Volatility is back. The only certainty is uncertainty.

For over a decade, 2014-2025, we had lower-than-average volatility. The CBOE Volatility Index (better known as the VIX), which represents the expected annualized volatility of the S&P 500, averaged 17.9. That’s significantly below its long-term average of 19.5. In fact, volatility in 2024 was the lowest since 2019, before the pandemic.

However, with heightened global geopolitical tension, inflation concerns, increasing recession risk, uncertainty over tariff policy and the potential for retaliatory trade wars catalyzed by an administration that has “unpredictability” as a brand, the only certainty is uncertainty. Volatility thrives under uncertainty. As evidenced in early April, with the sudden collapse in stock and bond prices and in the equally sudden recovery in late  April and May.

So, what’s next? Are YOU prepared?

Keep in mind, we’re still in the early innings of Trump 2.0, with more than 3+ years remaining on a promise for major transformation of government and a complete overhaul of historical trade relations. There is no scenario in which a change of that magnitude doesn’t lead to continued high volatility.

Investors seeking to reduce risk and Improve performance can incorporate Niche Options-Based strategies that move independently of the market with the ability to exploit volatility.

Execution is Everything.

The experts at Sizemore Capital invite you to join us and learn about the benefits of active management and niche option-based strategies in an age of chaos, crisis and conflict.

We will cover:

• The pros and cons of active vs passive strategies.
• Appropriate implementation and execution of niche options-based strategies.
• Manager selection in niche options-based strategies.

Register here to join us on Wednesday, May 21 at 11:30 Eastern / 10:30 Central.

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Is the Chinese market still investable? from CNBC.

I joined Sara Eisen on CNBC’s The Closing Bell to chat about Chinese stocks.

Emerging markets have underperformed the U.S. market since 2009 for various reasons: political instability, currency weakness, commodity price weakness, and cyclical preferences. But after years of outperformance, U.S. stocks are now very expensive relative to emerging markets. For a long-term allocation, it makes sense to underweight U.S. equities and overweight emerging markets, including China.

That said, a little patience might be warranted here. Chinese stocks are in bear-market territory, and the pain might not be over yet.

The recent slowdown in China’s GDP growth is worrisome. China’s economic statistics are notoriously unreliable, but the general consensus is that growth of 6.5% is the threshold China needs to continue employment gains. Well, Chinese growth has slowed to 6.5%… and appears to be losing momentum.

Because hard stats are unreliable, you have to look for anecdotal evidence. Recently, China had to deal with angry mobs marching in the streets demanding that the government “do something” to prop up sagging home prices.

This puts the Chinese government in a bad position. Home construction and related industries make up anywhere from 15% to 30% of the Chinese economy. If the government curtails new construction to prop up prices, that kills growth. But if they boost construction to keep the economy moving, they add new supply to an already oversupplied market.

Chinese builders are also highly leveraged. I’m not necessarily worried about bad loans because China can pretty easily prop up zombie banks if they need to. It’s more an issue of diminishing marginal returns, or getting less bang for the buck. The last time China faced a slowdown, they went on a spending spree for construction and infrastructure. It’s hard to see that being effective again.

And finally, there is the issue of tariffs and more broadly of aggressiveness towards China by the U.S. and Europe. Chinese theft of intellectual property has been a “known issue” for years, but it seems that sentiment here has reached a tipping point. The West tolerated an imbalanced trade relationship with China because there was a belief that a more capitalistic China would also be a more democratic and more Western-friendly China. It didn’t really work out that way. As China has grown wealthier, it has arguably become more hostile to the West, and it certainly hasn’t become more free or democratic.

Western leaders can legitimately ask why they allow a trade relationship that disproportionately helps a geopolitical rival.

The broader question is whether this is a cyclical bear market (which could end quickly) or if this is simply the next phase of a longer-term secular bear market that started in 2015. In either case, you might get tradable rallies. But it’s likely too risky for most investors to consider a long-term buy and hold investment here.

 

With one quarter left to go in 2018, there are three things on investors’ minds: the Fed, the coming mid-term elections and the ongoing trade war. Thus far, the market has mostly shrugged off these concerns, though income-focused investments such as bonds, REITs and dividend-paying stocks have had a hard time gaining traction.

