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Dividends and interest ARE real. Unrealized Capital Gains MIGHT BE real.



April 20, 2009 – Comments (15)


"We're rich"

"We're in GREAT shape for the future, dear."

"I'm on track to retire in five years."

All of these statements were probably uttered thousands of times during the major bull run that stocks had during the past decade.   Guess where most of these people are today?  Right back where they started a decade ago...if they're lucky.  A massive amount of imaginary "wealth" has been destroyed over the past year.  I put the word imaginary in the previous sentence because that's all those gains were...phantom money.  They weren't real.  Dividends ARE REAL.  Interest IS REAL.  Unrealized Capital Gains MIGHT BE real.

A bird in hand is worth two in the bush.  Capital gains come and capital gains go.  There certainly should be a place in one's portfolio to take advantage of the potential for stocks to rise in the long term, especially if you believe that massive inflation will rear its ugly head again some day.  However, I perfer to make the bulk of my investments in instruments that pay me.  I'll gladly take my money from the companies that I own today and let other people pray that the U.S. economy will grow enough or irrational exuberance will reappear and they will be awarded with larger multiples or higher earnings from the non-dividend paying, high P/E common stock that they own.


Now that I got that philosophical thought down on virtual paper, let's return to cold hard facts.  Ever wonder what economic growth would have looked like over the past several years had the overextended U.S. consumer not been able to use their giant ATM, er um home equity, to borrow and spend?  Here's a fantastic chart from John Mauldin's latest newsletter that shows it:


Without the massive mortgage equity withdrawals that happened, U.S. economic growth during '01 and '02 was negative and growth during the subsequent four year economic recovery would have been less than 1% per year. This slower growth was during the height of securitization and during a time when there was practically no risk aversion.  I wonder how long it will take the economy to recover now, when mortgage equity withdrawals have fallen off of a cliff.  They were only $9.5 billion during the second quarter of 2008 versus $223 billion during the first quarter of 2006. 

Add to this tighter credit, higher risk aversion, an increased savings rate, baby boomers passing their peak spending years and economic growth is probably going to be slow for a while.  Absent inflation, which is a very strong possibility, growth is what drives stock prices higher.  I'll take my money today in the form of large dividend and interest payments and let others try to squeeze their capital gains blood out of a turnip.


I came across another fantastic chart today that shows what has happened to home prices and where they are likely headed:

The graphic was posted by Henry Blodget over on Clusterstock.  Using home price data provided by Robert Shiller, Blodget estimates that home prices have another 10% to 20% to fall until they reach "fair value."  However he adds that prices are unlikely to plummet until they hit fair value and then stop on a dime.  It's entirely possible that they'll overshoot by 10% to the down side.  He believes that "although the rate of decline is likely to ease over the coming months and years...prices will likely keep falling through at least 2011."

Here's another chart that leads to a similar conclusion:


15 Comments – Post Your Own

#1) On April 20, 2009 at 6:04 PM, SNHamilton (99.98) wrote:

Dividends and Interest are real.  Hmmm.  I guess if you hide them under your mattress, in which case they slowly get less and less real everyday (due to interest) assuming no fires (which is a bad assumption in my area of Southern California).  Often though what happens with Dividends and Interest is....they get invested.  And if all you think is real is Dividends and Interest, well likely a good portion of that gets invested in Dividend yielding stocks.  Which means it gets translated back into unrealized capital gains (best case).  And the circle continues until you have lots of money or are broke, just like with any other stock investment.  Therefore, I don't really see the point at all why aiming for Dividend yield is better than aiming for unrealized capital gains.  


There are no magic bullets, just good investments and bad investments, and the only reason a dividend is useful is if I think I can reinvest the companies profits more successfully than it can.  Thus the success of Warren Buffet's sneaky buy the company and give him self 100% dividend plan.



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#2) On April 20, 2009 at 8:23 PM, TMFDeej (97.44) wrote:

The interest payments on corporate bonds cannot be reinvested and when they mature 100% of the original principal is returned.  No strategy is 100% perfect, the problem with this one would be if we experienced hyper inflation or a massive, unprecidented wave of bankruptcies.

