Leithner & Co Pty Ltd - Show Me the Money! Value Investing&Dividends

Unrealised capital gains, in sharp contrast, are neither endogenous nor objective nor permanent. They are “exogenous” – they do not derive directly from the company or its operations; rather, they arise indirectly from outsiders’ perceptions of the company and its assets, earnings, prospects, etc. The extent of an unrealised capital gain depends upon the price that the marginal market participant is prepared to pay for a company’s stock. Because this willingness changes from day to day, because prices change from day to day – and, indeed, because the buyers and sellers change from one point in time to the next – these prices and hence the unrealised gains that derive from them have a subjective basis. Also for these reasons, until they are realised their dollar value is usually volatile and can therefore be ephemeral. Dividends and unrealised capital gains, then, are measured in terms of a common metric: dollars and cents. But in several critical respects they are incommensurate. Like wallabies and road trains, it may make sense within a given context to count each separately. But in most contexts it makes no sense to combine these counts.

As Thornton Parker has noted (What If Boomers Can’t Retire? How to Build Real Security, Not Phantom Wealth, 2001, Berrett-Koehler, ISBN: 1576751120); “No Accounting for Gains The Wall Street Journal 29 October 2001), an unrealised capital gain (which he dubs “phantom wealth”) is created or destroyed when a market transaction establishes a new per-share price for a given parcel of a company’s shares. Yet on the basis of that marginal transaction, all of the company’s shares are treated as if they are “worth” the new price. For example, if a company has 100 million shares outstanding, and if in a transaction involving 100 shares the per-share price rises by $1, then the value of each of the 100 million shares is deemed to rise by $1. Although only a miniscule fraction (1 out of every million) of the shares has been traded, each of the 100 million shares is now valued at the new market price. In so doing, an unrealised capital gain of $100 million has been created out of thin air. In Parker’s words, “nobody knows where all that money came from and it is many times greater than the price increase times the number of shares traded. If, on a subsequent day, the price slips by a dollar, the $100 million vanishes – it was just a phantom.”

Parker worries that unrealised capital gains comprise a major component of most private wealth – especially retirement plans and particularly in the U.S. Given that few American stocks pay significant dividends, the major (and often the only) reason to buy them is the expectation of capital gain at some point in the future. To a greater and greater extent, then, today’s portfolios (whether private or institutional) are perceived as inventories of things that are bought and held in the expectation that they will subsequently be sold at higher prices. Significantly, however, “standard accounting practice requires virtually all other inventories of things that are bought for resale to be valued at cost or market price – whichever is lower. They may be marked down, but never up, and profits are not recorded until the items have been sold.

Portfolios of stocks are the glaring exception to that practice. When they are marked up, profits are recorded, even though they haven’t been – and may never be – made.” (See also Value Investing and the (Mis)Measurement of Results). It is in exactly this context that another fundamental difficulty attaches to unrealised capital gains: the ease with which they can be transformed into realised capital gains. Selling the shares whose market price has increased above their purchase price, which is usually assumed to be trivial, automatic and frictionless, need not be so and at critical junctures is demonstrably not so. Consider as an example a seminal analysis (published in the Journal of Financial Economics) of changes, measured annually between 1926 and 1979, in the share prices of companies listed on the New York Stock Exchange.

For each five-year period during these years, companies were placed into five equally sized groups (quintiles) on the basis of their market capitalisation (i.e., their number of shares times the market price per share). For the entire period, the average annual total return for companies in the smallest quintile was 11.6%; and the average for companies in the largest quintile was 8.8%. The analysis also concluded that the owners of “small cap” companies reaped stunning capital gains from the nadir of the Great Depression to the late 1930s, and that outsized capital gains can be reaped by purchasing “small cap” stocks at the troughs of recessions. Most notably, between 1930 and 1935 small-cap stocks “generated” average capital gains of up to 120%.

This path-breaking study, and others inspired by it, has provided a basis for the investment of billions of dollars by hundreds of thousands of investors in “small cap” funds. As David Dreman has shown, however (Contrarian Investment Strategies: The Next Generation, Simon & Schuster, 1998, ISBN: 0684813505), among their other shortcomings these studies overlook the inherent illiquidity of small companies, the frequently very low prices of their shares and the illiquidity of the NYSE during the Depression. During the 1930s, most of the small cap shares in question sold at a fraction of a dollar (many sold for as little as $0.25 or even $0.06 per share). Further, many of these companies’ shares were so thinly traded that appreciable numbers could be neither bought nor sold. A purchaser in 1930 would have been unable to buy more than a handful of shares (the average daily volume of companies in the smallest quintile was 240 shares per day during the entire 1930-1935 period, and the median volume in 1930 was 95 shares). Similarly, the seller who sought in 1935 to sell the shares purchased in 1930 would have encountered considerable difficulty selling even a handful. Given the very small number of shares involved, any unrealised capital gain incurred would have been very modest; and the gain would have been very difficult to realise.

Dividends and unrealised capital gains, then, are measured in terms of a common metric: dollars and cents. Yet in many respects they are incommensurate; the typical treatment of unrealised gains is a glaring exception to standard accounting practice; and the realisation of unrealised gains need not be as easy as is virtually always assumed. One more criticism of these definitions remains: blithely to combine the dollar value of dividends and the dollar value of capital gains into “total returns” distorts the historical record. This distortion has engendered a view about stocks, stock markets and investment results that is inaccurate at best and misleading at worst. It has distracted attention from the historical record as a whole, and has concentrated attention upon the most recent (and wholly unrepresentative) portion of that record.

