The Sector Strategist E-Book

Timothy J. McIntosh

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 270

Veröffentlichungsjahr: 2012

Beschreibung

Using Asset Allocation to Reduce Risk and Boost Investing Returns Presenting a revolutionary new investment philosophy that redefines how we view sector investing, The Sector Strategist challenges long held ideas about how this unique area of finance operates. Misconceptions, such as the belief that international stocks provide diversification, are preventing investors from making the most of the opportunities for financial growth that sectors provide, and the book presents practical, applicable evidence that a better, more profitable option is available. Additionally, the book hopes to give readers an opportunity to improve returns and protect retirement assets by providing a wide range of techniques and tools designed to optimize wealth that the author has developed over the last decade. * Designed to help investors avoid the often inaccurate assumptions made by "experts" which promote typical asset allocation * Written by Timothy McIntosh, investment expert and founder of SIPCO/Strategic Investment Partners, whose firm's stock portfolio has earned five-star returns from Morningstar annually since 2003 * Contains easy-to-apply tools for wealth protection and growth that have been proven successful during the market fluctuations of 2002 and 2008 The history and opportunities afforded by sectors have been written about at length, but no book has broken with tradition so radically, and with such success, as The Sector Strategist.

Leseprobe

Contents

Cover

Series Page

Title Page

Copyright

Introduction

Chapter 1: The Return Dilemma

Importance of the P/E ratio

Company Growth Rates

Conclusions about P/E Ratios and Subsequent Returns

Importance of Dividends in Total Returns

Gazing into the Future

Chapter 2: Sector Allocations

International Investing

Sector Volatility

Major Sectors

Utilizing Sectors in Market Cycles

Sector Performance

Chapter 3: The Health Care Sector

Reasons to Own a Health Care Firm

Additional Factors

Chapter 4: The Energy Sector

Global Demand

Future Supplies

Strong Financial Position

Strong Inflation Hedge

Sub-Sector Analysis

Investing in the Energy Sector

Stock Selection Case Studies

Chapter 5: The Consumer Staples Sector

Consistent Profit Growth

Global Growth Opportunities

Strong Financials and Reliable Products

The Consumer Staples Retailing Industry

The Food Products Industry

The Beverages Industry

The Household Products Industry

The Tobacco Industry

Chapter 6: The Technology Sector

Sectoral Factors

Broadband Growth

Government Spending

Strong Financial Characteristics

Sub-Sector Analysis

Investing in the Technology Sector

Chapter 7: The Financial Sector

Sectoral Factors

Demographics

Globalization

Low Interest Rates

Sub-Sector Analysis

Investing in the Financial Sector

Chapter 8: Bonds, REITs, and Commodities

Bonds: Corporates Are Worth the Risk

Corporate Bonds Risk Components

REITs: A Separate Asset Class?

Commodities and Gold

Chapter 9: Fundamental Analysis

The Balance Sheet and the Income Statement

Valuation Approaches

Intrinsic and Relative Valuation

Chapter 10: The Selection Process

Diversify across the Major Recommended Sectors

Chapter 11: The Right Allocation

Aggressive Portfolio

Moderate Portfolio

Balanced Portfolio

Endnotes

Chapter 1

Chapter 2

Chapter 3

Chapter 4

Chapter 5

Chapter 8

Chapter 9

Chapter 10

About the Author

Index

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Copyright©2012 by Timothy J. McIntosh. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

McIntosh, Timothy J.

The sector strategist : using new asset allocation techniques to reduce risk and

improve investment returns / Timothy J. McIntosh.

p. cm.

Includes bibliographical references and index.

