How to Give Yourself an Annual Pay Raise, Pt 2

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In Part 1 of “How to Give Yourself an Annual Pay Raise,” I discussed the fact that wages and investments haven’t kept pace with inflation over the last decade. Now that low interest rates and inflation have become official U.S. government policy (often referred to as financial repression), investors and retirees today have very few options to choose from to keep their standard of living in line with current inflation rates. I suggested one way to fill that gap is dividend paying blue-chip stocks. The authors of Triumph of the Optimists: 101 Years of Global Investment Returns have shown that over the last century investment returns have been far superior when dividends are reinvested. The compound return is almost double when long time frames are considered. What I have also tried to show is that major market declines are followed by strong market recoveries. Even more important is that within a long-term secular bear market there can be numerous cyclical bull markets. When investors think of the Great Depression and the stock market crash that led to an 86% decline in the Dow Industrials, that decline was followed by the Dow Industrials advancing close to 400 percent over a five year period.

Correction or Major Top?

Since the beginning of the new century we have experienced two bear and bull markets. If you panicked and sold your stocks at the bottom in March 2009, you missed the markets 103 percent advance. Nobody disputes this recovery in stock prices but every time the market hiccups the alarm bells go off calling for a market top and the end of the bull market. A study of market history shows that market tops are a process not a single day event. To borrow an analogy from Lowry’s Paul Desmond, the markets are like the seasons of nature: Spring—the beginning of a stock market recovery, summer—when the stock market is advancing the strongest, fall—when you begin to see various industries and stocks reach tops and begin to decline (similar to leaves falling off a tree), and finally winter—when all the leaves have fallen or when all sectors of the market are falling and in continuous decline. Given the above, our long-term trend analysis shows 45% of stocks in the S&P 500 are in strong upward trends (summer) with only 1% in the early topping out phase (fall). This, along with sector and breadth analysis, leads us to conclude the market is currently undergoing a much needed intermediate correction within an ongoing bull market that began in October 2011. For further explanation, click here.

season market

Mega-Caps Breaking Out

This brings me back to dividends and a new trend we see emerging, which is the breakout in large mega-cap stocks. Large cap stocks appear to be emerging as the new market leaders in this markets' ongoing advance. I wrote about this in my last piece “The Story Nobody Wants to Hear.” As shown in the six graphs below, which include technology, consumer staples, healthcare, and the retail sector, all of these stocks are exhibiting patterns that show clear uptrends and a breakout from a long period of consolidation.

5 year weekly charts

These stocks all share similar characteristics: they are large cap companies with a competitive advantage and dominating their respective industry, they all have high ROI’s, and pay consistent and growing dividends. They are also showing stronger performance than their peers and have acted more defensive in recent market pullbacks. More importantly, they have strong balance sheets, low levels of debt, and have a history of increasing their dividends. IBM has been increasing its dividend at an annual rate of 20% over the last five years, Wal-Mart 16%, Microsoft 14%, Abbott Labs 10%, Coca Cola 9%, and Procter & Gamble 18%.

Why This Trend Should Continue

If you think about it, would anybody have believed back in 2000 that they would see the day when companies like Microsoft and Intel would pay higher dividends than Treasury bond yields? Yet, that is exactly what we are starting to see and this trend doesn’t stop there. It is also an emerging trend with gold producers. Large cap miners Newmont, Barrick Gold, and Goldcorp have all initiated dividend programs over the last three years. Newmont has raised its quarterly dividend three times over the last twelve months with a dividend yield that beats 10-year treasury notes.

I believe this trend will continue over the next decade and there are numerous reasons why I believe this to be the case. To begin with, there is very little in alternative investments that compete with the growing dividend yields of large cap companies. In a strong economic environment growth companies can provide high returns as earnings growth translates to increasing stock prices. However, with a sluggish economy, low yields, and less investment opportunities here and abroad, companies will have to rely on providing shareholder returns through other means. In addition, blue chip companies are sitting on large piles of cash. Cash and short-term investments within the S&P 500 companies represent over 27% of market capitalization compared to a historical mean of 21%. Cash has risen to 13.25% of total assets. Right now, current payout ratios have fallen to a record low of 30% compared to an historical 86-year average of 58%.

With companies sitting on large piles of cash they have several options for using that cash. They can return capital to shareholders through dividends or pay down debt, a strategy now being rewarded by the markets. They can boost earnings per share through share buybacks, mergers, and acquisitions. They can deploy capital internally through capex or hiring new workers. Or finally they can just keep it.

In today’s zero percent interest rate environment very few CEO’s want to be seen sitting on idle cash earning a few measly basis points. Cash for maintaining working capital and reserves for emergencies is understandable. Beyond operating capital and emergencies cash balances that exceed prudent maintenance levels invite shareholder scrutiny or worse predator acquisitions.

That is why we think dividend increases are likely to continue well into this decade and beyond. Demographic trends also support this trend as baby boomers head into retirement in record numbers over the next few decades. Unlike their parents or government workers they don’t have defined benefit pension plans that are guaranteed and replace most of their working salary when they retire. What they have other than social security is what they have managed to save from their 401(k) plans. Cash investments, T-bills and CDs all pay less than one percent. These cash returns will not enable a boomer to retire. Bond yields are equally dismal with 10-year notes offering interest rates less than two percent and 30 year bonds barely offering a 3 percent return.

