On Monday April 12, 2010 the Dow Jones Industrial Average closed above 11,000 for the first time in a year and a half. Comprised of 30 mostly industry leading companies, the Dow was designed to represent a proxy of the overall health of the U.S. Economy and stock market.
Pundits are notorious and infamous for pointing to historical statistical references in order to make statements about the importance of dividends to investor returns. For example, we have read reports attributing dividends to numbers ranging from 30% to as high as 90% of total investor returns on various indices. Please, do not get us wrong, we love dividends and utilize dividend paying stocks generously in our portfolio construction process. Our problem is with statistical misrepresentation; not dividends.
Although dividends are certainly important and contribute greatly to investor results, we argue that specific analysis is more valuable and insightful than general references. We take exception to vague broad based statements such as: “dividend paying stocks have historically outperformed their non-dividend paying counterparts over the long-term. In fact, a higher dividend yield has typically meant better performance over time.” The previous statement was made by a prominent issuance-based mutual fund company in a marketing piece.
This is one of many reasons that motivated us to develop our F.A.S.T Graphs™ (Fundamentals Analyzer Software Tool™) in 1990. We wanted specific research not often miss-leading statistical references. Our F.A.S.T. Graphs™ allow us to evaluate the specific sources of long-term investor returns on over 10,000 mostly U.S. publicly traded companies.
Our research confirms that generalities regarding dividends & returns are in truth mere prejudices. Even though it takes more effort to conduct rigorous research than statistics alone can provide, we believe the insights and the rewards are ultimately worth it. Our F.A.S.T Graphs™ are designed to facilitate the more extensive research process.
In this Part 1 of this three-part series on Dissecting the Dow, we will look at the top ten best performing of the thirty Dow stocks since 1996 (14 plus years). We chose this time frame for an important reason. The year 1996 is a period where most companies in the Dow were reasonably valued just preceding the so called irrational exuberant period that ended in the spring of 2000. For perspective on returns, the performance charts compare the company's performance to the Russell 1000 Growth with Dividends.
Figure 1, below provides an overview the ten best performing Dow stocks since 1996. Nine of these top-ten pay dividends, with Cisco (CSCO) the only exception. Even though the Dow itself is not equally weighted, we calculated the average yields of these top ten as if they were. The current average yield of these top-ten companies is 2.18%. Interestingly as you will see later in parts 2 & 3 of this series the middle-ten best performing Dow stocks had an equally weighted current average yield of 1.85%. Yet most interestingly the bottom-ten have the highest equally weighted current average yield of 3.18%. This defies the conventional wisdom that higher yields drive higher returns.
Figure 1: Top Ten Review – Ranked by 15yr Performance as of 4/12/2010
(click to enlarge)
Figures 2a & b through 11a & b look at the top ten best performing Dow stocks since 1996 through the lens of our F.A.S.T. Graphs™. There are three different iterations of this tool designed to assist in calculating intrinsic value based on earnings. To the right of each graph you will see – Earnings Growth Rate – then a number printed in green ink.
For companies growing earnings at 15% or better, the graph is a PEG ratio (Price/Earnings equal to Growth Rate) calculation for value. For companies growing earnings at 5% or less, the graph uses Ben Graham’s formula for value. These graphs are marked in orange ink with – GDF – then a number that represents the value P/E ratio. For companies growing earnings between 5% and 15%, the graphs use a modified version of the first two and are marked in orange ink– GDF-EDMP – then the number representing the calculated value P/E ratio.
Therefore, the green line with white triangles represents fair value for each respective company. In other words, when the black line touches the green line, the stock is theoretically in value. Prices above the fair value line indicate over-valuation and prices below the fair value line indicate under-valuation.
Keep in mind that fair value does not necessarily imply high return. Slow earnings growers, even bought in value, will often generate lower returns than faster growing companies bought in value. However, and most importantly, notice how price and earnings correlate on each graph over time.
Figure 2a & b: United Technologies Corp. (UTX)
The top performing Dow stock, since 1996, is United Technologies Corp. Interestingly, UTX could also be seen as a poster child for the importance of earnings and its correlation to market price over time. Also, UTX has generated one of the largest total dividend income streams based on its 13.3% compounded earnings growth (red circle in Figure 2a). Since UTX started the period essentially in value and ended essentially in value, capital appreciation of 13.1% (red circle in Figure 2b) is virtually identical to earnings growth. Regarding dividends (not reinvested), they added 1.2% to total return.