ISBN 978-1-118-17190-5 (cloth); ISBN 978-1-118-22682-7 (ebk);

ISBN 978-1-118-23979-7 (ebk); ISBN 978-1-118-26452-2 (ebk)

1. Portfolio management. 2. Investments. I. Title.

HG4529.5.M386 2012

332.6–dc23

2011050801

Introduction

The stock and bond markets have offered investors rewarding returns for the past 100 years, or what is considered the “long run”. However, the long run may not be “long enough” for many investors. An individual investor has a finite period to grow investment assets, normally starting from age 35 to 65. Depending on the historical period the investor lives in, the ultimate returns on investment can be dramatically different than expectations. This is especially true if the investment growth period in question is 20 years or less. Investors in stock or equities have learned this truth if their window of opportunity was from 1929-1949 or 1964-1984. Investors in bonds also do not always escape the dreaded window of time as well. If interest rates are extremely low in the beginning time period, like 1948, then returns on bonds can also be substantially lower than the long-term averages. This problem is not just associated with stocks and bonds. Gold and commodities have suffered elongated periods of stagnated returns. Buying gold at its absolute peak in 1980 ($675) and holding it for 20 years ($284 in 2000) sure turned out to be a losing long term investment. Real estate does not always go up as several pundits argued forcefully in the mid-2000s. I expect that the real estate market will surely stagnate for another decade at a minimum based on historical precedent.

The fact is that all investment categories, or asset classes, are highly volatile over time. The most important aspect of garnering a respectable return on an investment is primarily determined by the starting date of your investment horizon and the value of the various asset classes at that point in time.

In 2012, major asset classes like stocks, bonds, real estate, gold, and commodities are either at long term averages or at a peak in value. Historically we are in a time of excess valuation that is closest to the early 1930s. Leverage is high, which will damper the future returns of real estate. Bond yields are extremely low due to excessive debt and Federal Reserve policies. Gold has returned to relative price levels last seen in the Reagan era. The best of the bunch is most likely stocks. However, when you examine the stock market based on a historical context, value is also not at the low end of the spectrum. This presents a big problem for both the individual investor and pension funds. This is due to the fact that expectations for long term returns are solidly in the 8% range. Over the last fifty years, a diversified portfolio of various assets would have provided for such a return. In the next fifty years, it is most likely that the same will occur. But, the 8% future return will most likely be back loaded. The next ten years do not offer an investor much hope to garner to same return guarantee.

This text was written to provide an alternative to traditional asset class investing and enhance the possibility of garnering an above average investment return. I begin in Chapter 1 with a description of return expectations. I discuss the history of the stock and bond markets over the past 100 years. You will learn what returns have been generated by the stock and bond markets over various periods of time. Additionally, I present the assets in a historical context, so that an investor may better understand how to better evaluate future return expectations. In Chapter 2, I present my sector strategy. I present evidence on how traditional investing and correlation has changed over the past thirty years. I discuss an alternative to traditional benchmarking to the index through sector investing. I describe the major sectors in the economy and list which sectors have not only been the best performers over time, but also the least volatile. Chapters 3, 4, 5, 6, and 7 present my recommended sectors. These are the sectors of the economy I recommend you should focus your equity investment dollars in. Each of these five chapters reviews a sector in detail including future prospects, breakdown of major companies, and rules of individual selection. I also give examples of purchases made within the sectors based on a contrarian investment strategy. Chapter 8 features the alternative investments I recommend to balance your stock portfolio. This includes corporate bonds, REITs, and precious metals. One of the most important topics, fundamental analysis, is explained in Chapter 9. You will learn some basic tools to dissect a balance sheet and income statement. I discuss the difference between growth and value investing and how to utilize relative value techniques for stock selection. Chapter 10 examines the selection process, including how many stocks and bonds you should hold. I also discuss methods to utilize my strategy through mutual funds and ETFs. I have added this chapter for those investors who are either beginners or do not have the time to select individual securities. In Chapter 11, the major components of the book are put together and several model portfolios are examined. Each portfolio is back-tested over the past 25 years. Fortunately, the last 25 years have presented investors with a multitude of different economic and market scenarios, including strong bull markets and tremendously destructive bear markets. Here is where all the research and theory come together. My recommended portfolios will look different from a financial plan you would see from a typical financial advisor or investment magazine. I believe most investment plans put together today that encompass traditional allocations to stocks and bonds won't work in meeting the needs of today's investor. In the next 11 chapters, I'll demonstrate a new investment strategy is necessary to survive and generate an above average return in the next decade.

