Wednesday, May 02, 2007
“You without me is like cornflakes without the milk”
-Oran “Juice” Jones
Macro Man was recently involved in a discussion about the relative merits of equities and gold. One of the participants observed that gold and other commodities had handily outperformed US and broad global equities in the current millennium, a fact which is clearly indisputable. However, he also quoted a passage from a financial blog [a famously unreliable source of analysis ;) ] discussing the historical relative performance of equities and gold. The author of the original piece noted that at the Dow peak in 1929, the Dow divided by the gold price was 19, the same ratio as today. Therefore, he concluded, equities have failed to outperform gold over a timespan encompassing nearly eighty years.
Can you spot the mistake in the analysis? That’s right, he conveniently forgot to include the income from dividends. Simply put, measuring stock market performance without dividends is like eating cornflakes without milk- it’s just not complete.
Most readers will probably be aware that dividend income represents a substantial portion of stock market return over time. However, it is easy to forget how powerful the impact is over long periods. Unfortunately, Macro Man does not subscribe to Ibbotson Associates or similar providers of historical data, so he can only go as far back as the end of 1969 in his analysis. However, even going back just 37 and a bit years, the impact of the compounding of dividend reinvestment is very striking indeed.
First off, let’s consider the naïve analysis referenced above: measuring equity indices not in dollars (or any other currency), but in ounces of gold. Now, it is certainly debatable whether gold is an appropriate measure of “absolute value”, but enough people seem to think it is that Macro Man is prepared to use it for the purposes of this example. The chart below shows the price of MSCI World and MSCI USA priced in ounces of gold. On December 31, 1969, both indices could “purchase” 2.84 ounces of gold. Today, on the other hand, MSCI World can only purchase 2.32 ounces of gold, while MSCI USA only buys 2.05 ounces of gold. So according to the author of the blog referenced above, gold has “won” and was a better investment than equities.
Not so fast, my friend. When we add dividends back in, equities win in a landslide. Even with the recent dramatic outperformance of gold, $100 invested in either MSCI World or MSCI USA in 1969, with dividends reinvested, would still be worth loads more than an equivalent amount invested in gold. Whereas one unit of either index could buy 2.84 ounces of gold in the Age of Aquarius, MSCI World with dividends reinvested now buys 7.03 ounces of gold, and MSCI USA buys 6.97 ounces. In other words, dividends reinvested take the equities from underperforming gold to easily more than doubling in value relative to the yellow metal. Small wonder, then, that no less an authority than Albert Einstein called compounding “the greatest mathematical discovery of all time.”
Since 1969, the dividend yield of MSCI World has been about 3% and the annual price increase has been about 7.4%. Now 10.4% per year sounds better than 7.4% per year, but over the course of an investing lifetime one might think that it would allow one to retire a year or two earlier at most. Right? Wrong. $100 invested in MSCI World at the foundation of the index by someone who took the dividends and bought bell bottoms with the proceeds every time they were paid would currently be worth $157,785. Not too shabby, to be sure. However, had our fashion victim instead plowed the dividends back into the index, that same $100 would now be worth $478,731. The latter figure would fund a substantially nicer retirement pad...
* This analysis does not include the tax costs of dividends. Total returns of equities would surely be lower if dividend taxes are paid out of dividend income. Macro Man has not seen any total return analysis that shows the post-tax compound returns of dividend reinvestment, and would be curious to know if any readers have seen such a study.
* Similarly, Macro Man would be curious to know how the numbers break down for longer data sets, such as those of Ibbotson. He’d imagine that the effect would, if anything, be more pronounced the earlier one makes the starting point, given the relatively high dividend yields that prevailed before the 1950’s.
* There is a school of thought in behavioural finance that dividends should be irrelevant to total returns, given that stock prices decline by the amount of any dividend payment. In other words, future returns of a $100 stock should be identical as those of a $100 stock that pays a $1 dividend and drops the price to $99. This school of thought pooh-poohs the notion that one might wish to purchase dividend-paying stocks as a source of income, suggesting instead that one could replicate the cash flow by selling tiny amounts on non-dividend paying stock (ignoring transaction costs, of course.) Intuitively, this makes sense, and yet....it does not appear to jive with real-world observation. Perhaps it is because as companies mature, it becomes more and more difficult for retained earnings to generate the same marginal profitability via fresh investment. Dilutive investment would therefore reduce the overall return on capital, therefore dampening future stock returns. Presumably the future return of a company that distributed as dividends any earnings that could not be invested to at least match existing marginal profitability would be superior. Microsoft and Intel come to mind as companies that held on to too much cash for too long, though they have belatedly seen the error of their ways.
* In that vein, Macro Man would be curious to know if any readers have ever seen studies performed on relative total returns generated by companies of similar size and profitability, but with one persistently offering a substantially higher dividend yield than the other. In other words, do companies with a market cap of $10 to $20 billion , earnings growth of 10%-15%, and a dividend yield greater than 3% generate superior, inferior, or identical total performance to companies with a similar size and profit growth but who pay a dividend yield of less than 1.5%. Macro Man reckons that an exhaustive study across countries, market cap, and time would make for a really neat thesis project, if there are any would-be academics out there.