Sizemore Capital’s Dividend Growth portfolio, which invests primarily in higher-yielding securities, has also had a hard time gaining traction in 2018. The portfolio returned 0.14% in the third quarter and 0.53% in the year-to-date through September 30. This compares to 7.2% in the third quarter and 9.0% year-to-date for the S&P 500 and 5.1% and 1.6% for the S&P 500 Value. [Returns data calculated from the performance of Sizemore Capital’s Dividend Growth model at Interactive Brokers; past performance is no guarantee of future results.]

Given its focus on attractively-priced stocks paying above-market dividend yields, I consider the S&P 500 Value to be a more accurate benchmark than the standard S&P 500. And frankly, it’s been a difficult market for value strategies.

Value vs. Growth

Over time, value strategies have proven to outperform.

This is not my opinion. This is empirical fact. In their landmark 1993 paper, University of Chicago professors Eugene Fama and Kenneth French found that value stocks outperform over time. More recent research by BlackRock found that in the 90 years through 2017, value has outperformed growth by a full 4.8% per year.

Figure 1: Value vs. Growth

But while value trounces growth over time, 90 years is a long time to wait. And there are stretches – sometimes long stretches – where value underperforms badly. We’re in one of those stretches today.

Figure 1 illustrates this in vivid detail. The graph shows the ratio of the Russell 1000 Value index divided by the Russell 1000 Growth index. When the line is declining, growth is outperforming value. When the line is rising, value is outperforming growth.

Value massively outperformed growth from 2000 to 2007, but it has struggled ever since. This has been particularly true over the past two years as the “FAANG” stocks – Facebook, Amazon, Apple, Netflix and Google (Alphabet) – have completely dominated the investing narrative.

I would love to tell you the exact date when the market will flip and value will start to dominate again. For all I know, by the time you read this, it might have already happened. Or that day might still be years away.

That’s not something I can control. But I can stay disciplined and focus on high-quality companies that I believe to be temporarily underpriced. And because my strategy has a strong income component, we don’t necessarily need prices to rise in order for us to realize a respectable return. The average dividend yield of the stocks in the Dividend Growth portfolio is 5.65% at time of writing. [This yield will change over time as the composition of the portfolio changes.]

As we start the fourth quarter, I am particularly bullish about some of our newer additions, such as Macquarie Infrastructure Company (NYSE: MIC) and Ares Capital (Nasdaq: ARCC).

Macquarie Infrastructure lowered its dividend earlier this year, which led investors to dump it in a panic. The shares dropped by over 40%, giving us a very attractive entry point.

Ares Capital, like many BDCs, has found the past decade to be difficult. But after a long, six-year drought, the company raised its dividend in September, and I expect further dividend hikes to come. At current prices, the shares yield a whopping 9.0%.

I also continue to see value in some of our long-held energy infrastructure assets, such as Energy Transfer Equity (NYSE: ETE) and Enterprise Products Partners (NYSE: EPD). Energy Transfer, in particular, is attractive due to its planned merger with is related company Energy Transfer Partners (NYSE: ETP). I believe this could be the first step to an eventual conversion from an MLP to a traditional C-corporation, which would potentially lower ETE’s cost of capital and allow for greater ownership by mutual funds, institutional investors and retirement plans like IRAs. CEO Kelcy Warren has indicated that this is the direction he ultimately wants to go.

I see the greatest risk in the portfolio coming from our positions in automakers General Motors (NYSE: GM), Ford Motor Company (NYSE: F) and Toyota (NYSE: TM). I consider all three to be wildly attractive at current valuations, but all are also at risk to fallout from the escalating trade war. As a precaution, I lowered our exposure to the sector earlier this year by selling shares of Volkswagen. But given the potential for a rally in the shares following a favorable resolution to the trade war, I feel it makes sense to hold our remaining auto positions and potentially add new money to them on any additional pullbacks.

All Eyes On the Fed

The Federal Reserve raised rates again in September, which was widely expected. But it was a subtle change to their statement that raised some eyebrows. They dropped the language saying that its policy “remained accommodative.” Does this mean that the Fed believes easy money is already over and that they’re not much more tightening to be done? Or does it mean that they’re about to get even more hawkish?

The statement was ambiguous. But it is noteworthy that the Fed is still forecasting another hike before the end of the year and three more in 2019. And Powell’s statements following the official statement suggest that he’s eager to continue draining liquidity out of the market.