Chapter 1

The Return Dilemma

Living in dreams of yesterday, we find ourselves still dreaming of impossible future conquests.

Charles Lindberg

Family Office Exchange (FOX), a leading provider of research and education to the wealthy and their advisors, released the results of a survey they made in early 2011. For 2011, wealthy families anticipated a median long-term return of 8% from their investments, consistent with previous years’ studies. On the corporate side of the ledger, sentiment is equally optimistic. According to Milliman, a large independent actuarial and consulting firm, large public U.S. companies currently maintain an expected rate of return of 8% for their firms’ pension funds, a slight decrease compared with 8.1% for 2009. The annual Milliman study covers 100 U.S. public companies with the largest defined benefit pension plan assets. Although the expected return has steadily declined during the past decade from a gaudy 9.4% in 2001, an 8% return expectation is still above the long-term averages.

The Milliman study also listed the percentage of pension plan assets invested in equities in 2010, which was 45%, a slight increase from the 44% in the previous year. Bond allocations were unchanged at 36%, and allocation to other investments, including cash, increased from 19% to 20% during 2010. Individual investors, who as a class are typically more aggressive, held 50.9% of their portfolios in stocks and stock funds according to the July 2011 AAII Asset Allocation Survey. This is below average given that the historical standard is for 60% of a typical portfolio to be earmarked for stocks. Bond and bond funds accounted for 25.5% of individual investor portfolios. The historical average is a surprisingly low 15%. This is no doubt due to the low returns earned on cash equivalents. In the survey, individual investors maintained a 23.6% position of their portfolio dollars in cash. The historical average is 25%. The question of all questions is Will the optimists earn the 8% expected return with those allocations? To answer this critical question, an investor must study history and make reasonable assumptions about the future.

An examination of 80 years of data shows the following results:

The annualized return for the Standard & Poor's (S&P) 500 Index (and its precursor S&P 90 Index) between 1930 and 2010 was 9.37%.

Dividends have been a noteworthy contributor to the total return of the S&P 500. From 1930 through 2010, dividends accounted for 43% of the S&P 500s return. The percentage contribution of dividends to the total return has been declining steadily since mid-century. During the past 20 years, dividends have accounted for only a quarter of the total return. U.S. bond market returns are lower in comparison to equities for the 80-year period starting in 1930.1 The average return is only 5.72%.

Most investors combine investments in stocks and bonds to hopefully produce a better return with less risk. This process is known as asset allocation. The theory is that by including asset categories with investment returns that move up and down under different market conditions within a total portfolio, an investor can potentially enhance return while reducing risk. Historically, the returns of the two major asset categories such as stocks and bonds have not moved up and down at the same time. If one asset is producing losses, such as stocks in 2008, other assets will rise in value to offset your losses. Table 1.1 shows the breakdown of the long-term returns of combining the two assets.

Table 1.1 Asset Allocation History, 1930–2010.

Source: Roger G. Ibbottson and Rex A. Sinquefield, “Stocks, Bonds, Bills, and Inflation: Year-by-Year Historical Returns,” Journal of Business, University of Chicago Press, 2011.

Most individual investors and pension funds would be happy with these long-term return scenarios. However, three key elements have a dramatic impact on whether or not these returns can be realized:

The current price-to-earnings (P/E) ratio of the market

The current dividend yield of the market

The current bond yield of the market

Importance of the P/E ratio

According to the Wall Street Journal, the P/E ratio of the S&P 500 Index at the end of 2011, based on earnings over the past 12 months, was approximately 15. The average P/E ratio of the S&P 500 Index and other large-cap stocks over the past 80 years has been approximately 16, based on 12-month trailing earnings. P/E, of course, stands for price/earnings, and it is one of the essential tools investors use to estimate value when it comes to stock analysis. The price/earnings ratio is one of the oldest and most frequently used metrics. Here is the formula;

The P/E ratio gives you an indication of a stock's value. If it is low (though some sectors tend to be chronically low) it usually means that the stock price reflects a reasonable valuation relative to the earnings stream. If it is high (though some sectors tend to be chronically high) it usually means that the stock price reflects a high valuation relative to the earnings stream. Most of the time the P/E is calculated using E.P.S from the last four quarters. This is also known as the trailing P/E. However, it can also be utilized by estimating the E.P.S. figure expected over the next four quarters. This is known as the leading or forward P/E. A third variation is sometimes used that consists of the past two quarters and estimates of the next two quarters. There is not a huge difference between these variations. It is important you realize that you are using actual historical data for the calculation in the first case. The other two are based on analyst estimates that are not always perfect or precise. My preference has always been on trailing P/E.

