Flight to Low Quality

December 15, 2002

November was another fine month for stocks. The S&P500 and the Dow were both up over 5%, while the NASDAQ rose over 11%. Small cap stocks were somewhere in-between, with the Russell 2000 (a small cap stock index) up around 9%.

Bonds were a mixed bag. Long-term government bonds were down just over 1% in October, after falling almost 3% in September. On the flipside, higher-risk bonds, like junk bonds, investment-grade corporates, and emerging-market debt all ran up. The Vanguard High Yield Corporate Bond fund (VWEHX) was up about 4.5% for the month. 

Why the flight to (low) quality?

If you recall from the last few issues of MAXadvisor, we talked about the panic investors felt when the Dow was in the low 7,000's, and how everyone had become severely risk averse. Much money piled into "safe" government bonds, lowering yields. Recently, as the market rallied back sharply, many of these same investors forgot all the things that made them scared in the first place - corporate scandals, a weak economy, looming war and terrorist threats, and lackluster earnings (to name just a few). Funny how a good days on Wall Street can rub out a lot of bad memories.

Such sudden fearlessness by investors sent the higher-risk asset classes north. Even one of the highest-risk areas of recent years, telecom stocks, ran up sharply. You can see such movements as some of the higher risk funds in our model portfolios took off. The Wasatch Global Science and Technology fund (WAGTX) was up almost 22% followed by the Gabelli Global Telecom fund (GABTX) up over 12%. Don't be too impressed - these funds have a ways to go until they get back to levels hit earlier this year (much less their old highs from the days of froth).

One more good month for stocks and our model portfolios may not show any loses this year, but it would have to be one heck of a good month. Currently only two of our model portfolios are down in the double digits since we officially launched them in April of this year - not a bad showing given this was one of the worst years on record for stocks.

But enough with tooting our own horn - what we really wanted to get to was something investors all but forgot about (but that the current administration has recently brought back into the limelight) namely, dividends.

Dividends are quarterly payments made by companies to shareholders. Since shareholders are really owners of a company - and the reason you own a company in the first place is to make money - years ago someone came up with the idea to give the owners of the company some of the profits the company generated. Hence, the dividend.

In fact, years ago (and we're talking hundreds of years here) you would have been laughed out of the room if you suggested it be any other way. A company makes money and they pay it back to shareholders. You "share" in the profits. There's obvious logic in that.

Along the way we got a little too clever for our own good. Some investors noticed that some companies did a very good job of taking the profits of doing business and reinvesting it back into the business and growing the business faster and making it bigger than companies that gave up their extra profits to the investors trying to live off there cash flow.

In fact, some of these companies became so valuable along the way that no shareholder in their right mind would have wished they could have seen a cash dividend of 5% a year. Rather, they sat back and watched the little company they invested $10,000 into become worth $100,000, $1,000,000, or even $10,000,000 over the years.

After a while corporate executives and investment bankers started questioning the very concept of dividends. Not only are companies "giving" away the fuel to grow the business when they pay out dividends, they are giving much of it to the government needlessly. See, dividends are so nice, they are taxed twice.

Say a company has revenues of $100 million dollars, costs of doing business of $90 million, and $10 million in profits - a 10% pre-tax profit margin. A corporation, unlike a partnership, is an entity in itself, so "it" has to pay taxes on that profit, just like a person would if they earned the money. We have a very low corporate tax rate compared to other countries, so say $2 million goes to Uncle Sam. This leaves $8 million. Say the company wants to keep $4 million and give $4 million back to shareholders (this is known as a 50% payout ratio).

If you are a shareholder of this company, you will get your share of the dividends. If own 1% of the company; you will get dividend checks totaling (dividends are paid quarterly) $40,000. This money is, of course, taxed as income, and personal income taxes tend to be higher than corporate income taxes (hey, you don't have a lobby group, do you?). You may have to fork over $15,000 of your dividend check to the government. So the profits were taxed once at the corporate level, and again at the personal level. Didn't our country have a revolution about abusive taxes?

So when companies explained that if they kept the money your stock price would go up (which is not a taxable event unless you sell) investors bought in. One thing we can all agree on is that there is a unilateral hatred of cutting the government in on your profits. You want income, buy bonds. Shares in companies are for making capital gains as businesses grow.

Fast forward to the present and 2/3rds of publicly traded companies don't pay any dividend at all, and those that do generally pay less than a 2% dividend per year (try living off that). Microsoft, one of the most successful companies of all time, is sitting on $40 billion in cold hard cash and to date hasn't paid one thin dime in dividends. Investors could care less; Microsoft has been one of the most successful long-term stock investments of all time.

There is one problem: most companies are not Microsoft. Most companies eventually reach a point were they can't really grow their business anymore. What to do with all the cash the business generates? Certainly we can't pay it to shareholders. This becomes the foundation of many half-baked acquisition "strategies" and new business initiatives.

In the late 90's, more wealth was destroyed by egomaniacal CEOs using company cash flows to build empires, often overpaying to acquire or build businesses. Today, you have many debt-laden companies trying to spin off these dumb ideas for pennies on a dollar invested. Just think how much money AT&T shareholders could have received in extra dividends if various executives didn't try to turn a cash-cow long distance company into a computer company, cable conglomerate, wireless world power, or internet industrialist.

The Bush administration, in an a bold new effort to stimulate an economy that just won't pay attention to previous efforts, is slated to release an economic plan that is expected to contain a dividend tax break.

The proposed dividend tax relief will likely be at the individual level, not the corporate level. Smart move - the government can't afford losing tens of billions in tax receipts. Plus it's much easier to get a tax break through if it's to the "voting" man, not giant corporations.

So with double taxation of dividends soon to be erased and the failures of leaving corporate execs with too much of your money to play with rearing its ugly head daily are bigger dividends just around the corner?

Unlikely. For one, paying out cash flow as a dividend makes a statement, "This company has no ability to grow anymore than an electric utility or a tobacco company". That's not the kind of talk that makes executive stock options worth millions. Two, some companies have odd notions of what profits really are. Dividends are real - profits an accounting entry, meaning many "profitable" companies would have trouble paying out a "real" dividend. Third, most stocks are so high in price that paying out even half their profits as dividends would only lead to anemic dividend yields of less than 1%. Remember, a 30 P/E ratio means a company only earns $1 for each $30 in share price, so if the company paid out half their earnings, and had a 30 P/E, you'd get a mere 1.6% dividend.

Then again, with money market funds paying about the same, a 1.6% yield ain't too shabby.