Review & Outlook

Our take on the investing, financial, & economic themes of the day

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.

Comment on Long Term (ten year) Performance

18 December, 2009 by Ben O'Brien in Commentary

Investment performance here at O’Brien Greene over the past 10 years tends to be on average considerably better than the performance of the S&P 500-stock index over the same period (the S&P 500 is the customary standard of comparison in the investment business). Our portfolios vary a good deal from one to the next, but on average they rose a lot more than the 7.7% in the S&P 500 index over the 10 year period. Whenever there is a big difference between the performance of the S&P 500 and the performance of one’s portfolio, one should ask why, because it could mean there is too much risk-taking, or too little.

So why did our portfolios go up more in price than the S&P 500 over the past 10-years and what does it mean? The big reason has to do with the start of the 10-year measurement period, when our portfolios largely missed the popping of the Internet/high tech bubble in the late 1990s. Missing that bubble, or more precisely the aftermath of the bubble, made a huge difference; thereafter our performance tracked the S&P 500 pretty closely year in and year out.

We do not set out to have the price of our portfolios go up more than the price of the S&P 500. If it happens, as it did over the past 10 years, it is almost accidental. That’s because beating the S&P 500 is not the goal, at least not as far as we are concerned. Rather the goal as we see it is to take less risk than the S&P 500, while reaping most of the gain. We are willing to give up the chance for big reward if we can reduce the chance of failure. It is the standard risk-return trade-off – – except for the fact in the past 10 years the risk-return trade-off did not conform to history.

The past 10 years saw the risk-return relationship stood on its head: the less risk one took, the more one’s reward – – the very opposite of what is supposed to happen. It was one of the few such periods in American market history when risk-taking was punished.

What’s the bottom line, as far as we are concerned? It is unlikely we will have another such 10 year period when low risk outperforms higher risk. If the future is anything like the past, risk-taking will be rewarded over the long term, and performance may well trail that of the more risky S&P 500.

Comment on Short-Term (ytd 2009) Performance

18 December, 2009 by Ben O'Brien in Commentary

There are times when the S&P 500 looks like it is doing great but when really only parts of it are doing well. We saw this in the late 1990s, as we said above, when high tech and Internet stocks soared and pulled the rest of the average along behind. We are seeing the phenomenon again. Low-quality stocks – – the autos, banks, mortgage companies left for dead last spring – – are soaring, while stable and high quality stocks like Exxon are not. Our portfolios owns high quality stocks. They are up nicely through November 30, 2009 (in double-digit figures) but the S&P 500 is up even more at 24.08%. Anyone trying to best the price performance of the S&P 500 must today own more low-quality stocks (more banks, auto companies, mortgage companies) than are in the S&P 500 index. This is not a game one wants to play at this time, at least not in our opinion. We think one should still own stocks, but of the high quality sort. Let someone else play musical chairs with the risky sectors of the market.

Stuck In Chinese Handcuffs

20 October, 2009 by Ben O'Brien in Commentary

Painfully reminded that wealth has an ephemeral quality to it (think of all the housing wealth that has simply gone “poof”), people have been stuffing money into the mattress. The Federal Reserve estimates that there is more money in money market funds ($9.5 trillion) than there is in the S&P 500-stock index ($9.2 trillion). The latter comprises the stocks we usually invest in at O’Brien Greene. So double that is in cash, idle. When you add the Dow Jones Industrial Average and all the other stock indices to the S&P 500, you get “total stock market capitalization”; of this total money market funds amounts to about 35%. However you measure, we are talking big numbers. Before the financial crisis, cash amounted to about 15% of that total. And it is not just individuals who are stuffing money into the mattresses. Barrons Magazine reported this weekend that corporations have never before had so much of their assets sitting idle in cash.

Are money market funds the same as the mattress? Sure. Neither pays any interest. The average money market fund pays 0.15% annual interest, which I suppose is more than you get in a mattress, but not much more. I don’t see much difference between the mattress and the money market. Either way, the money is not doing anyone any good, except maybe psychologically. Bottom line: it is a tragedy to see so much wealth-building potential sit idle.

Franklin Roosevelt had the same problem in the Great Depression. He described the problem as “capital going on strike.” To solve the problem, he reasoned that if you can draft soldiers into war, why not capital? So he drafted capital, in the form of a tax, to make it go to work. We know, of course, what happened. People hoarded more cash. Is this what we have in store now? Talk of ending stock options and bonuses seems rather pointless. It is just going to scare people with money to sit on it.

The very attempt to force people to spend money tends to have the opposite effect. I think of Chinese handcuffs, which we used to play with as children. The more you struggled to get out of them, the tighter they became.