The P/E ratio is a much better indicator of the value of a stock than the market price alone. For example, all things being equal, a $10 stock with a P/E of 75 is much more expensive than a $100 stock with a P/E of 20. Therefore, the P/E ratio allows you to compare two different companies with two different market prices—comparing “apples to apples,” so to speak. A potential problem with the P/E involves companies that are not profitable and consequently have a negative E.P.S. There are varying opinions on how to deal with this. I recommend that if a firm does not have a P/E due to depressed earnings, an investor should use an alternative valuation model, such as the Price/Sales ratio. It is difficult to state whether a particular P/E is high or low without taking into account two main factors:

Company Growth Rates

A P/E is based primarily on the growth rate of companies within the index. Generally, the higher the growth rate, the higher the expected P/E. If the projected growth rate does not justify theP/E, the market might be overpriced.

The average P/E ratio at the end of each year for the overall market, based on trailing four quarter numbers, is shown in Table 1.2. The far-right column gives the average 10-year future total return of the market on an annualized basis. Figure 1.1 shows the rolling returns on a 10-year basis.

Table 1.2 Average P/E Ratio for Overall Market.

Source for P/E ratios: Standard & Poor's.Source for return data: Roger G. Ibbottson and Rex A. Sinquefield, “Stocks, Bonds, Bills, and Inflation: Year-by-Year Historical Returns,” Journal of Business, University of Chicago Press, 2011.

Period P/EForward 10-Year Annualized Return12/31/193616.848.42%12/31/193719.344.41%12/31/193820.649.62%12/31/193913.887.26%12/31/194010.089.17%12/31/19417.4913.38%12/31/19429.4917.28%12/31/194312.4117.07%12/31/194414.2814.31%12/31/194518.0817.12%12/31/194614.4316.69%12/31/19479.5018.43%12/31/19486.6416.44%12/31/19497.2220.06%12/31/19507.1919.35%12/31/19519.7416.16%12/31/195211.0716.43%12/31/19539.8813.44%12/31/195412.9915.91%12/31/195512.5612.82%12/31/195613.6911.06%12/31/195711.879.20%12/31/195819.1012.85%12/31/195917.6710.01%12/31/196017.777.81%12/31/196122.438.18%12/31/196217.197.06%12/31/196318.669.93%12/31/196418.636.01%12/31/196517.811.24%12/31/196614.473.27%12/31/196718.106.63%12/31/196818.033.59%12/31/196915.933.16%12/31/197017.965.86%12/31/197117.918.44%12/31/197218.396.47%12/31/197311.956.68%12/31/19747.7110.61%12/31/197511.3314.76%12/31/197610.8414.33%12/31/19778.7313.82%12/31/19787.7915.26%12/31/19797.2616.33%12/31/19809.1617.55%12/31/19817.9813.93%12/31/198211.1317.59%12/31/198311.7616.19%12/31/198410.0514.94%12/31/198514.4614.40%12/31/198616.7214.84%12/31/198714.1215.28%12/31/198811.6918.05%12/31/198915.4519.18%12/31/199015.4718.20%12/31/199128.1217.46%12/31/199222.8212.93%12/31/199321.319.33%12/31/199415.0111.06%12/31/199518.1412.07%12/31/199619.139.08%12/31/199724.438.42%12/31/199832.605.91%12/31/199930.50−1.38%12/31/200026.41−0.95%12/31/200146.501.41%12/31/200231.89?12/31/200322.81?12/31/200420.70?12/30/200517.85?12/31/200617.40?12/31/200722.19?12/31/200840.70?12/31/200934.94?12/31/201017.23?

