Overcoming the Purple People Eater:
In Today's Environment Dividends Are More Important

by Dave Anderson

Money market mutual funds became a preferred form of saving in the mid-1970s, steadily attracting deposits as interest rates rose. Now, after 22 years of gradual, but relentless declines, these "return challenged" instruments have yields so low that formerly tolerable expense ratios seem "abusive." About 15% of today’s money market fund choices have obscene expense ratios of 0.75%, or more.

Rarely throughout capital market history has so much liquidity earned so little in the way of return. The sharp drop in short-term interest rates to less than 1% (levels not seen since "The Purple People Eater" was a chart-busting tune in 1958) is a crisis for senior citizens who rely on certificates of deposit, savings accounts or money market instruments for their living needs. If yields on these holdings remain at microscopic levels for much longer, it seems increasingly probable that investors will feel compelled to seek out more rewarding possibilities.

Three Paths to Consider

The first approach most individuals consider is moving out the yield curve in terms of maturity. However, the bond market seems nearly as out of synch (i.e. overvalued and overleveraged) today as the stock market was in the late 1990s. As a rule of thumb, each 1% rise in interest rates will result in a value decline equal to a bond’s duration. For example, a 5-year maturity Treasury would fall by 5% if yields rebounded from 2.5% to 3.5%. We often say that more money has been lost "reaching for yield" than reaching for Las Vegas slot machines.

A second alternative is to acquire less creditworthy guarantees and move down the quality spectrum. However, yield spreads on lower quality bond issues have fallen close to their historic lows. Investors should seek out professional help to properly "ladder (or stagger)" individual maturities in such a way as to minimize the impact of unpredictable "event risks."

The recent decision by Congress to lower dividend tax rates has important implications and offers a third, perhaps more attractive, alternative. Prior to 1986, parts of an investor’s dividends were "excludable" from taxation and companies with growing payouts greatly outperformed. We believe this pattern is reemerging as bond yields diminish in allure. In the wake of the new "investor-friendly" tax cuts on dividends, rates for high-bracket payers have tumbled to 15%, while the lowest brackets will see their maximums reduced to 5%, at least until 2009. For investors receiving $5,000 per year in qualifying dividends, their Federal income tax will be reduced by $500 to $1,000.

Dividend Paying Companies on the Increase

Even before this tax change, owning yield-oriented stocks was a smart, albeit an almost forgotten concept. Since 1900, nearly half of the total return on stocks came from shareholder payouts. The number of companies offering some sort of dividend peaked at 89% in 1985 and steadily declined, becoming nearly extinct in the 1999-2000-bubble period. However, cash payouts have regained popularity in the last two years. During 2003, nearly 1400 companies initiated or increased their dividends. Furthermore, we expect this trend will accelerate. More than half of the S&P 500 companies pay dividends greater than a 3-month T-bill and the entire index earns more than a 3-year T-note.

After three years of bear market and only one year of recovery, many investors now feel it is safe to look at their 401-k statements again. During the broad rebound in 2003, the popular press trumpeted a 50% rise in the high-beta NASDAQ, but something unusual has happened. For the first two months of 2004, the traditionally low-beta Dow Utility index (i.e. high-yield stocks) has risen 4.2%, without including income, while the NASDAQ is up only 1.2%.

There is a Better Way

The composite yield for the S&P 500 is only 1.8%. However, 10% of the 3,000 largest public companies have "qualifying" yields above the 10-year T-note. Many of these selections have low price to cash flow ratios and modest debt leverage--they are merely under appreciated and under-followed. As with individual bonds (vs. bond funds), we believe there are important ways an investor can maximize results, since expense ratios, in effect, eat up most of the "advantaged" income that investors earn. Because the average equity fund has "friction" (or an expense ratio) of 1.4%, the average "net" dividend yield is only 0.4%. Of course, some funds (Such as Vanguard Equity Income Fund which has a low expense ratio of 0.46%) offer less friction. The key point is that many hapless fund investors do not seem to know there are better ways to professionally customize their portfolio (reducing turnover and) keeping costs down to about 0.5% per year.

Wisdom and Diligence Is the Answer

In the "old days," when all income was treated as tax-equal, life was much simpler. The new tax plan adds complexity to an already confusing code. For example in order for a dividend to be qualifying, the investor must own a stock for at least 60-days during the three-month period before it goes ex-dividend. Building a properly diversified, income growth portfolio is even more complicated than "laddering" bonds and requires continued scrutiny. Unfortunately, most people turn to high cost mutual funds that are often managed by "benchmark-possessed" gunslingers. If you are going to delegate some of your funds to serious management, don’t use someone who caters to the maniacal consulting community, or measures results in daily segments. A carefully constructed portfolio of income producing stocks can best be overseen by using wisdom and diligence, not the collective anxiety of short-term, relative performance pressures.