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Thoughts on Dividends, Banks and Portfolio Management

8 February, 2010 by Ben O'Brien in Commentary

A client asked recently, why should I own any stocks that don’t pay a big dividend when I can own stocks that do pay a big dividend. And why hold on to stocks in troubled sectors like banking? What follows are some thoughts about portfolio management that address these concerns.

In my year end (2009) appraisal letter to clients, I derive long-term rates of return from stocks and bonds so that we can make projections about how much clients can take from their portfolios. Over the past 85 years, through recessions, inflations, booms and busts, stocks have returned about 10% a year. If one looks more closely at this 10% average return, about 5% is price appreciation and 4% is dividends. That’s the past. Looking forward, I said that the 5% appreciation is probably all right but that the 4% for dividends looked too high. I pointed out that dividends are presently 2% and I don’t see them going to 4% any time soon. Thus a total return from stocks of 7% seems more “prudential” for planning purposes going forward than the 10% of the past 85 years.

The 7% figure for stocks is an average figure that includes different classes of stocks but especially the two main categories called “growth” and “value”. Definitions of what is growth and what is value are a bit arbitrary, but generally a stock with a comparatively big dividend is a value stock and a stock without a dividend or a very small one is a growth stock. When one does well, the other often does materially less well, as happened last year, when Verizon and Exxon, which pay big dividends, fell in price while Hewlett Packard, which pays a tiny dividend, rose 47%.

Other things being equal we would indeed always opt for the bird in hand; that is to say, we would always take the big dividend-payer, but other things aren’t equal. Most growth companies don’t pay dividends; they reinvest earnings into growing businesses. Greater earnings growth also means the potential for greater appreciation as well. Not owning at least some growth stocks would likely drag down the appreciation component of equity returns; it could also mean avoiding important sectors of the economy, such as technology stocks, which tend to pay lower dividends. Additionally the government discriminates against dividend-paying stocks, and it is likely to discriminate even more at the end of the year. Dividends are presently taxed at 15%. Next year the rate is likely to go higher. Because the government taxes dividends twice, many corporations refuse to pay a dividend at all. Berkshire Hathaway is the most famous example.

Hewlett-Packard sells about 13 times earnings. At this level it is less expensive than the average stock, even though it is growing faster than the average stock. For instance last quarter it earned .99 versus .84 a year ago; for the full year 2010 it ought to earn $3.70 as compared to $3.14 year ago. This is a good company that’s growing and creating value for its owners. So even though it doesn’t pay a dividend, we want to own it to supplement our big-dividend-paying stocks that aren’t growing fast.

Why own Wells Fargo? Why own a bank in this climate? That’s harder to answer. Maybe we ought to get out of Wells and own no banks altogether. I am thinking about it. In defense of holding banks, their cost of raw materials is practically nothing. Thus they can borrow money at zero percent and then turn around and lend it out for several hundred basis points higher. The shape of the yield curve is ideal for banks right now. They have a license to print money. Is Obama going to go after the banks? Maybe. Can the banks mess up what ought to be mindlessly simple? Probably.

One last thought about portfolio management that cannot be quantified or analyzed; it comes from experience and the gut. You want things in a portfolio that can surprise. Whatever else banks are, they have the potential to confound expectations, which are quite low, and surprise. To date they have been surprising the wrong way. But I don’t like to have a portfolio of stocks where everything is doing well at the same time. That way lies trouble. Rather you want a blend, a balance, of in favor and out of favor, so that something is always in bloom.