Figure 1.1 Rolling Returns on a 10-Year Basis

Source: Roger G. Ibbottson and Rex A. Sinquefield, “Stocks, Bonds, Bills, and Inflation: Year-by-Year Historical Returns,” Journal of Business, University of Chicago Press, 2011.

Here is the performance of the S&P 500 from the lowest 10 P/E ratio starting points, versus the highest P/E ratio starting points. See Table 1.3

Table 1.3 Lowest/Highest P/E Starting Points.

Source for P/E ratios: Standard & Poor's. Source for return data: Roger G. Ibbottson and Rex A. Sinquefield, “Stocks, Bonds, Bills, and Inflation: Year-by-Year Historical Returns,” Journal of Business, University of Chicago Press, 2011.

Conclusions about P/E Ratios and Subsequent Returns

In predicting future returns for the stock market, P/E ratio should be your primary indicator. Here are eight key facts regarding this most critical statistic:

1. For the overall stock market, P/E is the major driver of whether returns will most likely be above or below average in future periods.

2. In general, the lower the market P/E ratio, the higher the subsequent 10-year average return.

3. When average P/E ratios are below 10 for the market as a whole, subsequent 10-year average returns are well above the standard.

4. The stock market can advance strongly through a combination of higher earnings and low starting P/E ratio. P/E ratio multiple expansion is a critical component in future returns being above the long-term averages.

5. During recessions, earnings for the S&P 500 companies can collapse, thus leading to a high P/E ratio based on trailing earnings. This could indicate an overvalued market based solely on P/E ratio. In this case, an investor may use a forward P/E ratio as a secondary indicator. In the preceding chart, 1991 is a good example.

6. A high trailing P/E ratio does not guarantee that future returns will be below average for the next year, or even the next five years. The shorter term predictability of high P/E ratios on future returns is poor.

7. Higher inflation causes lower P/Es and deflation causes lower P/Es; P/Es generally peak at higher levels when inflation is low and stable.

8. In addition to higher starting P/E ratios, higher starting profit margins have a negative impact on future expected returns.

Other Valuation Models

The foregoing P/E model utilized to forecast future returns has been criticized in some circles because of the limited nature of such a basic model. Other more sophisticated valuation models have been utilized by various managers to better hypothesize future returns including the Q ratio and the Shiller model. In addition, many analysts also use other factors along with the P/E ratios, including adjustments for profit margins and inflation considerations.

Q Ratio

The Q ratio was developed in 1969 by the late economist and Nobel laureate James Tobin. The Tobin Q measures the market value of a company (i.e., its stock price) relative to the replacement cost of its assets. More recently, the ratio has been promoted by Stephen Wright and Andrew Smithers in the book Valuing Wall Street. The Q ratio is the total price of the market divided by the replacement cost of all its companies. The Q ratio contrasts the total value of the stock market with the net replacement cost of corporate assets. When stock market prices are above asset values, an investor should buy an asset through direct purchase, rather than through equities. A Q value greater than one indicates that a company's assets could be purchased more cheaply than the company itself and consequently, the market is overvaluing the firm in question. A Q ratio of less than one indicates market undervaluation. Wright and Smithers found that a high Tobin's Q for the nonfinancial equities in the S&P 500 accurately predicts a future low real rate of return from investing in the S&P 500 Index. The team argued that in time arbitrage would ultimately drive the value of the private and public markets together.

Academic research has placed a high value on the predictive capability of the Q ratio. In a paper written for the Journal of Investing in 2002 by Edward Tower and Matthew Harney from Duke University,2 the Q ratio demonstrated strong predictive power. Their results suggested the Q ratio provided the most compelling value of the alternatives they tested, including several P/E models. Tower and Harney tested the Q ratio against P/E ratios using 30-, 20-, 10-, and 1-year moving-averaged earnings. The team then ranked the predictive capacity to succeeding rates of return on the S&P 500 index. They then categorized the outcomes by R-squared (represents the percentage of a fund or security's movements that can be explained by movements in a benchmark index).

