Using Market P/E to determine the Value of the Stock Market

Many of us follow the Market Index.  However, few of us realise its relationship to Market P/E.

The chart above helps us to relate Market Index to Market P/E.



“It’s time in the market, not timing the market” that counts."

This gives rise to the all-important question: does one’s entry level into the market, i.e. the valuation of the market at the time of investing, make a significant difference to subsequent investment returns?

In an attempt to cast light on this issue, an interesting multi-year comparison of the price-earnings (PE) ratios of the S&P 500 Index (as a measure of stock valuations) and the forward real returns was done by my colleagues at Plexus Asset Management. The study covered the period from 1871 to 2006 and used the S&P 500 Composite Index (and its predecessors). In essence, a total real return index and coinciding ten-year forward real returns were calculated, and used together with PEs based on rolling ten-year earnings.








This analysis strongly confirms the downward trend of the average ten-year forward real returns from the cheapest grouping (PEs of less than six) to the most expensive grouping (PEs of more than 21).

The second study also shows that any investment at PEs of less than 12 always had positive ten-year real returns, while investments at PE ratios of 12 and higher experienced negative real returns at some stage.

A third observation from this analysis is, interestingly, that the ten-year forward real returns of investments made at PEs between 12 and 17 had the biggest spread between minimum and maximum returns and were therefore more volatile and less predictable.

It is easy to understand why Grantham came to the conclusion that “the best case for caution and bearishness is value, which is a weak predictor of one-year returns, but a dynamic predictor of longer-term returns”.

http://investmentpostcards.wordpress.com/2007/06/05/us-equity-returns-what-to-expect/

Warren Buffett's Personal Stock Holdings (31.12.2009)

Although Buffett has 95% of his fortune invested in Berkshire Hathaway, he does maintain a very sizable personal investment portfolio.



Warren Buffett's concept of Equity Bond evidenced by Kraft Foods' increasing dividends over the years.






"Warren Buffett’s definition of a good company is one that has a limit on capital expenditure, a reliable income, and no competition. "

Free cash flow yield trumps dividends as a driver of returns

Managing risk: An emphasis on free cash flow and transparency

As dividend cuts make headlines, it is important to remember that dividend payouts are only the tip of the iceberg when it comes to identifying dividend-paying companies and sizing up dividend risk relative to a company’s total return3 potential. Moreover, in the current environment of rising dividend yields, it’s important to be cautious about “yield chasing”, as some of these yield premiums could be due to precipitous stock price declines instead of bona fide, sustainable growth in the underlying businesses.

Consistent dividends and dividend growth are characteristics of good businesses, but in the view of the management team of the PH&N Dividend Income Fund, other more important factors must be evaluated in tandem. These include strong free cash flow, a solid financial position, and a management team with a record of making intelligent decisions regarding how it deploys free cash.

In an era when corporate earnings can easily be obfuscated by the rotating door of GAAP methodologies4, it is refreshing to be able to rely on a valuation metric that is difficult to manipulate or misrepresent. Free cash flow is one such measure, and it is attractive for its transparency.

Free cash flow is the cash that is left over after a company has made the appropriate allocations to maintain or grow its asset base (working capital and capital expenditures). Essentially, this pool of “free cash” allows a company to pursue shareholder-friendly activities, such as paying dividends, making acquisitions, and paying down outstanding debt.

The chart below was adapted from research conducted by Empirical Research Partners – it depicts relative returns for U.S. large cap stocks sorted by dividend growth, share repurchases, and price/free cash flow over the 35-year period from 1970-2005.



You will notice the following:

• Strategies focused only on dividend growth have only modestly outperformed the S&P 500 Index.
• Companies that pay no dividends at all have the worst return records.
• Strategies focused on price/free cash flow were the most effective at outperforming the S&P 500 Index.

Even in today’s severely compromised market environment, companies are fiercely protective of their free cash flow. Despite the downturn, free cash flow has held up remarkably well due to a couple of factors: a low capital expenditure base and aggressive management of working capital.

https://www.phn.com/Default.aspx?tabid=1103

How Much Stock Dividend Did You Receive in 2009?

While the annual dividend receipt of $5,000 is quite insignificant compared with my portfolio size of over $850,000, bear in mind it only comes from my individual stock holdings, which grew from about $200,000 at the start of the year to about $280,000 by the end of November. The $5,000 dividend payout, therefore, represents about a 2.0% dividend yield for my individual stock holdings.

It is amazing that at one point in November, Bank of America is yielding 6% and Citigroup is yielding 7%. It reminds me of 2002-2004 where I invested in R. J. Reynolds and Altria when they were facing apparently huge litigation risks and yielded over 5%. Am I bottom fishing again?

http://www.pfblog.com/archives/6316_how_much_stock_dividend_did_i_receive_in_2007.shtml

Value investing style drives investors to many companies that pay handsome dividends. Therefore, it is quite useful to ask the question: how much stock dividend did you receive in 2009?

Unlike bond payments which are fixed, stock dividends could be raised

A good starting point for income investors is the S&P Dividend Aristocrats list, which features companies that have increased their annual dividend payments every year for more than 25 consecutive years. Here are the 20 highest yielding stocks in the index, along with their ticker, P/E ratio, dividend yield and dividend payout ratio.