Keeping Up With Inflation

Today’s official inflation rate is close to three percent. Other inflation gauges like John Williams Shadowstats show actual inflation rates running closer to six percent.

shadowstats inflation

In the table below I have shown what is required to maintain the same standard of living under different inflation rates over a ten year period.

annual living expenses

As this table illustrates, even under modest inflation rates today’s investor or retiree is either going to have to postpone retirement or find a part-time job to supplement their retirement living needs.

Looking at the Hard Numbers: Dividends vs. Interest

In the following table I have shown the track record of a sample of big blue chip companies that make up the Dow Industrials. Included in this sample are consumer product companies, entertainment, technology, and a retailer. The actual dividends are shown in the table below.

dividend table

As you can see, actual dividends doubled from 2002-2007, and are up nearly fourfold by 2012. Furthermore, based on earnings and cash flow history they are projected to rise another 37 percent in the next five years. I know of very few individuals who have seen their salaries or income go up fourfold over the last decade. Nor do I believe that few individuals can expect to see salary increases of 37 percent over the next five years.

In another comparison that illustrates this point I have shown the income returns from a five and ten year Treasury note, and a thirty year Treasury bond over the next ten years. I assumed the five year note is rolled over at a similar yield over the next five years. By comparison I used the current projected dividend growth rates made by Value Line for the next five/ten years for the dividend income. It is assumed that an individual invests ten thousand into each of the ten Dow stocks and holds the portfolio of ten stocks for the same time period as the Treasury notes and bonds. The results are shown below.

dividends vs interest income

To begin with, the income from the blue-chip Dow stocks produces a higher income return right out of the gate. The only income return that would beat the dividend portfolio would be a 30-year Treasury bond. However, unlike the Treasury notes and bonds the dividend portfolio continues to grow each year and surpasses the yield on a thirty year bond in year three. The yield on notes and bonds remains fixed for the entire ten year holding period.

What About the Bear Market?

Before I conclude I would like to address the 2007 - 2009 bear market. Below I have shown long-term charts of four out of the ten stocks included in my study. Two are not only much higher than they were five years ago, but also breaking out to new highs. IBM and McDonalds are super dividend growth stories with a five year dividend growth of 20 and 21 percent respectively.

ibm mcd ko xom

The other two companies, Coca-Cola and Exxon Mobil, are nearing their former highs. During the downturn and subsequent recovery all of the companies included in my study increased their dividends each and every year. IBM and McDonalds dividends went from $1.50 to $3.15 for IBM and from $1.50 to $2.85 for McDonalds. Despite the downturn Exxon Mobil went on to increase its dividend from $1.37 to $1.94 while Coca-Cola’s dividend increased from $1.36 to $2.04. Not one company in my study missed paying a dividend. In fact every one of them increased their dividend each and every year.

Lastly, most blue chip companies that make up the Dow are selling at lower P/E multiples than what they were selling for five and ten years ago. Each one of them has either doubled or tripled their sales and earnings over the last decade.

While the bear market of 2007-2009 might have been scary to experience, it isn’t without a few benefits. If you simply held on to these stocks you got rewarded with 10-20 percent pay hikes each year. Most of these companies have already regained or exceeded their losses. If you were dividend reinvesting you would have picked up more shares during the downturn and would now have a higher level of income both from reinvestment and from dividend increases.

What Can and Can't Be Predicted

As far as the future is concerned I can’t guarantee that there will be no more corrections or bear markets in the days, weeks, or years ahead. What I do know is that five or ten years from now you will still be filling your car’s tank with gasoline, individuals will still be using computers and smart phones, drinking Coke, and eating Big Macs here and around the globe. That is why companies that produce a well established product or service that most of us use on a daily basis will, more than likely, still be doing so five and ten years from now.

Similarly, I can’t predict what the inflation rate is going to be five and ten years from now. What I do know is that our government and our central bank are pursuing a policy of inflation in order to reduce the value of the nation’s outstanding debt. With trillion dollar annual deficits, and with the Fed’s balance sheet growing by trillions of dollars over the last four years, it is likely that inflation will remain a permanent part of the investment landscape over the next decade with periodic bouts of disinflation in between.

Don't Rely on Social Security

On the day this was written the trustees of Social Security and Medicare issued a report that discloses both programs will exhaust their reserves three years sooner than previously estimated (see WSJ article, Stress Rises on Social Security). Currently Social Security is paying out more than it takes in payroll taxes. This means after this year’s Presidential election the issue of exhaustion will have to be taken up by whoever occupies the Whitehouse next January. The issue has been kicked down the road far too long and is in serious jeopardy of going broke unless needed reforms are made. This creates another uncertainty for investors nearing retirement or currently retired. Of all the reforms proposed there seems to be a common thread: extending the retirement age and going to means-testing. If you doubt this just remember that Social Security benefits used to be tax free to recipients. During the 1980’s fifty percent of the benefits became taxable based on a retirees total income. In 1993 President Clinton raised that percentage to eighty-five percent.

That is why I believe so strongly that unless investors structure their portfolios to include some form of inflation protection they are going to run into difficulties as living expenses rise each year. The trend in entitlements is moving towards reduction or elimination. This may evolve in several directions: make recipients pay more for the benefits received, means-testing and reduction, or higher taxation.

This leads me back to dividends as a part of an investment strategy. It is one of the few that is available to investors that allows them some form of control over their future income streams. In an era where interest rates have been capped and the government is constantly running the printing press it may be one of the only ways to give yourself an annual pay raise.

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About James J Puplava CFP