The Q ratio had the top score in regard to predictive power. The P/E ratio categories (30-, 20-, 10-, 1-year) offered secondary predictive value, in order of the length of time period. Since 1900, the average Q ratio has been 0.78. The ratio has had a wide range for the period, hitting all-time lows twice, in 1948 and 1974 (0.3). The high point in history came in year 2000, when the ratio hit 1.88. As recently as March 2009, the ratio once again had dropped to 0.43, offering a compelling buying opportunity versus the long-term averages. There have been noted criticisms of the Q ratio. In calculating the Q ratio, book value minus intangible assets is utilized. Thus the denominator excludes intangible assets. Intangible assets (e.g., patents, trademarks, brand recognition, license agreements, and trade secrets) are increasingly important in the economy of the 21st century.

Professor Robert E. Hall of Stanford University published a paper on the stock market and capital accumulation in the American Economic Review in 2001.3 He found that intangible assets do play a larger role and that the accumulation of intangible capital had been much faster in the previous decade. A new paper released in 2010 evaluated the Q ratio with the addition of intangible assets.4 Professors Erica Li of the University of Michigan and Laura Liu of the Hong Kong University of Science and Technology found that adding intangible assets to Tobin's Q explained stock returns significantly better than the Q theory that maintained only tangible assets. The authors Li and Liu also found that intangible assets are more crucial for firms to sustain their comparative advantages than tangible assets because it is more costly to accumulate intangible assets rapidly. Furthermore, they found that it is advantageous for a company to consistently invest in intangible assets. Considering the growing impact of intangibles on the Q ratio, the long-term range of .3 to 1.88 might no longer be as germane as history suggests. The current Q ratio as of August 2011 is well over 1, suggesting a stretched overvaluation of the markets. However, based on trailing P/E ratio mechanism, the stock market was trading at only 13 times trailing earnings, indicating longer investment horizon value. Overall, the Q ratio has merit based on its strong predictive value. However, consideration must be given to the increasing importance of intangibles in calculating the Q ratio.

The Shiller P/E Method

Robert Shiller from Yale University has developed a separate, widely followed P/E model. Shiller has postulated that utilizing a longer-term cyclical P/E ratio is a better methodology. In this manner, an investor will not be misled by earnings at the top or bottom of economic cycles. Shiller thus smoothes earnings by calculating average earnings over the previous 10 years. He measures this as the cyclically adjusted price earnings ratio.

The inherent problem with Shiller's approach is that there are no assurances that average earnings will end up estimating normalized earnings. If earnings are elevated over a previous 10-year period, an analyst will end up with a higher than average normalized estimate. The reverse is also true. David Bianco, Chief U.S. Market Strategist at Merrill Lynch, has also recently questioned the utility of the Shiller P/E. Mr. Bianco found the 2011 Shiller P/E of 24 was 50% above its 1900–2010 average. The problem was Dr. Shiller's estimate of earnings, at only $55 on an inflation adjusted ten-year trailing average. Comparing this to the average 2011 estimate of traditional analysts of nearly $100 for the S&P 500, Dr. Shiller's average substantially discounts current earnings. I find Dr. Shiller's model, although theoretically correct, not as useful as traditional P/E models or the Q ratio.

Corporate Profit Margin Analysis

Since 1948, net corporate profit margins for the S&P 500 corporations have ranged from just above 4% to nearly 10%. Net profit margin is calculated by dividing net profits by net revenues and is generally stated as a percentage. The net profit margin is a signal of how efficient a firm is at producing a profit after all costs have been factored in. The higher the net profit margin, the more successful the firm is at turning total revenue into actual profits. I prefer the net profit margin to other profitability ratios because it takes in all factors in a corporation. It not only measures how well the firm can control expenses at the cost of goods sold level (gross margin) and how well a firm manages its operating costs (operating margin) but also factors in the firm's interest on debt and tax structure. Net profit margins allow an analyst both to compare firms within similar sectors and to gauge which sectors and/or industries are most profitable. Profitability has risen and dropped rapidly depending on the economic environment and the individual standing of the corporation. From 1950 to 1965, profitability remained extremely elevated (6–10%) due to the economic boom that followed World War II. Net profit margins then peaked during the mid-1960s and declined substantially throughout the 1970s. The period of the 1970s was one of very high inflation, uncertain economic policies, oil embargoes, and labor unrest. In the mid-1980s, margins continued to decline, although at a more level pace, ultimately hitting a low of 4% in the recession of 1991. Average net margins for the S&P 500 doubled over the following decade, reaching a high of 8.1% in 2001. Margins rose until the financial crash of 2008, after which margins once again dropped to the 4% level.