There are limits to how aggressive the Fed can be here. If they follow through with raising rates as aggressively as they plan, they will push short-term rates above longer-term rates, inverting the yield curve. I don’t see the Fed risking that, as an inverted yield curve is generally viewed as a prelude to a recession.

Figure 2: 10-Year Treasury Yield

Meanwhile, bond yields have finally pushed through the long trading range of the past six years. The 10-year Treasury yield broke above 3.2%, a level it hasn’t seen since 2011.

I do not expect yields to rise much above current levels, as I do not see such a move justified by current inflation rates or growth expectations. But this is something I am watching, because the Dividend Growth portfolio, given its yield-focused strategy, is sensitive to changes in bond yields.

Looking forward to a strong finish to the year,

Charles Lewis Sizemore, CFA

At the halfway point, 2018 is shaping up to be a good year for us. The first quarter was rough. In addition to the correction that dinged virtually all long-only portfolio managers, rising bond yields punished some of our more rate-sensitive positions, particularly REITs and MLPs. Though as yield fears subsided in the second quarter, the Dividend Growth portfolio recouped nearly all of its losses and entered the third quarter with strong momentum.

Through June 30, the portfolio returned 0.39% before management fees and -0.36 after all fees and expenses. Encouragingly, the returns for the second quarter were 7.92% gross of management fees and 7.17% net of all fees and expenses. [Returns figures compiled by Interactive Brokers and represent the real returns of a portfolio managed with firm capital. Returns realized by individual investor may vary based on account size and other factors. Past performance is no guarantee of future results.]

By comparison, through June 30, the S&P 500 index was up 1.67% through June 30 and up 2.93% in the second quarter.

So, while 2018 got off to a rough start, our portfolio has significant momentum behind it as we enter the second half. Our positions in energy — most notably midstream oil and gas pipelines — in real estate and in private equity managers have been the strongest contributors to returns. Our positions in European and emerging market equities have been the biggest drag on returns.

As a portfolio with a strong income mandate, the Dividend Growth portfolio is naturally going to have more interest-rate sensitivity than a broad market index such as the S&P 500. When yields are rising – as they were in the first quarter – this presents a risk. But when yields are stable or falling – as they were in the second quarter – it presents an opportunity.

The question we now face is this: What are interest rates likely to do in the second half of the year?

Ultimately, I expect that the path taken by interest rates will depend on two factors: inflation expectations and fears stemming from the nascent trade war.

I’ll address inflation expectations first. The unemployment rate has been hovering around the 4% mark for all of 2018. Traditionally, many economists have considered a 5% unemployment rate to be “full employment,” as there will always be some segment of the population that is either between jobs or not reasonably employable. Also, there are new would-be workers that come out of the woodwork (students, stay-at-home mothers, bored retirees, etc.) when the labor market gets sufficiently tight as it is today.

At 4%, we are significantly below “full employment,” which has led many economists to expect an uptick in inflation. Thus far, however, inflation has remained muted. PCE inflation (the rate used by the Federal Reserve in its decision making) has been running near or slightly above the Fed’s targeted 2% rate over the past six months, but it is not trending higher, or at least not yet.

If you’ve followed my research for any length of time, you know my view of inflation and the tools used to measure it. I don’t believe it is realistic to expect inflation at the levels seen in previous expansions due the demographic changes affecting the country. America’s Baby Boomers as a generation are well past the peak spending years of the early 50s. In fact, the front end of the generation is already several years into retirement.

The Boomers have been the economic engine of this country for over 40 years. As they retire, the borrow and spend less, taking aggregate demand out of the economy.

This isn’t purely academic. It’s been happening in Japan for over 20 years. Japan’s reported unemployment rate, at 2.8%, is even lower than ours. And Japan’s deficit spending and central bank stimulus absolutely dwarf those of America if you adjust for the relative sizes of the two economies. Yet Japan hasn’t had significant, sustained inflation since the early 1990s… when Bill Clinton was still the governor of Arkansas.

At the same time, automation technology and artificial intelligence is already eliminating jobs. Walk into a McDonalds today. You can order at a kiosk and never actually speak to a human employee.

At the higher end, Goldman Sachs reported a year ago that half of its investment banking tasks could viably be automated away.

While there are clearly exceptions in certain high-skilled jobs, the fact is that labor gets replaced by cheap technology as soon as it gets too expensive. It’s hard to imagine sustained inflation in this kind of environment.

