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June, 2002


There was a fascinating article by Andrew Gluck in "Investment Advisor," the 3/02 issue, pp. 34-38: "Arnott Asks, Why Not?" Rob Arnott is the CEO of First Quadrant, a money management outfit. Mr. Arnott has been a prolific writer of financial papers and his company bio. indicates he's won the Association for Investment Management and Research Graham and Dodd Scroll four times. He seems to speak with authority on investment matters and recently offered some challenging (to conventional investment "wisdom") conclusions about risk premiums, retained earnings, and high dividend payout ratios.

Mr. Arnott's research leads him to believe that:

  1. While there is an equity risk premium (the likelihood of increased return for stocks over bonds due to the greater risk of the former), it is not 5%, as often thought, but around 2.5%;
  2. When dividend payout ratios are low and retained earnings high, it turns out that "the reinvestment gets sloppy and subsequent earnings growth becomes atrocious;"
  3. High dividend payout ratios usually correlate with relatively high earnings growth.

All in all, his research shows that, contrary to the "it's different this time" mentality of the 1990s, dividend yields for stocks do matter. In general, we ignore their importance to a stock's total return at our peril. Traditionally, equities have paid dividends, or yields, at about a 4% a year level. Given that the total return for stocks has been roughly 11% a year, this means that the growth, or capital appreciation, portion of an asset's return has been only about 64%, on average.

Further, as noted in item #2 above, overall if the dividend payout is low, so is the company's rate of growth. In a nutshell, company management does not make as good use of the extra money it controls, through providing no or low yields, as the shareholders would if they received it as significant dividend checks. Quite the reverse. If the top brass are sitting on large amounts of cash, as a rule it gets squandered in one way or another, from unwarranted benefits for the executives, at the expense of common stock shareholders, to poor investments in unrelated businesses, or to unprofitable expansions of existing endeavors, leading often to artificially inflated earnings, supported by unethical accounting practices, and so on.

He also suggests that, when the earnings yield of stocks (the reciprocal of the price to earnings ratio) is comparable to [or worse than] the yield of bonds [as is the case now], then the total return of stocks, on average, cannot be reasonably expected to be significantly higher than bonds (after taxes and what Warren Buffett calls "frictional costs"), currently about 5-6% a year.

Since most personal finance retirement calculations, and those of institutions controlling the trillions of dollars in assets set aside for future retirees and their retirement annuities, are based on 8-9% average total returns on stocks, a huge shortfall will likely occur in the years ahead. With Benjamin Graham, in The Intelligent Investor, it is Arnott's impression that retirement portfolios of all kinds need to be generally much more conservatively allocated than is presently the norm.

Ralph Wanger, the value oriented Chief Investment Officer of Liberty Wanger Asset Management, points out that yields we receive, unlike the potential capital appreciation of a company's stock, are a sure thing. He suggests the stock's dividend is the only variable a corporation's management cannot fudge, and encourages individuals and institutions to favor companies that pay out a larger percentage of cash flow as dividends.

It turns out too that when the market as a whole has a low dividend payout ratio, the total return of that market tends to be low for the next several years.

Yet, stocks continue to be historically one of the best investment vehicles for the average person. And getting completely out of the stock market due to short-term timing concerns is often a loser's game.

So, assuming equities are to remain a significant part of one's portfolio, it behooves us, especially at a time when yields are generally low, to seek stocks with high dividend payout ratios, since these will tend to perform better than the rest of the market, both in up and down markets.

Here, then, are five assets to consider, with relatively high yields and what appear to be good prospects for total return, relative to equities as a whole:

Price to
Allied Capital Corp.ALD$22.7711.49.7%
Standex Int'l.SXI$25.0014.23.4%
Worthington Inds.WOR$14.70NMF4.4%
Reliant EnergyREI$17.405.58.6%
Alliant EnergyLNT$24.9113.68.0%

Taken as a whole, these companies offer lower risk than equity markets generally, the long-term potential for superior capital appreciation, and several times the median U.S. stock dividend. Indeed, their average "coupons" are competitive with the recent Moody's Aaa corporate bond yield.


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

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