April 2005 Market Commentary

“Dividends Count” pdf version

Last quarter once again the stock market made lots of moves that resulted in little change in the averages (they were down slightly for the quarter). Buffeted by rising oil prices, concerns about inflation, rising interest rates, and geopolitical uncertainty investors couldn’t seem to decide if they wanted to own stocks or not. This pattern characterized the stock market for the first three quarters of 2004. While the end results weren’t bad in 2004, it wasn’t easy to get there.

Most analysts think that stock returns in mid to high single digits are far more likely this year and have abandoned expectations of double-digit returns. If true, the question for investors thus becomes what is the best way to achieve those returns with the lowest level of risk? We think the answer clearly involves dividend-paying stocks, which have always been at the core of our investment approach.

There are three reasons why dividends are important in designing an investment portfolio:

1. If one’s return expectations are in the mid to high single digits capturing 2% to 5% of this return from dividends means far less is needed from capital appreciation.

2. While dividends are by no means a protection against stocks declining in value they do tend to cushion such declines.

3. The favorable tax treatment of dividends (15% federal tax rate) makes them compelling from a tax standpoint and far more attractive than interest income, which for most investors, is taxed at far higher rates.

In the late 1990’s dividends were largely eschewed by many in the investment community. That was, after all, a period of “easy” capital gains and capital gains were taxed at more favorable rates. The theory was that since dividends were subject to double taxation (at the corporate level before disbursement and the individual taxpayer level after disbursement) it was better for companies to retain those earnings and use them to grow the company. Unfortunately substantial amounts of retained earnings were used to fund investments which in retrospect did not produce enough earnings to cause the anticipated stock prices increase. In addition it was a lot easier to play games with earnings which were not disbursed than with cash which had to be paid to stockholders.

In mid-2003 Congress changed the tax landscape for dividends and capital gains. Combined with the bear market of 2000 – 2002 in which the Standard & Poor’s 500 declined more than 35%, investors decided to take another look at their approach to investing and particularly to dividends. More pressure was applied to companies, which had chosen to retain large amounts of earnings, to share those earnings with the stockholders rather than reinvest them in the business. Dividend increases grew substantially in 2004, with the highlight being the large year end dividend distribution from Microsoft. That trend has continued in 2005.

As a result of these changes, an investment approach that was termed by some an anachronism in the late 1990’s has now come back into vogue. For our firm it’s always been in vogue.

April, 2005