This distortion and distraction, it seems to me, has since the 1980s created and encouraged a Mass Cult of Capital Gain. Everybody, it seems, “knows” that as a class stocks are outstanding investments. Armies of financial advisors constantly remind us that, yes, prices fluctuate; but for every step backward, they reassure us, there are two steps forward. According to publicity material distributed by the Australian Stock Exchange in the late 1990s, “in its major swings [throughout the twentieth century] the [Australian] market has never failed, following a fall, to rise above the previous high point … In most years the total return on equity investments is greater than the rise in the Consumer Price Index.” Much research has preceded, extended and elaborated this point. Ibbotson Associates, based in Chicago, originated a series of studies whose methods have been widely imitated and whose results have been widely corroborated. Ibbotson took yearly averages of the Standard & Poor’s 500 Index and constructed 66 consecutive and overlapping 10-year periods beginning in 1926 (i.e., 1926-35, 1927-36, and so on through 1991-2000). Ibbotson found that when capital gains and dividends are combined, the resultant “total returns” were positive in all but two of the periods.

But when “total return” is disaggregated into its component parts (i.e., when dividends and capital gains are viewed separately) the results of “investing for capital growth” are not nearly as rosy as many advisors, brokers and others have suggested. Table 1 shows that in the U.S. the 75-year period since 1926 contains two distinct phases. Dividends provided half of the returns (111 ÷ 220.1) between 1926 and 1981. (This percentage does not include the impact of re-invested dividends). Without them, i.e., relying upon capital gains alone, more than a third of those 56 years produced losses.

Since 1981 markets have boomed, companies been driven more and more (and perhaps primarily) to undertake actions designed to raise their stock prices – and the resultant and unprecedented capital gains have dwarfed dividends by a margin of more than five to one. But this era, it should be emphasised, is both recent and relatively short; it is demonstrably unrepresentative of the historical record as a whole; and for these reasons we have no compelling grounds to believe that this era will extend without interruption into the future. (In this context it is instructive to recall that Prof. Irving Fisher, a leading economist of his day, declared in the autumn of 1929 that the prices of stocks had reached a “permanently high plateau.” Not quite obliging him, the NYSE proceeded during the next three years to fall 87%).

	1926-1981	1982-2000
Total Number of Years	56	19
Years of Capital Loss	21	2
Starting Value	12.8	122.6
Ending Value	122.6	1320.3
Total Appreciation	109.8	1197.7
Total Dividends Paid	111.0	222.5
Total Return	220.1	1420.2
Per Cent of Total Return Derived from Capital Gain	49.8	84.3

During the 1926-2000 period as a whole, according to Ibbotson, dividends comprised 40% of the S&P 500’s annualised total returns. Again, this percentage does not include the impact of re-invested dividends; and to include their impact is to boost an investor’s return for the entire 75-year period by many hundreds of percentage points beyond that achieved by mimicking the S&P 500. Gail Duduck, in a report dated 20 February and quoted in Barron’s on 4 March 2002, partitions the returns from capital gains and the return from dividends. In 13 of the 20 decades she studied (that’s right, she looks at roughly 200 years of financial history), returns generated by re-invested dividends exceeded returns “generated” by capital gains. Over the past 200 years, according to Dudack, “dividends represented an average 57% of the total return seen over the course of each decade.”

More generally, according to The Wall Street Journal (4 January 2002), the 10.7% average annual percentage gain that the S&P 500 has recorded since 1926 falls to 6.3% without dividends. To gauge the impact of dividends and their compounding over time, consider the present dollar value of $100 invested in the S&P in 1926. With dividends and their compounding, one’s kitty would have grown to $253,000 today; without dividends, it shrinks to just $10,500. Similarly, according to Meir Statman and Roger Clarke (Journal of Portfolio Management, Winter 2000), if the Dow’s present level were adjusted for dividends reinvested since 1894 in the companies comprising it, then at the end of June 2000 it would have stood at more than 800,000.

These results, startling at first glance, are pregnant with the profoundest implications. It is well known, to give a prominent example, that an investment in The Coca-Cola Company has compound at a rate of 16% per annum since 1919. In contrast, it is relatively little known that this rate of return has been achieved only if the dividends received during those eighty years were used to buy more of TCCC’s shares. (Note the critical distinction between the retention by a company of earnings and its directors’ decision to invest retained earnings in working capital, acquisitions, etc; and the payment of dividends to shareholders and the shareholders’ decision to invest those dividends in an excellent company’s shares. This “excellent company” can be, but need not be, the same company that paid the dividend). TCCC listed in 1919 at $40 per share, and a single share from 1919 now (incorporating stock splits and the allocation of dividends to the purchase of more shares) has a price of more than $5.0 million ($6.0 million in 1998).

One share of Coca-Cola in its first year has become 62,500 shares through stock splits and the use of dividends to purchase more shares; and these 62,500 shares today generate an annual dividend of approximately $37,500. Without this use of dividends to buy more shares, the single share that was purchased for $40 in 1919 (and which was split on various subsequent occasions) would today sell for “only” $250,000 – a difference $4.75 million and 1,800%. During the eighty year period since the company’s float, the original $40 share has paid slightly more than $21,000 in dividends. Recycled into more TCCC shares over the decades, these dividends (plus the company’s innate profitability and the miracle of compounding) have made all the difference.

Clearly, however, TCCC is an unusual company: very few have consistently boasted such high profitability and (relative to its profits) such little need for capital. Accordingly, very few companies have over many decades been able to compound their owners’ wealth to the degree that TCCC has. And that is precisely the point: dividends, invested in that very small number of companies that over the decades has generated consistently high profits and required little capital, beget steadily greater dividends; and it is this growing flow of dividends from secure and efficient companies – and not the “phantom wealth” of unrealised capital gains – that constitutes the bedrock of investment wealth and the primary justification for owning companies’ shares. Part IV elaborates this fundamental implication. But first Part III evaluates one of the major premises of the argument set out in Part I.