Of course, this doesn’t mean that Mr. Market won’t decide to fret about it in the second half and send yields higher again. But I would consider any short-term weakness on higher bond yields to be a buying opportunity.

This leaves the fear of an economic slowdown. Right now, the economic numbers look healthy and there is no immediate sign of recession on the horizon. But unemployment tends to reach its lowest points near the end of the expansion. Furthermore, the Fed is aggressively raising rates, which is flattening the yield curve. A flat or inverted yield curve is a sign of economic distress and usually precedes a recession.

Does any of this mean a recession is “due” tomorrow? No, of course not. But it does suggest that we are late in the economic cycle, at a point when value sectors and higher-yielding sectors tend to outperform.

So, while I may make a few minor portfolio adjustments in the third quarter, I believe we are very well positioned at the half.

Looking forward to a strong finish to 2018,

Charles Lewis Sizemore, CFA

 

The first quarter of 2018 was not kind to value and income investors. Long-term bond yields started rising in the second half of last year, and that trend accelerated in January. For the quarter, the Dividend Growth portfolio lost 7.36% vs. a loss of 1.22% on the S&P 500. [Data as of 3/30/2018 as reported by Interactive Brokers. Past performance is not a guarantee of future results.]

Remember, as bond yields rise, bond prices fall, as do the prices of bond proxies such as utilities, REITs and other high-yielding stocks.

At the same time, the great “Trump Rally” that kicked off after the 2016 election reached a frenetic climax in December and January. The proverbial wall of worry that has characterized the “most hated bull market in history” since 2009 crumbled and was replaced by the fear of missing out, or “FOMO” in traderspeak.

The combination of a surge in bond yields and a sudden preference for high-risk/high-return speculation over slow-and-steady investment caused most income-focused sectors to underperform in January.

And then February happened. Volatility returned with a vengeance, dragging virtually everything down, growth and value alike. So, in effect, value and income sectors enjoyed none of the benefits of the January rally, yet still took a beating along with the broader market in February and March.

Sector	Benchmark	Qtr. Return
Large-Cap Growth	S&P 500 Growth	1.58%
Large-Cap Stocks	S&P 500	-1.22%
International	MSCI EAFE Index	-2.19%
Utilities	S&P 500 Utilities	-3.30%
Large-Cap Value	S&P 500 Value	-4.16%
Real Estate Investment Trusts	S&P U.S. REIT Index	-9.16%
Master Limited Partnerships	Alerian MLP Index	-11.22

It’s striking to see the differences between sectors. Even after the selloff in the leading growth stocks — the “FAANGs” of Facebook, Amazon, Apple, Netflix and Google — the S&P 500 Growth Index still managed to finish the quarter with a 1.58% gain.

Meanwhile, the S&P 500 Value Index — which is a reasonable proxy for Sizemore Capital’s Dividend Growth Portfolio — was down 4.16%.

It actually gets worse from there. REITs and MLPs — two sectors in which Sizemore Capital had significant exposure at various times during the quarter — were down 9.16% and a staggering 11.22%, respectively.

Suffice it to say, if your mandate calls for investing in income-oriented sectors, 2018 has been a rough year.

I do, however, expect that to change. While I consider it very possible that we see a bona fide bear market this year, I expect investors to rotate out of the growth darlings that have led for years and into cheap, high-yielding value sectors that have been all but abandoned.

Why a Bear Market is a Real Possibility

They don’t ring a bell at the top. But often times, there are anecdotal clues that a market is topping.

As a case in point , my most conservative client — a gentleman so risk averse that even the possibility of a 10% peak-to-trough loss was anathema to him — informed me in January that he would be closing his accounts with me because I refused to aggressively buy tech stocks and Bitcoin on his behalf.

He wasn’t alone. Again, anecdotally, I noticed that several clients that had been extremely conservative since the 2009 bottom suddenly seemed to embrace risk in the second half of last year. The fear of missing out — FOMO — had its grip on them.

This is the first time I’ve seen FOMO in the wild since roughly 2006. I was working in Tampa at the time, and the Tampa Bay area happened to be one of the centers of the housing bubble. I recall watching a coworker buy a house she couldn’t quite afford because she was afraid that if she waited, prices would quickly get out of her reach. She and her husband bought the house as the market was topping, and it was a major financial setback for them.

