Shiller Data Shows Just How Important Dividends Are to Stock Investing

I was reading a blog post over at CXO Advisory Thursday. [Steve LeCompte who mans the shop there does outstanding work. If it's not part of your daily reading, it should be.] In that post, CXO did a quick analysis of a system based on P/E10 ratio. P/E10 is, as Steve explains it, “the ratio of the inflation-adjusted S&P Composite Index level to the average monthly inflation-adjusted 12-month trailing earnings of the index companies over the previous ten years.”

Steve used data from Robert Shiller to evaluate the system. That prompted me to take a fresh look at the Shiller data, which I had not seen in quite some time. The chart in the first worksheet, which I had ignored previously because I was only interested in the data, surprised me. It’s a graph of the S&P 500 Index adjusted for inflation going back to 1871 (not 1971, but 1871). Here’s my version of the chart (I changed some colors and used a logarithmic scale for the y-axis):

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Like I said, this got my attention!! Here’s why: note the peak in 1901. I’ve drawn a horizontal line at that peak (it’s the lower one). Now look towards the right of that horizontal line. In 1982, the stock market was back down to the level it was at in 1901. In other words, over that 81-year stretch, stock prices had made no progress!

It’s almost but not quite as bad during the last 40 years. You can clearly see that in March 2009, the inflation-adjusted S&P 500 index almost got back down to the level it was at back in 1968 (upper horizontal line).

Talk about depressing! Forget about the lost decade; we got close to the "lost FOUR decades"! And it’s the clearest evidence anyone needs to prove that buy and hold is horrible. Or is it?

One key element upon which the Shiller chart is based is the index price. In other words, the Shiller data does not include dividends. Had Shiller graphed total return, which takes into account dividends and reinvests them, things would have appeared much, much better.

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Notice the huge improvement when dividends (which are constantly being reinvested) are included. That’s good news. But it’s also bad news. It’s good news because it shows that the stock market is not nearly as bad an investment as the price-only chart may lead you to believe. But it’s also bad news when you look at how things are today versus the past. Instead of paying dividends, gigantic sums of money have been diverted away from dividends and towards buybacks as this chart and accompanying article show. The thing that is so disturbing about this is that the entire premise of a stock buyback is to reduce the number of shares so that earnings per share rises, which leads to a stock price increase. But that’s the exact opposite of what actually happened. Earnings per share collapsed, as have stock prices. There may have been a reduction in the number of shares, but that was insignificant to the earnings catastrophe that the recession caused. Instead of frittering money away, these companies, and their shareholders, would have been much better off had they kept the money in reserve as opposed to squandering it in a fruitless attempt to boost the share price.

Click image to enlarge

In sum, the Shiller data shows just how important dividends are to stock investing. If you’re investing in stocks, and relying on price appreciation only, the data truly is depressing. You are facing serious headwinds where 80 years of gains can be wiped out. Without dividends, buy and hold is a worthless, and potentially dangerous, investment strategy. Dividends have been the crucial factor that have made stocks a profitable investment over time. The problem right now is that many company boards of directors have been diverting money that could have gone to dividends into stock buybacks.

Data sources: Bloomberg, Global Financial Data, Robert Shiller.

Comments

[Senan:]

+1, very eye opening article and graphs, good work. Personally I do lean towards big dividend paying stalwarts. However, as a novice amateur investor there a romanticism with chasing small growth shares with the potention to rocket. We're all unfortunately looking for the next get rich quick pick.

Sep 25 03:42 AM

[frugalandpu...:]

What are the best divided ETFs ?? Can you name 3 ?

Sep 25 06:13 AM

[sticktoitiv...:]

The article was great until the conclusion. The data on dividends is extensive, but the large number of buybacks are a recent development. We are in the middle of a nasty recession. It may be crowding out the positive effects long term.

It's kind of interesting to see what happens when dividends and buybacks are combined. The company doesn't have to pay a dividend on stock it bought back, and can eventually raise the dividend on the other shares, even in a static earnings environment.

Sep 25 12:22 PM

[Graham and ...:]

As Bill Gross of Pimco pointed out, the average return on U.S. blue chip stocks in the 20th century was dividends, plus inflation, plus 0.6% real. And the last term is sufficiently close to zero for our purposes, depending on your starting and ending points.

Put another way, stocks are glorified TIPS (Treasury Inflation Protected Securities) that should be bought for yield, not for (real) capital gains. And they shouldn't be bought at all, unless their dividend yield exceeds the TIP yield

This was not the case in the year 2000, which is why we had a decade of miserable returns.

Sep 25 04:36 PM

[David Van K...:]

Stock buybacks are generally a poor use of a company's capital. There are lots of reasons, but one of the most important is that companies tend to pay top price for their shares. That is because they institute buyback programs when they have lots of discretionary capital, which means business has been good, which means shares are likely fetching high prices. Another reason is that many share buybacks are to get shares to pay executives (stock or option grants are part of their compensation.)

But companies (especially in the USA) have another restriction. They can't raise their dividend too much, because when times get tough, they may have to reduce the dividend, which is viewed very negatively. This is an important part of the ongoing policy and culture at many companies: Never reduce the dividend. So after raising the dividend a prudent amount, if there's money left over, it may be directed to a buyback program. (Those aren't monitored as closely, and many in fact are never completed.)

There's no surprise at all that when tough times hit over the last couple of years, buybacks dropped through the floor, while dividends (although many have been cut out of necessity) have held their own in a relative sense. The graph shows this vividly.

Sep 25 07:44 PM

[Dividend Di...:]

I agree that investors would be wise to consider a dividend reinvestment based strategy for their portfolios in order to capture long-term gains. I also agree that many companies, in hindsight, were unwise to pump cash into buybacks as valuations soared yet liquidity concerns and lower earnings followed shortly.

However, despite my advocacy of dividends, I have to defend a capital appreciation strategy in the market, which you have simplified to “…buy and hold is a worthless, and potentially dangerous, investment strategy.” Investing in the stock market is potentially dangerous. Making blanket statements without appropriate context is also dangerous.

How many investors purchased their entire portfolio in the S&P500 in 1901 and cashed out in 1982? I’m going to assume, irresponsibly, 0. A basic definition of buy and hold is that the concept that one can enter the market on the lows and sell on the highs (buy 1951, sell 1971 or buy 1981, sell 2001), does not work for small, or unsophisticated, investors so it is better to simply buy and hold. However, that is greatly dependent on an individuals’ investing timeframe, which you fail to mention. Also, this completely excludes the fact that most investors make portfolio purchases over time (you have the dollar cost averaging crowd, and the mere fact that most people accumulate their earnings to invest over time).

I personally disagree that small investors can’t make “timely purchases” or that “buy and hold is dead”, or buy and hold is worthless. Small investors can make out fairly well for themselves following Buffett’s advice of “Be fearful when others are greedy and greedy when others are fearful” (buy March 2009, sell Sept 2009).

Sep 26 09:29 AM