The Importance of Dividends–Part 2

In an earlier column, I discussed some of our philosophy regarding dividends.  This week, I would like to expand on that somewhat as well as give a quick update regarding taxation of dividends in the President’s budget proposal.

Modern financial theory holds that the value of any investment is the sum of the present value of its future cash flows.  This logic applies whether the investment is a publicly traded stock, a piece of commercial real estate or a hot dog stand.  With a dividend-paying stock, you are getting a return on your initial investment each quarter rather than relying purely on future earnings growth to make a profit. While short-term volatility can be considerable, over longer time periods stock prices follow rising earnings and dividends.

As part of our investment process, we compare the current market price of a stock to its theoretical value using a dividend discount model.  The output indicates whether the company is overvalued (expensive) or undervalued (on sale) based on certain assumptions. All else equal, a company that does not pay a dividend must have a higher expected growth rate than a dividend-paying stock to command the same valuation.  Part of our job is to analyze whether the model’s assumptions regarding dividend growth, the sensitivity of a stock to movements in the overall market, and other factors are reasonable. 

The dividend payout ratio is the proportion of a company’s earnings that are paid out as dividends to shareholders. If a company earned $1.00 per share for a year and paid a $0.40 dividend during that time, the dividend payout ratio would be 40%.  The traditional theory taught in universities and graduate schools all over the world used to be that the lower the dividend payout ratio, the higher the earnings growth rate in subsequent periods.  Recent studies have demonstrated exactly the opposite, that is, that higher dividend payouts actually resulted in higher future earnings growth.  This relationship was shown to hold true across a number of different countries and time periods.  If this theory continues to hold true, it would be a double win for investors, since they would capture both a higher current dividend as well as higher future earnings growth by investing in dividend-paying stocks.  (If you are asking yourself why we don’t invest exclusively in dividend-paying stocks, please see my November 25, 2009 Blog entry). 

Currently, qualified dividends are taxed at the same rate as long-term capital gains, at a maximum rate of 15%.  If the Bush tax cuts currently expire at the end of 2010 as scheduled, dividends would be taxed at higher ordinary income rates for 2011 and beyond. Tax brackets are scheduled to increase, with the top bracket rising back to 39.6% from the current 35% level.  However, President Obama’s budget proposal that was recently submitted to Congress has a maximum 20% tax rate on qualified dividends for single taxpayers earning over $200,000 and couples earning over $250,000.  For those earning less, the qualified dividend tax rate would remain at 15%.  While an increase in taxes on qualified dividends from 15% to 20% is not anyone’s first choice, it is a lot better than going from 15% to 28% or 39.6% as many feared.  It is too early to say whether this portion of the budget proposal will pass, but I believe that the result is unlikely to be significantly worse.

Bill Hansen, CFA

February 26, 2010

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Let’s Make Like BRK.B and Split

In late January, the financial world was abuzz with the news that Kim Kardashian’s shoe rental company launched its first retail kiosk at an L.A. mall! No, wait, wrong headline – Warren Buffett’s Berkshire Hathaway B shares underwent a 50-for-1 split! The shares, which had been trading just below the $3500 mark, split on January 21 and began trading around $70. Wow, seems like a great deal, doesn’t it? In the sense that a single share seems more affordable, yes. The operative word there is “seems.” Stock splits don’t affect the value of the company or its market cap (and if you’ll notice, 3500/50 = 70). To borrow an analogy from a coworker, think of the company as a pie. You could divide the pie into 4 quarters and charge $10 per quarter. Now, I don’t know about you, but when I go to a bakery or a coffee shop for a piece of pie, I am not interested in shelling out $10 for 1/4th of a pie. I also don’t know of many places that will sell you a fractional piece of a menu item. So, the shop owner would do much better to slice the pie into 8ths or 16ths, and offer each piece for $5 or $2.50, respectively. The smaller, more affordable quantity is more appealing to the vast majority of people, but the overall value of the pie hasn’t changed – all the pieces together still add up to $40.

