August 1, 2003The recent rise in Treasury rates has captured investor attention lately – particularly as it relates to the relative attractiveness of equities. As most investors know, interest rates have fallen to near record lows. But this summer we have seen a most dramatic rise in rates. The yield on the 10 Year Treasury has increased from 3.1% on June 13 to 4.4% at the end of July; an increase of over 40% in 46 days. (See chart) The only comparable move was in 1987 when rates increased 46% over the much longer time frame of 9 months.As long time clients of Westwood know, we have been investing in dividend yielding securities for our value portfolios for quite some time as part of our barbell strategy within the current economic environment. This recent rise in rates has taken place faster than anyone expected but does not cause us to materially change our views.
With rates up from multi-year lows, it is worthwhile to compare the return one might receive by investing in Treasuries vs. an alternative investment. In October of 2002, we outlined how General Electric (NYSE-GE), at $22.00 per share, paying $0.72/share dividend and growing at 8% per year can be more attractive on an annualized, total return basis than an investment in a 10 Year Treasury yielding, at the time, 3.6%. Reinvesting the dividend every year resulted in a 10.9% annual rate of return for an investment in GE and a 3.6% annual rate of return for the Treasury. (Read Ode to Pimco here.)
Today, GE retains its relative attractiveness over the 10 Year Treasury. As shown here, we will
continue our assumption that GE will only be able to grow earnings at 8% per year. GE raised its dividend to $0.76 /share in December 2002 and the price has risen to today’s level of $28.56. The 10-Year Treasury, by comparison, is yielding 4.4%.
Assuming GE grows its dividend at a rate equal to its theoretical earnings growth rate of 8%, they would be paying $1.64 / share in 10 years. Based on its recent share price, that equates to a dividend yield of nearly 6%. If we again make the assumption that GE’s price does not keep pace with dividend growth and the yield rises over the next 10 years to 3.5%, we can back into an implied price for GE of $46.88.[1] In addition, we would have received $11.89 in dividend
income over the period, resulting in an annualized return of nearly 10%. In contrast, the 4.4%, 10-Year Treasury held for the entire period, provides static $4.43 per year in income and does not offer potential for price appreciation. Comparing these two investments, GE’s total return continues to best the 10-year bond with an annual return still double that of the Treasury.
We believe that companies with the ability to generate free cash flow and support a growing dividend will come to take the mantle of leadership and pull the market ahead as investors begin to realize the true value in the high-flyers of the 1990’s. The new tax law changes favoring
corporate dividend payments have sparked changes in the boardrooms of the fundamentally strong companies and we have seen an unprecedented amount of change in dividend policies in the month of July. According to Standard & Poor’s, July has been the biggest month for dividend increases in recent memory. We entered the year with a historically low rate of companies in the S&P 500 paying dividends and a historically low dividend payout ratio on those companies. The percent of S&P 500 constituents paying a dividend has been declining for the majority of the last twenty years. In July, 6 companies initiated a dividend, bringing the percentage up from approximately 70% to 73%. 44 companies reported dividend increases in July, bring the Year-to-date 2003 total to 171 companies increasing or initiating a dividend. As a result of the new,
lower 15% tax rate on dividend income and the newly increased company dividends, investors will receive an additional $9.2 billion more in dividend income over the next year.[2]
Yet what we have seen in stock market performance is not reflective of the changes occurring within the tax code and the boardrooms of public companies. The high-flyers of the previous decade, who favor share buybacks over dividends and who carry rich valuations relative to lower levels of growth have outperformed recently. In 2003, companies that do not pay a dividend have returned nearly 34% while those that do, have returned just 13%. Over the last 12 months, the disparity is even greater. Non-dividend paying companies are up 42% versus 8% for those that do pay a dividend.
Historically, dividends have comprised nearly half of the S&P500’s total return (see above). With investors favoring high growth, low dividend paying companies over the bull market era of the 1980’s and 1990’s, dividends have played a smaller role in the total returns of portfolios. Again, only hindsight will tell which investments will have been the best to hold over the coming years. But we think the new tax law changes favoring dividends, historically low payout ratios and a more attractive relative return profile will allow dividend securities to once again take the day.
[1]Price = Dividend Rate/ Dividend Yield
[2] Source: Bear Stearns 7/28/2003
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