A great idea for income seeking investors is investing in stocks that pay good yields and have consistent dividend payments. With inflation averaging around 3 - 4% per year, your investment in dividend paying stocks would provide you with a source for income that keeps its purchasing power over time, which unlike fixed income securities can also provide you with capital gains. Unlike bond payments which are fixed, stock dividends could be raised and thus provide stockholders with a nice raise for owning the right companies.

http://www.dividendgrowthinvestor.com/2008/06/20-highest-yielding-dividend.html

Dividend Growth Investing

The 1929 & 2007 Bear Market Race to The Bottom

19 February 2010






We can always learn something from studying the past, but past performance is no guarantee of what is to come.

Well during Bull Market, there are bad weeks, and in Bear Markets there are good weeks.

http://www.gold-speculator.com/mark-lundeen/22558-bear-market-race-week-123-djia-market-volume-dividend-payout-yield-considerations.html

Total Stock Returns = Fundamental Return + Speculative Return

Over long periods of time, if you take the entire stock market, you would expect the speculative return to be very negligible. This makes a lot of sense, right? In the end, you’ve got to show me the money! And history agrees. Over the last 100 years, the total annualized return for the total U.S. market was 9.6%, and all but 0.1% of that was explained by earning growth and dividends. (See graph below.)





Fundamental Return = Earnings Growth + Dividend Yield

Speculative Return = P/E Ratio Changes

Total Return = Fundamental Return + Speculative Return

What are we buying when we buy a share of a company? Essentially, we are buying a stream of future money. That money is returned to us the form of earnings growth (which increases the share price) and dividends (which goes straight to us as cash).


http://www.mymoneyblog.com/will-future-long-term-stock-returns-be-less-than-8.html

The Little Book of Common Sense Investing by Vanguard founder Jack Bogle

Double Your Dividends by Investing in Foreign Companies

http://www.globaldividends.com/newsletter.asp?d=2010



http://www.investmentadvisor.com/Issues/2007/August%202007/Pages/The-Income-Barista.aspx




http://www.zimbio.com/Stock+Portfolio+Investing/articles/554/Three+useful+dividend+growth+reinvestment

Australian companies usually have high dividend payout ratios and dividend yields.

http://topforeignstocks.com/2009/08/24/top-10-banks-of-australia-by-assets-deposits/

10 by 10: A New Way to Look at Yield and Dividend Growth

Dividend investors often set minimum requirements for an “acceptable” initial dividend yield and/or dividend growth rate when they are considering buying a dividend stock.

Thus one investor might say, “I won’t invest in a dividend stock with a starting yield less than 3%.” Another might say, “I want a minimum 10% per year dividend increase.”

The goal, of course, is to purchase stocks whose yields and dividend growth rates are high enough to make them better bets than safer fixed-income investments like money market accounts, certificates of deposit, and bonds.

The dynamic that determines the goal of “high enough” is how a stock’s initial dividend yield and annual dividend growth rates interact over time. Obviously, a 6% initial yield will require a lower annual growth rate than a 2% initial yield to achieve a given return within a given time. By the same token, a 6% initial yield will get to a given return faster than a 2% initial yield for any given rate of growth.

Most dividend investors have a long-term holding period in mind when they buy dividend stocks. They are not looking to trade them often, but rather to hold them, allowing time for the dividends to increase and compound, until the stock itself becomes a money-generating machine irrespective of the stock’s price fluctuations.

Here is a useful way to look at this: Look for stocks that will achieve a 10% dividend return on your original investment within 10 years’ time. I call this the “10 by 10” approach.

The two 10’s are arbitrary, of course. You can put in any goals you like. I chose 10 and 10 because:
10% is a healthy rate of return, almost equal to the long-term total return of the stock market itself, which most studies show is between 10% and 11%. (Total return includes price appreciation as well as dividend return.)

10 years is a useful time frame for people of most ages. Young people, of course, have a much longer investment timeframe, but nevertheless may consider 10 years long enough to wait for the kind of return they are seeking. Older people—say in their 60’s and 70’s—still often think in terms of timeframes at least as long as 10 years, since just by having lived to their current age, their life expectancy usually is longer than 10 years from right now.

And, of course, 10 is a nice round number. It is easy to think in terms of 10% return and a 10-year timeframe to get a good grasp of the underlying principles.

So the question becomes simple: What initial yields, compounded at what rates of growth, achieve 10% return within 10 years?

The following table answers that question. It shows initial yields (across the top) and annual growth rates (down the side). Where any two values intersect, the table shows how many years it takes to achieve a 10% dividend return. Beneath the table are a few notes on calculation and interpretation.



The faster you hit your 10% dividend return rate goal, the fewer years that your stock choice is subject to prediction risk—that is, the risk that you overestimated its rate of dividend growth. As all dividend investors know, their initial rate of return is fixed at the time of purchase, but the future rate of dividend growth is somewhat speculative. Also, the higher the rate of projected dividend growth, the lower the probability that it will actually be achieved. Getting to your goal in fewer years is generally better all around.


http://www.dividendgrowthinvestor.com/2008/11/10-by-10-new-way-to-look-at-yield-and.html

Global High Dividend Stocks Have Outperformed the Markets

Dow Dividend Yield

The list is ranked based on dividend yield as of Dec. 31, 2009. As you can see, the dividend yield varies from an attractive 5.9% to 0%.

