In Hussman’s commentary from Oct 3, 2010 he discusses current stock market valuations on what that says about returns for the next ten years. He says,

Still, with the S&P 500 at a Shiller P/E over 21, and our own measures indicating an estimated 10-year total return for the S&P 500 in the low 5% area, it is clear that investors have priced in a much more robust recovery than we are likely to observe. Our long-term total return estimates are consistent the historical norms based on Shiller P/Es – since 1940, Shiller P/E values above 21 have been associated with annual total returns for the S&P 500 averaging 5.3% over the following 7 years and 4.9% annually over the following decade.

In his view, the market is currently overvalued by about 30% and combined with lower than normal GDP growth in the future the market will return only about 5% per year over the next decade. Well, I agree, with his thinking even if my own outlook calls for 0% returns over the next decade. For the moment, lets take Hussman’s optimistic view (that’s a joke) and see what that means for returns of various dividend stock portfolios. I did a similar analysis in a post the power of dividends to protect portfolios in bear markets. In Hussman’s 5% scenario returns would look something like this;

The cell highlighted in green is the market total return, 5%, which is made up of a 2% dividend yield and 3% annual price appreciation. The yellow cells indicate dividend yields and growth rates that I consider realistic in being able to find is most market environments. Again, it is plain to see the effect the good dividend yields and growth rates have on returns even in this more optimistic but still low return environment.

What is even more surprising, if you’re not fully convinced about the power of dividends, is that these returns for dividend stocks are LOWER than what they would be in my bear market model (one which declines 50% but returns to even in 10 yrs). So, maybe a bear market is not such a bad thing after all….

My point is that dividends matter even in more optimistic but realistic market forecasts, that the current market is overvalued on a historical basis, and that you should read Hussman.

In reading investment commentary on the web, much of it truly uninformed, and a lot of the investment product advertising material, I notice that investors confuse two very different type of investment return calculations. When calculating investment returns one can calculate a simple arithmetic mean or the geometric mean (compounded return). The one that truly matters to your investment success, how many dollars you end up with in your account, is the geometric mean. As they say in the investment business, ‘you eat geometric returns’. Are the two really that different? Yes, they can be. Look at the chart below;

Source: Ed Easterling, Cresmont Research

As you can see the more investment returns vary the lower the compounded return. There two basic effects going on here. First, is the law of negative numbers – you need a larger positive return to offset any negative return. If you lose 50% over a period of time, you need to gain 100% to get back to even. Second, the larger the variation of returns around the arithmetic mean the smaller the compounded return. And it matters. In case F, you get 53% less return than case A!

Easterling classifies these two effects as Volatility Gremlins. Negative returns and high volatility are very destructive to long term wealth building and particularly destructive to retirement portfolios where yearly withdrawals are taking place.

My main point is quite simple here – by understanding these volatility gremlins and their effects you can more appreciate investment strategies that reduce volatility and focus more on absolute returns.

My conclusion in last week’s post was that it was too early to consider tech stocks as ‘good’ dividend payers, bar maybe Intel. The main reason is that tech dividend yields are among the lowest of any sector of the market and payout ratios are very low, both despite burgeoning cash balances and diminished (or less capital intensive) growth opportunities. Managements are coming around but returning cash to shareholders still does not seem to be among tech companies’ top priorities. Consider Microsoft.

I’ll just come right out and say it. Microsoft stock is cheap. Really cheap. I can’t find historical data going back far enough that tells me the last time it was this cheap. How cheap is it? Microsoft’s market cap is $211B as of yesterday’s close. It has $36B in cash and $6B is debt, call that $30B in net cash. It also generated $22B in free cash flow last year. That’s $22B after wasting money on stuff like Bing and even some productive stuff like Windows and Office. Add the numbers and figure how long it would take for Microsoft to buy itself. ($211B – $30B net cash)/$22B, that’s about 8 years to buy back all the outstanding shares. There are few if any businesses in the market that generate 40%+ return on equity (that is not a typo) and trade at this kind of valuation. Any other valuation metric also says the stock is cheap.