So it is with a stock split. Investor perception is that $20 to $80 is a reasonable price to pay for a share of stock, so sometimes companies will split the shares when the price has risen above these levels. In Berkshire’s case, the split was due in part to the acquisition of Burlington Northern Santa Fe. In order for Berkshire to be able to offer shares of BRK.B in exchange for shares of BNI, they had to reduce the share price. Why? If BNI is trading around $100, and you own 20 shares, your investment is worth $2000, which is less than BRK.B’s per-share price of $3500. In the same way that you can’t order half of a menu item, you can’t trade fractional shares of stock, only whole shares.

To sum up, I will quote John Ogg from 24/, “A split is technically a non-event on true fundamentals. But at this point it has finally become a stock that the public can own.” It’s the same pie, just divided into smaller pieces.

Sarah DerGarabedian, Research and Trading Associate

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Somebody’s Economy is Doing OK

The Wall Street Journal recently reported that a bronze statue just sold at Sotheby’s auction for $104.3 million.  “It must be an ancient relic,” I said.  Nope – it was cast in 1960.  “It must be by Leonardo da Vinci,” my colleague said.  Nope – it was created by Alberto Giocometti.  “The person who would spend $104.3 million on that must have a lot of other money,” another colleague said.  Yes, probably.

Meanwhile, jobless claims moved higher.  The four-week moving average of new jobless claims ticked up from 456,000 to 468,000.   The unemployment rate is a lagging indicator of the near-term direction of the economy, but the initial jobless claims report is a leading indicator.  Some fear that the economy will “double dip,” meaning, take another leg down before a sustained recovery. 

Though having higher jobless claims is certainly not good, other leading indicators are pointing to the economic recovery.  The Conference Board measures an index of 10 leading indicators such as yield spread (the difference between the overnight bank lending rate and the 10-year Treasury), building permits, and the stock market.  The Conference Board recently reported that the index of leading indicators jumped 1.1% in December.  This is on the heels of a 1% increase in November. 

We take this as a good show of economic recovery (not to mention the recent report of 2009 4th quarter GDP of 5.7 %!).  Joblessness is painful to those experiencing it.  You can’t write off this reality because of other improving leading indicators.  However, the economy has to improve before job growth can resume.  In the mean time, we will save our cash and hold off on that $104 million dollar statue purchase.

Harli L. Palme, CFP®

Financial Advisor

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To Die or Not to Die in 2010

Since 2001 we have had a stable estate tax with gradually increasing estate tax exemptions.


2002-2003          $1,000,000

2004-2005          $1,500,000

2006-2008          $2,000,000

2009                          $3,500,000

2010                          $0 ???

For now in 2010 there is no federal tax on estates.  Of course nobody believes this will last.  The House and Senate will most likely come to an agreement to bring back the $3,500,000 exemption.  This is what the House tried to pass before 2009 ended.  The Senate was too busy with healthcare, so no fix was passed. The Senate I believe is pushing for a higher exemption and doubling the amount for married couples which will eliminate the need for a by-pass trust.  In other words, if an estate was valued at $7,000,000 the assets would not need to be split for each spouse to receive the full exemption. In either case, when they do decide it will most likely be retroactive to January 1, 2010.  If you die before they decide your estate may have to litigate to keep the zero tax.  One drawback to not having an estate tax is your heirs would inherit your cost basis on assets.  This could cause your heirs to pay hefty capital gain taxes if they liquidate assets after your death.  In prior years assets inherited qualified for a step-up in cost basis, using the value on the date of death for the new cost basis.  An estate will have the ability to increase the tax cost basis by $1.3 million plus an additional $3 million for transfers to a surviving spouse. This caveat is still uncertain as to whether or not it will go back to the old way of a full step up in cost basis.

We will keep you informed as to the outcome.  In the mean time keep on living and enjoy the economic come back, and the future market growth we are certain to experience in the years ahead.