Do margins foretell future equity returns? The answer is mixed. A low net margin starting point, such as the 4% level, does indicate a floor in equity pricing. In the two years since 1948 the net margin level hit 4% (1991, 2008), both offered investors a great buying entry point. However, during the early 1950s, net margins were above 8% and subsequent short-term and longer-term stock returns were excellent. Blackrock Corporation recently reported in an updated paper5 that the likelihood that margin trends, in isolation, are not an effective tool for forecasting market returns is limited. Blackrock pointed to evidence that of eight post-war peaks in the S&P 500, only two actually correlated with peaks in corporate margins.

Importance of Dividends in Total Returns

As mentioned previously, from 1930 through 2010 dividends accounted for 43 percent of the S&P 500s return. Table 1.4 shows the percentage of return from dividends for each decade since 1930.

Table 1.4 Return from Dividends.

Source: Ned Davis Research.

PeriodAverage Annual ReturnDividend Contribution1930s0.30%NM1940s8.90%66.7%1950s19.2%29.3%1960s7.7%43.1%1970s5.7%72.1%1980s17.4%27.5%1990s18.1%12.9%2000s−1.0%NM

As the dividend contribution declined over time as a percentage of total return, the payout ratio for companies has also declined. Table 1.5 shows the payout ratio for companies over the preceding 80 years.

Table 1.5 Payout Ratio.

Source: Ned Davis Research.

PeriodAverage Payout RatioAverage Dividend Market Yield1930s90.1%5.9%1940s59.4%6.8%1950s54.6%5.1%1960s56.0%3.1%1970s45.5%5.2%1980s48.6%4.5%1990s47.6%2.8%2000s39.0%2.6%

In 1973, 52.8 percent of publicly traded nonfinancial firms paid dividends.6 The percentage of payers rose to a peak of 66.5 in 1978. It then fell dramatically throughout the boom years of the 1980s and 1990s. By 1999, only 20.8 percent of firms paid annual dividends. From 1973 to 1977, one-third of newly listed firms paid dividends. In 1999, only 3.7% of new listings paid dividends. Dr. Eugene Fama and Kenneth French postulated that the decline in the incidence of dividend payers over this period was due to an increasing tilt of new publicly traded firms that were more growth oriented within new industries. These firms had the following characteristics: small size, low earnings, and large investments relative to earnings; they generally paid low or nil dividends. This is a far cry from the days after the Great Depression. During the late 1930s and 1940s, dividends were widely distributed among public companies; they were considered a key source of income and were utilized as an important tool to assure safety.

Investors that experienced the great losses resulting from the 1929 crash demanded higher dividends. In fact, the average dividend yield on stocks exceeded 20-year Treasury Bond yields through 1957. The number of companies issuing dividends today has diminished over time as new industries have emerged (e.g., information technology, biotechnology) that would rather reinvest their own capital. But dividends are a large part of total return for the market and also protect investor capital during poor market environments. For example, during the “lost decade” of the 2000s, the S&P 500 Index declined −2.3% due to price depreciation, but the income provided by dividends (1.8 percentage points) minimized the losses, resulting in a less painful −0.5% total return throughout the decade. Investors that concentrated investment dollars in high-dividend firms did even better.

Inflation can also have a dramatic impact on stock returns. The decade of the 1970s provides an example of how inflation has impacted returns for stocks. During the 7-year period from 1974 to 1980, the average rate of inflation was 9.3% while the S&P 500 Index had an average annual return of 9.9%, with dividend income accounting for nearly half of the total return.