The problem is that Microsoft stock used to be really expensive, it used to be a high growth company, and in the past 10 years it has transitioned into a more stable lower growth company at cheaper valuations. And it has a bit of an image problem. Everyone loves Apple these days and hates Microsoft. A lot of people are certain Microsoft is going out of business – its just a matter of time. Maybe they are. I don’t really care. But right now the stock is priced for even worse than that. There are great businesses that are bad stocks and bad businesses that are great stocks. If you’re looking for a value stock that’s 30-40% undervalued and you’re willing to wait until the market comes around and realizes this then Microsoft is a great buy for capital appreciation and you get a decent dividend while you wait.

But I’m NOT going out and buying Microsoft stock by the boat load. I invest in quality dividend stocks in a certain target zone and Microsoft is not quite there. It just raised its dividend to $0.16 per share from $0.13, a nice bump. It has doubled its dividend in the last 6 years, that’s a 12% growth rate over this time. At yesterday’s closing price, its forward dividend yield is 2.6%. Potentially you’re looking at a stock that will generate 14.6% (2.6% + 12%) returns going forward if/when the market agrees. Not bad.

But if the market does not agree and the stock price stays flat for another say 10 years then you’re looking at returns of 4.55% per year. Ideally I don’t want to invest in stocks that are dependent on the market realizing their value to generate my target returns. What would change my mind? A higher stock yield, around 4%, would definitely do it. Microsoft has the ability to pay such a dividend and still maintain good dividend growth. Maybe management will come around soon.

P.S. There are other ways to generate income off these kinds of stocks. I would also include Intel in this bucket although its closer to quality dividend stock territory than Microsoft (although the McAfee acquisition really irked me). In a later post I’ll discuss an advanced income generating strategy that involves options that is great to use for stocks like this.

Today I'll discuss another reason to own dividend paying stocks - they protect your portfolio during bear markets.. Or, in other words, they increase your returns during bear markets vs non-dividend paying stocks.

First, lets make a simple model of a bear market. As I have stated earlier my investment outlook calls for another 10yrs of zero return for the S&P500 from today's levels, which would also be about the same level it was in 1998! We're not Japan but we're sure getting closer. For this analysis, I'll use a pretty pessimistic model, that has a 50% loss in year 1, followed by 4 flat years, then a steady increase back to where it started. If I took a $100 portfolio it would look something like this;

Now lets look at the annual returns of different portfolios using this market model.

The table shows the annual returns for portfolios with different initial dividend yields and different dividend growth rates. Lets start with the obvious. If you have a portfolio in stocks that pay no dividends and no dividend growth you will make no money, zero returns, for ten years. That's row #1 in the table.

Next, lets look at what the market return would be. The market, e.g. the S&P500, currently yields about 2% and dividend growth can be around 5% per year (I think this forecast is generous but lets give the market the benefit of the doubt). The annual returns from this market portfolio would be 4.01% per year, the cell shaded green in the table. Even in this flat environment, the index would give you 4% per year. Not bad, better than a 10yr US Treasury and certainly better than the much vaunted growth stocks in such a market.

Now, look at the cells shaded yellow in the table. These are returns I consider quite feasible to achieve by picking quality dividend stocks. Its my target zone. Take a 4% yielder with 5% div growth, not hard to find at all in today's market (DEO for example). Such a stock would give you annual returns of 8.01%, double the market return, over this terrible future time period. That's about the long term nominal stock market return! Even a 3% yielder with 10% growth, like JNJ, would give you annual returns over 7%.

On the other hand, consider higher dividend yielders like those with 6% yields and 5% div growth. The annual returns would be 12% per year! 6% yielders with dividend growth are harder to come by but they are out there. Consider maybe the best stock of all time, Altria (MO). Good yield and good dividend growth.

How does this all work? How can you get increased returns from dividends when the market tanks and then returns to just flat over 10 years? Its quite simple really. Its because of the power of re-invested dividends. When you re-invest dividends you buy more shares the lower the price. That first year when the market tanks 50% you buy twice as many shares as you would have had the market not moved. When the market does recover the returns on those shares bought at lower prices is much greater than the return on your initial purchase. And those returns compound over time.

In summary, despite a lousy market environment you can still make great returns through the power of dividends. They enhance and protect your portfolio even in bear markets.