Gregory D. James, CFP®

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Financial Literacy

I don’t remember my parents ever discussing money with me, but I grew up knowing they weren’t too keen on spending money. My mother was a traditional homemaker and for every dollar my dad earned, my mother saved 75 cents – and I’m not kidding. If they had lived they would be 87 and 89 today. They were part of the truly “frugal generation.” We see that clients in that age group tend to have a similar frugal nature. My parent’s investment choice was a bank savings account and CDs. They paid cash for everything, never having any debt, even on the homes they owned. My mother spent 10 years in a children’s home because her parents could not afford her. That alone provided the framework for her determination to never be poor again (just like Scarlet O’Hara). Of course, she should have invested in something other than cash for a better long term return.

Later generations have not practiced that same “thriftiness.” We didn’t have a depression era mentality. Of course, there are a lot more temptations to spend money in 2010, with a new “must have” gadget coming on the market every six months or so. Even so, the last 12 months should have provided the impetus for people to save more and spend less. I have decided that having money in retirement is a matter of choice. You choose to live large in your working years and the result is poverty at age 75. You choose to save some (but not enough) and the result is financial stress in your retirement years. To have financial independence in your retirement years is a direct result of adequate savings during your working years.

It is important that we teach young adults that they cannot spend $70,000 a year when their income is $65,000. They must live within their means and start saving at an early age. This actually might involve doing without from time to time, or putting up with a roommate. What a concept! I have just purchased a flat screen television because my children said I was the last person in the US to still have a tube television. There may be some truth to that as I couldn’t even give my old television away even though it worked just fine!

Initially, everyone should establish an emergency fund and that should be a priority. One of the reasons people build up debt is that they must resort to credit cards for unplanned expenses because they don’t have any excess cash. Of course, you should always participate in any retirement plan your employment offers. Beyond that, and after an emergency fund is established, excess cash should be invested. If you started early, a 10% savings rate could be increased gradually to a 20% rate – fairly painless. Truly, not many of us actually did that when we were young, but don’t you wish you had?

Barbara Gray, CFP®

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To Convert or Not to Convert?

I hate paying taxes. I know, I know. The government needs money to provide services and secure the national defense. I just hate paying taxes. You probably share my sentiments.

You will be surprised to know I am actually considering an option that would require me to pay more taxes over the next two years. For 2010, the IRS has changed the rules for conversions of traditional IRAs to Roth IRAs.

In the past, if you converted, you must pay taxes on the value of the distribution when you prepared your tax return the following year. However, for conversions processed in 2010, you can spread the tax liability over two years.

So, why would anyone want to do this? Distributions from traditional IRA accounts are taken at ordinary income tax rates. If you think you will be in a higher tax bracket in retirement, it might make sense to pay taxes now.

Presumably, you would pay less tax now than at retirement, when your IRA account has (hopefully) appreciated in value, and tax rates may be higher. Keep in mind that Roth distributions are tax free if you have had the Roth for at least five years and are over 59 ½.

There are other reasons to consider a conversion:

• Individuals who were previously ineligible to convert to a Roth because of income limits can now take advantage of the conversion option.
• You are not required to take minimum distributions from a Roth account.
• Distributions will be made income tax free to your heirs over their lifetimes.

Still, it may not be the right decision. If you think your tax bracket will be lower in retirement, then why pay more taxes now? If you have a short time horizon to retirement, it might not be worth the tax liability. Do you have cash available to pay the taxes? Using funds from the IRA you are converting or selling taxable assets to raise funds might be defeating the purpose.

Confused?  Your financial advisor would be glad to review your situation and determine if a Roth conversion is the right step for you.  Please give him or her a call.

Cristy Freeman, AAMS
Senior Operations Associate

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Do December Job Losses Mean “Double Dip”?

This morning we received a disappointing jobs report from the Department of Labor indicating that U.S. employers cut 85,000 jobs during the month of December. Since the consensus of analysts was expecting a loss of only 10,000 jobs, one can only wonder if this disappointing news means the end of positive jobs data.