I do not reinvest my dividend payments on any preferred stock.  I only reinvest the payments on common stock when I feel the company is a good value and has good prospects going forward.  I am not currently reinvesting my dividends in Altria and many MLPs, but I am reinvesting in PM, JNJ, FPL, EXC...


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#3) On April 20, 2009 at 10:50 PM, SNHamilton (99.98) wrote:

If you adapt a balanced strategy between stocks and bonds, and maintain your % (alla Graham) I still maintain it is irrelevant whether your stocks are issuing a dividend.  Corporate bonds are another issue, and probably a bit tangential.  Regarding the portion of the portfolio concentrating on stocks:


Example 1.  You have CVX, it gives dividend, you buy JNJ with it.


Example 2.  You have AAPL, you sell a little, you buy MVL.


Both examples are the same.  If CVX and JNJ go to 0, you lost it all.  IF AAPL and MVL go to 0, you lost it all.  Dividends give you an illusion of safety, but having all your money in dividend stocks is just as risky as non-dividend stocks since all your money allocated to stocks is still in stocks.  Selling a stock or getting a dividend is equivalent (ignoring friction fees) and you are restricting your investing world artificially by concentrating on dividends.  Now, I happen to think dividends are fun, and have nothing against owning them, but they are in no way fundamentally superior.



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#4) On April 20, 2009 at 11:28 PM, Effloresce (26.33) wrote:

I like dividends, personally. I like that tangible result of cash in hand, and I like having the option of just automatically reinvesting that if I choose to do so. I made over 10K in dividends in 2008 on NAT alone, and believe me that is a highly tangible result.

But I agree that divvies aren't necessarily the end-all and be-all. It's just one strategy of investing, and the thing about dividend bearing stocks is that there are seemingly no sacred cows any longer, even when it comes to some of the Dividend Aristocrat superstars. I've held GE for years and considered their dividend about as rock-solid and secure as could possibly be, I mean to me the possibility of a divvy cut just seemed unthinkable when it came to GE, but we all know how that one turned out when that 70+ year dividend increasing streak went right out the window.

So at this point I consider no dividend to be entirely secure. I do enjoy them though, very much. I look at them as being like a cash gift. :)

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#5) On April 21, 2009 at 1:15 AM, portefeuille (98.91) wrote:

Do you not see the difficulties you run into when arguing that dividends are real and that the GDP effect of mortgage equity withdrawals is unreal?

Let us take the definition from wikipedia:

In economics, mortgage equity withdrawal (MEW) is the decision of consumers to borrow money against the real value of their houses. The real value is the current value of the property less any accumulated liabilities (mortgages, loans, etc.) Some authors also use equity extraction and include net payments received at time of house sale.[1] In this case the traditional usage of equity extraction is the purchase of a new house.

The rate of MEW has been linked to Marginal propensity to consume (MPC), as measured by Personal Consumption Expenditure (PCE). In the United States, during the dramatic rise in house prices MEW funded PCE 1.1 to 1.7% from 1991 to 2000, and almost 3% from 2000 to 2005.[1]


1. Sources and Uses of Equity Extracted from Homes (pdf), Alan Greenspan and James Kennedy, Finance and Economics Discussion Series, 2007-20, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C.


There we have just what you describe in the second part of your post.

Let us look at the central part of the definition:

... decision of consumers to borrow money against the real value of their houses. The real value is the current value of the property less any accumulated liabilities (mortgages, loans, etc.) ...

Now this means that a home owner that engages in MEW is simply doing what the company is doing when deciding to pay a dividend.

His believe that his property has enough "real value" is just as real as the believe of the executives that the company has enough "shareholder equity" to pay out dividends.

And the ratio of MEW/equity corresponds to the ratio dividends/equity.

And this:

Some authors also use equity extraction and include net payments received at time of house sale.[1] In this case the traditional usage of equity extraction is the purchase of a new house.

corresponds to "reinvesting the dividends", so the analogy carries quite a bit ...