It may be in bad taste to recount personal anecdotes like these, but I do for an important reason. I want to avoid falling into the same mental trap.

Today, the market is expensive by historical standards. The cyclically-adjusted price/earnings ratio — or CAPE — is sitting at levels first seen in the late stages of the 1990s tech bubble.

Meanwhile, we are now nearly a decade into an uninterrupted economic expansion, and we’re effectively fighting the Fed. Chairman Jerome Powell has made it very clear that he intends to raise interest rates fairly aggressively to nip any potential inflation in the bud.

None of this guarantees that the current stock correction will slide into a bear market. (The same basic conditions were true in the 1998 correction, and stocks went on to rally hard for another two years.)

But it does tell me that caution is warranted, and that now — more than ever — we should stick with financially-strong value and dividend stocks. In a turbulent market, I expect to see investors seek shelter in “boring” value stocks offering a consistent payout. In a market in which capital gains no longer appear to be the “sure thing” they were a year ago, a stable stream of dividend income is attractive.

Will Value Get Its Mojo Back?

Growth utterly destroyed value last quarter. But this is really just a continuation of the trend of the past five years.

Consider the five-year performance of the iShares S&P Value ETF (IVE) and the iShares S&P 500 Growth (IVW). Growth’s returns have literally doubled value’s, with most of the outperformance happening in 2017.

Growth massively outperformed value in the last five years of the 1990s. But this is by no means “normal” or something that should be expected to continue indefinitely. Consider the performance of the same two ETFs in the five years leading up to the 2008 meltdown.

Value stock returns didn’t quite  double their growth peers. But they outperformed by a solid 40%, and that’s not too shabby.

This by no means guarantees that value stocks will outperform or that the specific value stocks Sizemore Capital owns will outperform. But if the market regime really has shifted — and I believe that it has — then the “FAANGs” story is over. Investors will be searching for a new narrative, and I believe that value and income stocks will be a big part of that story.

In the first week of the second quarter, I moved to a moderately defensive posture, shifting about 20% of the portfolio to cash. This gives us plenty of dry powder to put to work once this correction or bear market runs its course. But if I’m wrong, and this is yet another buyable dip, then we still have substantial skin in the game.

And whether the market goes up, down or sideways, we’ll continue to collect a high and rising stream of dividend income.

Looking to a better second quarter,

Charles Lewis Sizemore, CFA

The ETF Flow Portfolio met its first real challenge in the first quarter of 2018, and I’m proud to say it passed with flying colors. The portfolio returned 2.99% for the quarter compared to a loss of 1.2% for the S&P 500. (Returns were net of trading costs but gross of management fees, which may vary by account size. As always, past performance no guarantee of future results.)

But what excites me the most isn’t the outperformance. It’s the fact that the outperformance was achieved by successfully side-stepping the major drawdowns in February and March. The S&P 500 was down 3.9% in February and 2.7% in March on a price basis. By comparison, ETF Flow was down 0.06% in February and up 0.46% in March.

By using its short-term momentum indicators, ETF Flow rotated into defensive positions and spent most of February and March in bonds and cash equivalents.

The stock market has arguably been the greatest wealth-creating machine in all of human history, and it allows passive investors to own a little piece of the world’s greatest companies. But that doesn’t mean that buying and holding an index fund is the best strategy at all times. Market valuations swing like slow-motion pendulums, gradually moving from underpriced to overpriced and back to underpriced again. Unfortunately, after nearly a decade of uninterrupted bull market, stock prices have swung towards being overvalued again. The cyclically-adjusted price/earnings ratio (“CAPE”), among other valuation metrics, suggests that stocks are priced to deliver flat or negative returns over the next decade.

At the same time, stocks investors are effectively fighting the Fed, as Chairman Jerome Powell is committed to gradually raising short-term rates and winding down the Fed’s balance sheet, which was inflated by years of quantitative easing.

Meanwhile, GDP growth and employment both look exceptionally strong at the moment, particularly compared to recent years. But these are lagging indicators that tend to be at their highest near the end of the economic cycle.

None of this is to say that expensive stocks can’t get more expensive or that the stock current correction is guaranteed to slide into a full-blown bear market. But it does suggest that it is prudent to maintain a nimbler trading strategy or, at the very least, to diversify into complementary, noncorrelated strategies. And this is precisely the role that ETF Flow successfully filled during this correction and the role that I expect it to fill going forward.