As we move into this economic recovery we must remember that one piece of data does not a trend make. In fact, we have seen most indicators (leading, coincidental and lagging) improve over the last 6-9 months. When reviewing economic data, it is very difficult to make any conclusion from a single piece of data. Instead, it can be more important to follow the trend of data to get a sense of whether the economy is improving or weakening. During 2009, monthly job losses moderated substantially. Employment losses in the first quarter of 2009 averaged 691,000 per month, compared with an average loss of 69,000 per month in the fourth quarter. In following the recent trend, it is clear that the economy is strengthening.

We must remember that it is the job of the news people to shock us in order to ensure that we “tune in” tomorrow. Buried in today’s headlines, we learned that the US Labor market actually added 4,000 jobs in November rather than losing 11,000 as initially reported. This marked the first job growth in two years. This is excellent news that, along with the current trend, should indicate job growth for quarters to come.

In the early 1980’s we experienced what some call a “double dip” recession. This double dip recession was actually two recessions (Jan. 1980-July 1980 & July 1981-November 1982) separated by a period of rapid economic growth. In fact, the economy recovered so strongly from the 1980 recession that inflation forced the Fed Reserve to increase interest rates to a point that forced the economy into the second recession of 1981-1982. Let’s not forget that the economic period after the recession of 1981-1982 was arguably the strongest period of sustained economic growth in history.

This lesson in history teaches us that a slow and steady recovery may be more sustainable than a quick, inflation driven recovery. Although the trend to economic growth remains intact, the reasonable rate of change may allow the Fed to remain accommodative. This freedom could allow the Fed to raise rates when it feels the economy is stable enough to handle a tighter money supply.

Each and every one of us has either been directly affected or had a friend or family member who has been affected by the worst recession since the 1930’s. Their pain and suffering make us wish for a sharp economic recovery and strong job growth. However, we must not forget that before you can run you must first learn to walk. As long as the trends remain positive we will be running in no time.

Michael J. Ziemer

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All I Want for Christmas is Two Gold Teeth

Ah, gold. For thousands of years this metal has been prized by countless civilizations as a symbol of wealth, both as a store of value and a glittering personal adornment. Given the recent upheaval in our financial system, many people are wondering if gold is perhaps a more prudent investment than the stock market. My colleague Barbara wrote a recent blog article comparing the returns of gold versus those of stocks and bonds, and showed them to be not only inferior over the long term, but an ineffective hedge against inflation, as well.

Let’s not forget, however, that you can wear gold, and it looks a whole lot better around your neck than a statement from your advisor. I heard an interesting story on NPR’s All Things Considered about the cultural significance of gold in Iraq and its importance in the marriage ceremony. Apparently, there is an Iraqi saying that gold is both a decoration and a treasury (and in a war-torn country, the fact that it is portable is no small consideration). I also read an interesting commentary on by economist Ben Stein (who in my mind will ever remain Ferris Bueller’s boring econ teacher in the 80s movie by John Hughes). Stein has always been a huge proponent of saving for retirement, so this article was a slight departure from the usual rhetoric when he said – get this – “Economics tells us to enjoy the life we have. Maybe sometimes the best investment is buying something you want.” Now, mind you he does NOT advocate spending money frivolously if it will mean eating cat food in retirement, but if you have saved and invested prudently it is OK to have a little fun because, in his words, “the life we have right now is the only sure thing we’ve got.”

So, you want to invest in gold? If you have a little to spend and you’re otherwise invested prudently, buy it in the form of jewelry (though the prices are at an all-time high right now). Don’t be a Silas Marner and bury it all under your floorboards – live a little, buy something pretty. ‘Tis the season for giving, after all. In fact, wasn’t it one of the gifts brought by the wise men on the very first Christmas? (Of course, they also brought frankincense and myrrh, which appear to be tree sap. Sounds to me like one was a wise man, and the other two were wise guys.)

P.S. My ring size is 5.

Happy Holidays!