(it might help do think of the following "loose analogy":(shareholder equity) <-> (The real value is the current value of the property less any accumulated liabilities (mortgages, loans, etc.)))



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#6) On April 21, 2009 at 1:28 AM, portefeuille (98.91) wrote:

I do know that you take the point of view of the dividend recipient and not the company paying it, but if you demand "home owners" to refrain from MEW you should also ask the company to refrain from dividend payouts.

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#7) On April 21, 2009 at 6:07 AM, TMFDeej (97.44) wrote:

Port, you misinterpreted the point of that part of the post.

I'm not demanding that homeowners refrain from pulling equity out of their homes.  I don't care whether they do or not.  I'm just saying that MEW was responsible for a large part of the perceived U.S. economic growth over the past several years and that the implosion in home values means that the U.S. economy will not have that tailwind going forward.  Growth is going to be much slower than what we've become accustimed to as "normal" over the past decade for years to come.


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#8) On April 21, 2009 at 6:15 AM, TMFDeej (97.44) wrote:

Sam, let's take a look at an example of a dividend paying stock that I own.  At the time that I purchased Chesapeake Energy'sSeries E Preferred Stock it had a yield of around 10%.  As long as CHK continues to exist I can continue to collect 10% per year on my initial investment indefinitely and do whatever I want with the money because I am not reinvesting it.  

CHK, the company's common stock was trading at a little under $70/share less than a year ago.  It is going to take a loooooong time for anyone who purchases the common stock then to recoup their losses...let alone make 10% per year on their money.  Capital gains might happen but dividends are cash in hand.  The same thing goes for interest on bonds.


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#9) On April 21, 2009 at 6:23 AM, TMFDeej (97.44) wrote:

One other quick point about capital gains.  Unless a company is being inefficiently valued by the market either it or the economy has to grow in order for its value to increase (or inflation has to exist).  Companies need to thrive in order to make capital gains on most stocks.

In order to make money on bonds, companies just need to survive.  

The margin for error is huge on bonds but much smaller on non-dividend paying stock.

The same goes for dividend paying preferred stock.  Unless a company completely implodes and stops paying dividends to common shareholders it is required to continue to pay its preferred dividends first.

The least safe of the investment types that I have mentioned is dividend paying common stock.  However, it is the safest for investors who fear inflation because the value of common stock is not as capped as the value of bonds and preferred stock.


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#10) On April 21, 2009 at 7:34 AM, SNHamilton (99.98) wrote:

My point Deej is that your yield of 10% a year (which is not indefinite, since many things can happen including bankruptcy...not that its likely just sayin) is equivalent to selling stock.  If you like dividends because it is a convenient way to transfer money out of your portfolio and spend it on things like food and clothes, that is fine.  But I have heard many investors, who are clearly reinvesting their dividends, echo your sentiment thinking returns on  dividends yielding stocks are somehow more real or more predictable...and it sounds that at least in the case you do reinvest your dividends we agree that is not the case.



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#11) On April 21, 2009 at 7:47 AM, TMFDeej (97.44) wrote:

Sam, if you think that a company is going to go bankrupt then you should not invest in it period.

A dividend that is funded by a company's free cash flow is not the same as selling stock.  The amount of money that someone is willing to give you for the stock in said company has to increase by 10% in order for it to be the same and there's no guarantee that it will. Even if the company's earnings were to grow by 10% multiple contraction could easily wipe out any capital gains and clearly natural gas companies earnings are not growing right now.

Companies just have to continue to exist to pay interest on bonds and preferred dividends or even common stock dividends (assuming the payout ratio is low) from cash flow. 

A company that does not pay its owners aka shareholders dividends that is not inefficiently priced by the market has to grow to generate capital gains and even if it does grow and thrive, the company's management must use its money wisely. 

