Equity, The Blind Optimist

Nov. 25, 2008 8:19 AM ETDIA, KBE6 Comments
Paul V. Azzopardi profile picture
Paul V. Azzopardi

SPDR KBW Bank ETF (KBE), invested in major US listed banks, now has a dividend yield of around 9% while the DOW Diamonds (DIA) yields half that.

This got me thinking about dividend yields on stocks. I suspect that DIA was the trigger: Charles Dow’s principles about how the market generally works, later dubbed Dow Theory, had at its core investors’ search for value and not, as now popularized, the confirmation by the averages, which was added later by others.

To Dow, value was sustainable dividend yield. Roughly, he believed a yield of anything less than 3% as being too low and 6% about right. Today, we have to adjust the headline dividend yield by stock purchases.

Many of us were nurtured on a paradigm which states that dividend yields, even after adjustment, are generally lower than bond yields, say 10 year corporates of equivalent rating.

As we can see, KBE and even the less threatened DIA are now challenging this paradigm.

One can argue, rightly in my opinion, that current dividends are not sustainable and have to fall even further and only then will we come to a point where we can apply Dow’s concept of a sustainable yield.

At the end of the road, though, we may still be surprised to find that dividend yields will exceed bond yields for some years to come.

Peter L. Bernstein, in his “Against the Gods”, notes that until 1959 dividend yields were higher than bond yields and that this had been the case since at least 1871.

Bernstein attributes the 1959 paradigm shift to inflation, which took off after the Second World War. The relative inflation-proofing obtained via stocks led to investors’ willingness to pay more for them relative to the income stocks produced. Since 1959, bonds yielded more than stocks.

The possibility of a deflationary environment apart, the reason why I suspect there is a moderately good chance that there will be another paradigm shift in the opposite direction, pushing dividend yields above bond yields once again, is the realization by many investors that the agency problem involved in trusting other people with one’s capital is much bigger than we previously suspected.

The helplessness of investors in the face of excessive CEO pay has now been compounded by the realization that we really don’t know what’s behind the balance sheet.

We thought that opaque balance sheets only belonged to technology companies, or maybe oil companies, but we now realize that the incentives of management and capital are at such odds that we even have to squint at banks, the cores of many pension funds’ equity portfolios.

The bottom line is that this realization is likely to increase the cost of equity capital.

Bonds can be inflation-proofed and one bond default throws a company into bankruptcy – so, with bonds, there is steel inside the glove. Equity is just jello. Changing directors and management triggers a bonanza out of the company’s coffers.

Equity is a blind optimist hoping that dividends will continue and not be cut, that the assets are there, that liabilities are not understated, that management is on its side, that laws and regulations will be respected, that inflation is measured correctly, and that eventually the exit price will be higher than the entry price. Hogwash!

With this crisis’ momentous historic slap in the face, a more realistic and rational equity would hopefully look at things differently.

This article was written by

Paul V. Azzopardi profile picture
Paul V. Azzopardi is an investment counsel and manages a private fund. A believer that individuals should take an active interest in their investments, he provides a free blog to investors wishing to manage their own ETF portfolio at ETFinvestmentsNewsletter.com (http://etfinvestmentsnewsletter.com/). (Please see further details under My Blog.) Paul initially trained and worked as a professional accountant and then obtained an MBA from the University of British Columbia. He has worked in the securities industry for the last twenty years as a manager of private client accounts. Paul has just finished writing a book on behavioural finance which is due to be published by Harriman House in the UK. His first book, "Investment and Finance - A Common Sense Approach", an investment primer, was published in 2004 by Progress Press. He lives in Ontario, Canada, and can be contacted at email@paulvazzopardi.com (mailto:email@paulvazzopardi.com).

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