Looking forward to a strong 2018,

Charles Lewis Sizemore, CFA

Below you can view our most recent factsheet:

I wrote earlier this year that the 60/40 portfolio is dead. Well, rumors of its death were not greatly exaggerated. The 60/40 portfolio that served retired investors so well over the past 30 years is gone… and it’s not coming back any time soon. As investors, we have to move on.

Rest in Peace 60/40 Portfolio

While it’s true that a simple 60/40 portfolio of the SPDR S&P 500 ETF (SPY) and the iShares Core US Aggregate Bond ETF (AGG) is actually enjoying a nice run in 2016, up a little more than 3% for the year, don’t get used to it. The math simply doesn’t work out going forward.

Let’s play with the numbers. Back in 1980, the 10-year Treasury yielded a fat 11.1%, and stocks sported an earnings yield (calculated as earnings / price, or the P/E ratio turned upside down) of 13.5%. This implied a back-of-the-envelope portfolio return of about 12.5% per year going forward, and for much of the 1980s and 1990s that proved to be a conservative estimate. Both stocks and bonds were priced to deliver stellar returns, and both most certainly did.

But what about today? The 10-year Treasury yields a pathetic 1.6% and the S&P 500 trades at an earnings yield of just 4%. That gives you a blended portfolio expected return of an almost embarrassing 2.8%. [Note: The usual disclaimers apply here. These are not intended to be precise market forecasts.]

You know the refrain: past performance is no guarantee of future results. There is no guarantee, at least with respect to stocks, that expensive assets can’t get even more expensive. It’s possible that the great bull run in stocks could continue indefinitely, however unlikely it might be.

But I can’t say the same for bonds. Starting at a 1.6% yield to maturity (or even the 4% you might find on a mid-grade corporate bond) you cannot have returns going forward that are anything close to the returns of the past several decades. Bond yields would have to go negative, and I don’t mean the (0.15%) we see today on the Japanese 10-year bond. I’m talking (5%) or (10%) or even more.

That’s not going to happen. Or if somehow it did — if investors got so petrified that they piled into bonds to the extent that yields went negative to that degree — then I would assume the stock portion of your portfolio effectively fell to zero at that point.

The bottom line here is that even under the most optimistic scenario, investors are looking at disappointing returns in a standard 60/40 portfolio.

So, what are investors supposed to do about it? They can’t just stuff their cash in a mattress for the next 5-10 years. Most of us actually need to earn a return on our money.

I’d offer the following suggestions:

Consider taking a more active approach to investing.

To the extent you invest in traditional stocks and bonds, don’t be a buy and hold index investor. Yes, low fees are great. But the fact that you paid Vanguard only 0.09% per year in management fees won’t really matter if you’re returns are still close to zero.

Instead, try a more active strategy, perhaps focusing on value or momentum. Or perhaps try a dividend focused strategy. With a dividend strategy, you can realize a cash return even if the market goes nowhere for years at a time.

Consider investing outside of the market.

If you’re willing to get your hands dirty, consider starting your own business or investing in a cash flowing rental property. Yes, there is more work involved, and there is the risk of failure. But there is also risk in trusting your savings to a fickle market when both stocks and bonds are both expensive by historical standards.

Consider a truly alternative asset allocation.

This final point is really my specialty. To the extent I can, I am eliminating traditional bonds from the portfolios of most of my clients and replacing them with non-correlated (or at least minimally-correlated) alternative investments. A standard 60/40 stock / bond portfolio might instead become a 50/50 dividend stocks / alternative investments portfolio.

“Alternative investments” is a generic term that can mean just about anything. In practice, for me it has meant a combination of long/short strategies, options writing strategies, absolute return hedge funds, and liquid alternative portfolios.

Will a non-traditional portfolio like this outperform over time?

Frankly, I don’t know. No one does. We’ve never seen a market like today’s.

But to me, it’s the only move that makes sense. Taking the traditional path is a virtual guarantee of disappointment. Incorporating alternatives into the portfolio at least give us the potential for solid returns.

Charles Lewis Sizemore, CFA is the principal of Sizemore Capital, an investments firm in Dallas, Texas.

Photo credit: Pheonix149

I like getting paid in cold, hard cash. And frankly, who doesn’t?