Figures 3a & b: Microsoft Corp. (MSFT)
Even though MSFT did not start paying a dividend until 2003, thanks to its faster earnings growth of 19% and a special $3.00 dividend paid in 2005, their cumulative dividend was actually higher than UTX. However, due to high valuation in 1996 and low valuation at the end of the period, total return was lower than earnings growth. Nevertheless MSFT, based on strong earnings growth, came in second in total performance.
Figures 4a & b: Wal-Mart Stores Inc. (WMT)
During this period, WMT was emerging from a pure growth stock to a growth and income stock. Therefore a lower payout ratio at the beginning of the period than at the end resulted in slightly less total dividend. Also notice how very high valuation in 1999 caused stock prices to go sideways for approximately ten years. Once again, the importance of earnings to total performance and dividend income is evident.
Figures 5a & b: Cisco Systems Inc.
Even though Cisco is the only DOW 30 stock that doesn't pay a dividend, its 20.3% earnings growth is the highest in the index. Significant overvaluation in 1996, with a P/E ratio of almost 37 (close to twice its earnings growth rate), stopped Cisco from becoming the top performer. Further evidence, that earnings growth and valuation are the dominant drivers of performance, regardless of dividends. Notice how dramatic overvaluation in 1999-2000 quickly reverted to the mean (earnings).
Figures 6a & b: Int'l Business Machines Corp. (IBM)
Thanks to beginning undervaluation, IBM placed fifth in our top ten Dow 30 list. The capital appreciation for IBM of 11.6% was slightly higher than its 9.7% compounded earnings growth. Dividends added 0.8% to total return of 12.4%. Therefore dividends did make a meaningful contribution; however, capital appreciation based on earnings was the dominant source of performance. Notice how consistent IBM's earnings growth has been over this 14+ year period.
Figures 7a & b: Caterpillar Inc. (CAT)
Even though Caterpillar is the most cyclical and the slowest earnings grower of our top ten, excessive ending valuation enabled it to come in sixth place. When you examine how closely stock price follows cyclical earnings, the importance of earnings is once again evident. Dividends added 1.5% to the total return of 12%.
Figures 8a & b: Exxon Mobile Corp. (XOM)
In seventh place in our Dow 30 top ten is Exxon Mobile. Although a little lumpy, earnings growth of 10.6% translated into a total shareholder return of 10.8%. In this case, a steady and growing income stream added 1.7% to total return.
Figures 9a & b: Chevron Corp. (CVX)
Chevron Corp. placed eighth in our top ten Dow 30 list, even though it carries the highest current dividend yield of 3.4%. In this case, strong dividend income added 2.1% to total return representing almost 20% of the total. This is an accurate and specific assessment of the importance of dividends rather than a mere generality.
Figures 10a & b: Home Depot Inc. (HD)
Home Depot comes in at ninth place in our list with a total rate of return of 10%. Dividends contributed 1.3% to the total. We have two interesting points to make on Home Depot. First, it became overvalued during the irrational exuberant period before quickly falling back to earnings justified levels. Secondly, notice how stock prices closely followed earnings down during the housing generated recession.
Figures 11a & b: Intel Corp. (INTC)
Our tenth place top ten Dow 30 stock is Intel. With valuations in line at both the beginning and end of the period, capital appreciation and earnings growth are virtually identical. Therefore the importance of dividends is spotlighted as they added 1.2% to total return, generating a return greater than their earnings growth rate.
Conclusion – Part 1
We chose the Dow Jones Industrial Average because it only holds 30 stocks and because of its return to above 11,000 for the first time in over a year and a half. Consequently, in contrast to an index that contains 500 or more companies, the entire index is possible to examine easily in its entirety. With the Dow 30 now back above 11,000 we felt that readers would be interested in specifically reviewing how it got there. We found it interesting that four of the top ten best performing Dow 30 stocks were technology companies (MSFT, CSCO, IBM, and INTC). Two of the top performers are the energy giants Exxon and Chevron. Only three of the top ten performers had earnings growth under double digits. Therefore, we are concluding that the importance of earnings growth to long-term shareholder returns is validated.
In parts 2 and 3, we will review the middle ten best performers and finally the bottom ten performers of the Dow 30. Our goal and hope with this three part series is to provide readers a more comprehensive view of the Dow Jones Industrial Average than they have previously experienced. Most importantly, we strive to provide our readers greater insights into the sources from which returns are generated. Therefore, becoming more empowered long-term investors as a result.
Disclosure: Long UTX, INTC at time of writing