Sarah DerGarabedian, Research and Trading Associate

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Super Human Power to Save

“How does anybody ever make money in the stock market?” my buy-and-hold investing father asked me. I couldn’t believe he was asking me this because he’s made a lot of money in the stock market over the last 30 years. It’s just that over the last decade, even the tried and true stock market investors are weary.

The way my dad has made money in the stock market is with two simple strategies. Save your money. Invest and be patient. First and foremost, my dad has a super-human power to save. He is a minister and chaplain and this does not add up to an enormous salary. But he has saved religiously (no pun intended) a little bit of every pay check he ever received. Most people cannot do this. It is by saving his money, that he has made money.

Secondly, once that money is invested, keep it put. This is something else that requires serious strength of conviction, particularly during 2001, 2002, 2008 and the first part of 2009. My dad asked “How does anybody ever make money in the stock market?” during 2008 when it felt like everything he’d saved was washing away. But he stayed invested and it has paid off. Despite the various market declines, the long term trend is up. For instance, when my dad starting investing in 1980, the S&P 500 index was at 107, in 1990 it was at 353. Now it is hovering around 1100, and these levels do not even consider dividends.

This is how you make money in the stock market. Even when things look grim, keep saving, keep investing. You can’t control the stock market (believe me, I’ve tried), but you can control what you do with your money. You can spend it or you can save it. Choose to save regularly. Choose to invest wisely, and stay invested. Be patient and give it time.

Harli L. Palme, CFP®

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The Importance of Dividends

The current dividend yield on the S & P 500 index is about 2%. According to a recent article in Barrons’, dividends accounted for 43% of stock market returns over the past 83 years. The remaining return came from the change in stock prices. So far in 2009, dividends have accounted for only about 10% of the market’s total return.

We believe that dividends help put a floor under the value of a stock, because you are receiving an ongoing stream of cash flows from the time that you make your investment. Growth stocks, which pay lower or no dividends, must earn their total return exclusively from the change in price.

It is important to consider both the level and sustainability of dividends. The S & P 500 has a payout ratio of about 45%. This means that for every $1.00 in earnings, companies are paying an average of about $0.45 in dividends. Significant levels of debt or off-balance sheet obligations like under funded pension plans or post-retirement health care benefits may restrict a company’s ability to pay dividends in the future, since they have other needs for this cash. When evaluating individual stocks for inclusion in client portfolios, our Investment Policy Committee considers both the current dividend yield and the payout ratio. A high payout ratio of 75% or more may indicate that the dividend is at risk of being cut in the future. An unusually high dividend yield is also a sign that the dividend may not be sustainable. If something seems too good to be true, it usually is.

Why not buy all dividend paying stocks? Different clients with different investment objectives may have different levels of dividend paying stocks. A retiree who is spending from their portfolio, in addition to possibly having an allocation to fixed income (bonds), may have more dividend paying stocks than a younger client in the accumulation phase. Increasing portfolio income is one factor that we take into consideration as we review client portfolios for potential improvements. Also, a cornerstone to our investment philosophy is broad diversification including growth and value companies, small, medium and large companies and international companies. We never know for sure what is going to do better, so we want to have a mix of assets that will perform well under a variety of market conditions. If we focused exclusively on dividend-paying stocks, we would be forced to underweight sectors of the economy like technology that we believe have attractive future growth prospects. This year, large growth companies have returned over 32% versus 17% for large value companies. Small and mid-sized growth companies have also outperformed their value counterparts during this period. Therefore, including an allocation to growth companies that pay little or no dividends has helped portfolio returns this year.

Currently, dividends are taxed at the same rate as long-term capital gains. With the Bush tax cuts currently set to expire at the end of 2010, dividends are scheduled to be taxed at higher ordinary income rates for 2011 and beyond. The main implication of this from an investment perspective is asset location. If the tax on dividends does rise, we would lean towards putting higher-dividend stocks in a tax-deferred account such as an IRA where feasible.

Bill Hansen, CFA
November 25, 2009

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