Here's a bar chart showing the dividend yield of the Top 15:

How to Create a Stream of Lasting Dividend Income

Future Dividends Growing at Varying Growth Rates 
(Graphic)





How to Create a Stream of Lasting Dividend Income
Thanks to the power of reinvested dividends and dividend growth.

Retention Rate Is Important Factor For Dividend Growth Companies

Investing in a company that simply increases it dividend will not ensure an investor that the investment will yield higher returns. One factor to evaluate is the earnings retention rate. Retention rate is the amount of earnings left over after accounting for the dividends paid to shareholders. If a company pays all earnings to shareholders, then the earnings retention would be zero. If a company pays out 70% of its earnings to shareholders, then the company's retention rate would equal 30%.

The table below shows the average retention and dividend growth rates over the past ten and five years for a number of companies we have recommended. As can be seen, since 1999 these companies, as a group, had an average retention rate of 17%, or more than four times the average of the S&P 500 for the same period. Their average dividend growth rates for the past five years were also far superior to the S&P 500 -- even taking into account the three companies in the group not paying dividends for the entire period.



http://disciplinedinvesting.blogspot.com/2009/05/retention-rate-is-important-factor-for.html

The power of compounding from Reinvested Dividends

The two charts below show the cumulative return of a dollar for the S&P 500 Index on a price only basis and total return that includes reinvested dividends since 1926. The second chart shows the power of compounding on a percentage basis.

Dividend Growers Have Outperformed with Less Risk

Investors continue to be rewarded with better risk adjusted returns by maintaining a focus on investing in dividend growth stocks. A recent report from Oppenheimer contained a Ned Davis Research chart noting the dividend growers and initiators continue to achieve higher risk adjusted returns for the period 1972 - 2008.

For investors then, continuing to focus on stocks/companies that increase the company's dividend on an annual basis can be a rewarding investment approach.

"...many of the dividend payers of final interest will likely tend to be large, more established, companies with market capitalizations of more than $5 billion, and this select set will comprise the bulk of our group. In an effort to boost returns, though, we will also seek out mid-cap stocks with good dividend prospects."


http://disciplinedinvesting.blogspot.com/2009/03/dividend-cuts-no-worse-than-in-prior.html

Carlsberg Financial Data (1998 to 2007)

No growth in net dividend.

What about its share price over the same period?

Dividend Aristocrats: A Comprehensive View

There tends to be much debate on whether dividends are a critical factor in determining the suitability of a particular investment. One fact is clear though and that is since 1926 the dividend component of the S&P 500 has accounted for one-third of the index's total return

Dividend Aristocrats have outperformed the S&P 500 Index on both a return basis and with less risk (beta).

The ability of management to maintain stable or increasing dividends indicate the quality of the firm’s earnings and its growth prospects.














The math behind compounding shows if one looses less in a down market, it takes a lower return to get back to even. In essence, if one looses less in the down market period, the portfolio will have more invested when the market turns around and moves higher.

http://seekingalpha.com/article/183829-dividend-aristocrats-a-comprehensive-view

More Gems from Buffett

Screen as many stocks as possible.  You will find a good investment among these many stocks.

The moment you find value in a good stock, buy and don't wait hoping to find a better one.

Cash is the worst form of investment.  You need to keep some cash so that your future is not determined by others.

Imagine being a farmer with your own farm.  The farm is productive but every 10 years, there are 2 severe drought years.  Do you sell your farm during those years?  No.  Similarly, in investing, be prepared for these bad years.


[My comment: In stock market investing, one can expect on average a bad year (a bear market) in every 5 years.]

The Principles of Dividend Investing

The point is that dividend growth followed earnings growth.















http://seekingalpha.com/article/176988-the-principles-of-dividend-investing

Relative Contributions of Price Returns and Dividend Returns to Total Returns over the Decades

Stocks that pay dividends provide a nice inflation hedge since their revenues and net income would be affected by an increase in overall prices paid by consumers. Dividends soften losses during bear markets, and they provide the only sources for investment gains in troublesome times. In addition, dividend income takes away the need to sell large chunks of your portfolio in a declining market. Retirement income could be solely derived from dividends and their growth would compensate the dividend investor for the erosion in the purchasing power of the dollar.

If a retiree holds a diversified portfolio of stocks which have the ability to grow their dividend payments over time, they would be well prepared for retirement. They should be focusing on stocks with high yields and ability to grow dividends; stocks with average yields but with above average dividend growth and some domestic and foreign index funds for diversification.


http://www.dividendgrowthinvestor.com/2008/03/case-for-dividend-investing-in.html

The power of dividends is substantial, especially when you reinvest them.

This chart, from Bernstein Global Wealth Management, demonstrates how reinvesting dividends can substantially improve your total returns.

http://www.investmentu.com/2008/April/mark-skousen.html