It's not difficult for management to squander shareholder capital.  Look at the myriad of companies out there over the past several years, like ALV for example, that has bought back its own stock at high prices only to have to turn around and issue new shares at low prices.  That is an aggregious waste of shareholder capital that woule not have happened if the company was paying a larger dividend instead of buying back its shares.  With a dividend, shareholders would have had the right to choose what to do with their money and they would have only had themselves to blameif they decided to reinvest their money in the company.

I'm enjoying this debate.  You're move ;).


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#12) On April 21, 2009 at 8:23 AM, SNHamilton (99.98) wrote:

My move huh, I thought as I was done, but as a chess player I cannot resist... 


My move: Lets not complicate life by slipping preferred shares into the already confusing discussion.  I completely agree with you that whether dividends make sense depends on whether you expect you can reinvest the money more effectively, or the company.  In fact I think I made this point in my original reply.  If the company can invest cash better than you it should issue a dividend, if it can't it should.  Not complicated in my mind.  So let us set aside that issue as something we both agree on.


For common stock (again, switch between discussion of preferred dividends, and bonds, and common stock just confuses things so lets just settle the common stock discussion) lets look at a couple possibilities:

1a.  Dividend is issued, you spend money on guns and ammo.

2a.  Dividend is issued, you reinvest money in company

3a.  Dividend is issued, you invest money in different company. 


In  case 2a, you own a larger % of company than case 1a or 3a, and the company has lost assets equivalent to your gained assets.  OK, compare to selling stock.

1b.  You sell stock, you spend money on guns and ammo.

2b.  You do nothing.

3b.  You sell stock, you buy other stock.


In case 2b, you own a larger % of company than case 1b or 3b.  Either set of cases lets you transpose stock into guns and ammo, or other stock, or whatever.  So really, they look identical to me...except from the transfer of responsibility of managing cash assets from management to shareholders (an issue we already agree on).


Hmmm.  I suspect we don't really disagree on that much (except how to translate the theory into practice as reflected in our respective portfolios)...Draw?

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#13) On April 21, 2009 at 1:08 PM, WillSurfForFood (61.38) wrote:

I think  SNHamilton is exactly right on this issue. There are different types of investments, you can buy debt or you can by chunks of a business. There is no fundamental difference between dividends and no dividends. As we have seen over the last year even what cash can buy can change quite a bit so there is no absolute holder of value, anything can change relative to other things.  You just want the things that are increasing in value the most relative to everything else.

 Having said that I have grown to like dividends more and more. It does make me happy even if it is not entirely rational when I receive dividends. I also think paying out a healthy dividend is a good way of keeping a company honest when it comes to issuing more shares either as exuctive compensation or just to raise money.  

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#14) On April 21, 2009 at 5:29 PM, MDSBInvestor (< 20) wrote:

There is an enormous difference between "dividends or no dividends."  With dividend payments I have complete flexibility in deciding how to allocate my capital.  I can reinvest in any company I see as promising or I can use the dividends to pay my current bills.  With dividends I can allow my position in company A to build a position in company B if I choose to do so. (Maybe A and B are both excellent companies but the market is undervaluing B at the moment.) Companies that pay no dividends require me to sell part of my position in A to buy shares in B.

The OP's point is excellent.  Dividends are real capital in hand while unrealized capital gains are only potentials that can't be realized without selling out all or part of your position.

During a recession I can use dividend income as a supplement to (or if I'm rich enough a replacement for) my employment income.  I sure wouldn't want to have to sell off shares in this market to cover current expenses if I were laid off.

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#15) On April 27, 2009 at 11:13 AM, OctoStalin (33.92) wrote:


Retained earnings are real. A lot of people act like money not paid out as dividends ceases to exist, wrong. You OWN the money not paid out as dividends, you just can't control it. Higher dividends are not necessarily better.

A 10$ stock earns 1$ a share. It pays out 25 cents as a dividend (2.5% yield) and invests the other 75 cents back into its business. Let's say it uses the money to buy a hotel that earns 7.5 cents a year. Next year it will have earned 1.075 dollars a share. It's price should theoretically rise 7.5%, and it dividend will also rise 7.5 percent.


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