index was 7.62%. With current yields just slightly above 1%, there is no way that future bond returns will match those of the past generation. Over this time, investors have relied on bonds that paid an interest rate above the inflation rate. The secular decline in bond yields amidst a low inflation environment has rendered this strategy untenable for the coming decade or even decades.
Given this reality, investors looking for income will need to look at equities for their dividends. Although doing so entails greater risk, there are advantages, too, in that dividends can grow with time and are taxed at lower rates to U.S. investors, and the underlying equities can appreciate. Appreciation also benefits legatees when the equities are maintained in taxable accounts.
In balanced portfolios, dividends from companies that consistently grow their payouts are an essential income component. Today, there are many high-quality companies whose dividend yields exceed the 1.5% available from the S&P 500 index or the 1.8% from the Dow Jones Industrials index.
Although few investors are willing to wait patiently for several years before they start seeing positive results, a graphical depiction of dividends as a share of personal income vs. interest over the past generation is dramatic. Interest as a share of receipts on assets peaked in the mid-to-late 1980s at 18% whereas today it is about 8%. Dividends however have grown from about a 4% share to about 6.5% today. (Source: 2021 Ned Davis Research, Inc.)
The demand for income-producing assets will increase dramatically over the next thirty years. Based on United Nations estimates, world population will reach almost 10 billion people by 2050. (Source: United Nations World Population Prospects 2019). Advances in medical science along with increases in longevity mean increasing demand for income-producing assets and further pressure on bond yields. Among industrialized nations, all of which are experiencing falling birth rates, the rising proportion of the elderly are being sustained by a smaller proportion of those of working age. As a result of expected increases in life expectancy, the Social Security system that relies on taxes paid by the working population to pay for those already retired will become increasingly stressed. This same phenomenon is applicable globally. The demand for income-producing assets will continue to increase commensurately and interest rates will remain pressured. Hence, reliance on dividends for portfolio income will only continue to increase.
Given the increased risk inherent in common stocks, what should an investor look for in an attempt to put greater reliance on dividend income? Simply put, an investor must employ solid fundamental evaluation techniques. What do a company’s earnings and cash flows look like? Do cash flows cover the dividend? How fast have they grown and how consistent has that growth been? What is a rational expectation of how fast the company can grow, going forward? Have the dividends been growing and ,if so, at what rate and for how long? Will this dividend growth continue? Has the company ever cut its dividend and, if so, why? Is the payout ratio reasonable and is it increasing or decreasing? What has been the nominal yield and yield on cost that the stock has delivered?
As long as world economies grow, earnings and dividends will grow despite occasional recession-induced setbacks. Moreover, dividend growth companies -- those that have never cut their dividend payouts -- have, over long periods of time, outperformed all stocks that pay dividends as well as non-dividend paying stocks. This applies to both S&P 500 companies and those of developed foreign markets. In developed foreign markets, dividends are a greater part of total returns than in the U.S. and are paid in greater proportion across more market sectors than just Energy, Utility, Real Estate, and Telecom Service.
Today, the valuation discrepancy between dividend-growth companies and non-dividend paying companies is at a historical extreme, perhaps the widest ever. These dividend-payer companies are known as Dividend Aristocrats, Champions, and Contenders depending on how many years in succession they have raised their payouts. The returns of major market indices have been powered by a relative handful of high-valuation technology companies that pay no or very small dividends. Many of these are overvalued and will face competitive challenges in justifying their valuations.
This past year has presented an extraordinary challenge for all investors, given Covid-19- induced volatility. And, the fourth quarter witnessed a dramatic change in market leadership as the Energy, Financials, and Industrials sectors took the lead. We believe that a value -oriented portfolio consisting of companies that sell at reasonable valuations of revenues and earnings -- and that are positioned to grow their dividends for the next several years -- will provide investors with worthwhile returns at a reduced level of risk.
We would welcome the opportunity to help you evaluate your investment strategy in light of your objectives, risk tolerance and time horizon. Please feel free to reach out to Marc Lane, in confidence. His email address is MLane@MarcJLane.com.
Kenneth N. Green is the Senior Vice President and Director of Investments at Marc J. Lane & Company, the investment affiliate of The Law Offices of Marc J. Lane, P.C.