But stock dividends are more than just a quarterly paycheck. They are a way of doing things. I would go so far as to argue that they are a philosophy of life (or at least of business).

That might sound a little kooky at first, but hear me out.

In the Wolf of Wall Street, Jordan Belfort (or at least Leonardo DiCaprio playing Belfort) says that money does more than just buy you a better life; it also makes you a better person. That’s certainly debatable. But I can credibly say that paying a dividend makes for a better kind of company. And here are a few reasons why:

1. Dividends are an outward, visible sign of who the real boss is. Remember, the SEO in the suit running the company isn’t the owner. He’s an employee, no different than a common assembly line worker other than for his larger paycheck. You, the shareholder, own the company. And management shows that they understand and respect that by regularly paying and raising the quarterly dividend.
2. Dividends dissuade fruitless empire building. Corporate CEOs really aren’t that different from politicians. At the end of the day, they spend other people’s money and often times waste it on useless projects or on mergers that add no value. Why? Because growth – even unprofitable growth – gives them more power and control. Well, paying a regular dividend forces management to be more disciplined. If you’re paying out half your profits as a dividend, you have to be more selective about the growth projects you choose to pursue with your remaining cash. They focus on the most profitable and worthwhile and, by necessity, pass on the marginal ones.
3. Dividends foster more honest financial reporting. At one point or another, many (if not most) companies will… ahem… perhaps be a little less than honest in their financial reporting. Outright fraud is pretty rare. But accounting provisions allow for a decent bit of wiggle room in how revenues and profits are reported. Even professionals can have a hard time figuring out what a company’s true financial position is if the numbers are fuzzy enough. Well, while revenues and profits can be obfuscated by dodgy accounting, it’s hard to fudge the numbers when it comes to cold, hard cash. For a company to pay a dividend, it has to have the cash in the bank. So while paying a good dividend is no guarantee that the company isn’t being a little aggressive with its accounting, it definitely acts as an additional check.
4. Share buybacks – the main alternative to cash dividends – never quite seem to work out as planned. Companies inevitably do their largest share repurchases when times are good, they are flush with cash, and their stock is sitting near new highs. But when the economy hits a rough patch, sales slow, and the stock price falls, the buybacks dry up. And another (and frankly insidious) motivation for buybacks is to “mop up” share dilution from executive stock options and employee stock purchase plans. The net effect is that a company buys their shares high and sells them back to employees and insiders low. Call me crazy, but I thought the whole idea of investing was to buy low and sell high, not the other way around. A better and more consistent use of cash would be the payment of a cash dividend.
5. And finally, we get to stock returns. I’m not particularly excited about the prospects for the stock market at today’s prices. Based on the cyclically adjusted price/earnings ratio, the S&P 500 is priced to deliver annual returns of virtually zero over the next decade. But if you’re getting a dividend check every quarter, you’re still able to realize a respectable return, even if the market goes nowhere. And that return is real, in cold hard cash, and not ephemeral like paper capital gains.

Hey, not every great company pays a dividend. And certainly, a younger company that is struggling to raise capital to grow has no business paying out its precious cash as a dividend when it might need it to keep the lights on next month. But for the bulk of your stock portfolio – the core positions that really make up your nest egg – look for companies that have a long history of paying and raising their dividends.

Charles Lewis Sizemore, CFA is the principal of Sizemore Capital, an investments firm in Dallas, Texas.

 

A wonderful serenity has taken possession of my entire soul, like these sweet mornings of spring which I enjoy with my whole heart. I am alone, and feel the charm of existence in this spot, which was created for the bliss of souls like mine. I am so happy, my dear friend, so absorbed in the exquisite sense of mere tranquil existence, that I neglect my talents. I should be incapable of drawing a single stroke at the present moment; and yet I feel that I never was a greater artist than now. When, while the lovely valley teems with vapour around me, and the meridian sun strikes the upper surface of the impenetrable foliage of my trees, and but a few stray gleams steal into the inner sanctuary, I throw myself down among the tall grass by the trickling stream; and, as I lie close to the earth, a thousand unknown plants are noticed by me: when I hear the buzz of the little world among the stalks, and grow familiar with the countless indescribable forms of the insects and flies, then I feel the presence of the Almighty, who formed us in his own image, and the breath of that universal love which bears and sustains us, as it floats around us in an eternity of blist.