The world packed in a lot of living during the first quarter. As evidenced by global stock markets, the fortunes of the world plunged, rallied, plunged, and rallied again. As the fate of Wall Street was deliberated in Washington, DC, markets tended to take cues from political events rather than good old fundamentals. The widely followed ups and downs were the financial manifestations of the inauguration of President Obama, rumors of a massive bank bailout, a disappointing lack of clarity from Treasury Secretary Timothy Geithner on the details of the bailout, and finally, a full court PR press by the Treasury Department as well as evidence of economic recovery in a number of economic indicators. If the description of the quarter leaves you breathless, the day-to-day turns have been truly something to behold. In the end, the S&P 500 was down just over 11% for the quarter, in spite of an impressive 20+% rally during March.
 
The global and virtually simultaneous plunge in consumer spending, private investment and export demand during the third and fourth quarters of last year as a result of the credit crisis has understandably left investors and politicians weak in the knees. Fear of more of the same has left people spooked about business in general and skeptical of politicians bearing expensive solutions.  Looked at through the lens of the stock and bond markets, there are several signs emerging that may signal a return to what passes for sanity in the financial markets. These indicators are all interconnected in terms of economic activity and most important, their changes can mark shifts in sentiment as well as buying decisions on Main Street. 

 

 

Although headline focus of late has been on those troubled companies that have had to reduce or eliminate their dividends in this difficult economic period, many more have increased or maintained their dividends.  At Northstar, we have looked at the dividend performance of our 134 approved list stocks.  Far more companies have raised or held stable their dividends during this time. 
 
In the 14 months beginning in January, 2008, our stocks have recorded 104 dividend increases compared to 16 reductions.  Most of those cuts were concentrated in troubled financial-related companies. 
 
Much has been written about the importance of dividends to overall investment returns.  During periods of high growth, the general consensus is "who cares", but during most other times dividends are an important component of total investment returns. During the high growth decade of the '90s, dividends only contributed 14% of monthly total return of the S&P 500 Index. In some prior decades the contribution was 50% or more.   We do not yet know about the current decade, but I am sure dividends are becoming more meaningful.  The chart below illustrates the impact of dividends on long-term investment results.  $1 invested in the S&P 500 Index on January 1, 1930 would have appreciated to $42 at the end of 2007.  With dividends reinvested, that dollar would have grown to $1,052.

 

Source: Standard & Poor's 1929-11/30/2008

 

The impact of dividends on investment results is clear.  It also has a lot to with how we look at a company from a research standpoint.  Companies with a history of consistent dividend growth and a modest payout ratio (the percent of the dividend to earnings per share) tend to exhibit stability and steady growth.  Non-dividend paying stocks often have strong growth trends, although the volatility of returns can be greater.
 
At Northstar, we seek out well-capitalized companies in those industries that should prevail in the foreseeable economic climate.  By adding the dividend discipline to the equation, we should be able to identify stable companies that will recover in the next market upturn.  Going forward, we will continue to focus on dividend policies in our equity selection process.

 

 

 

By having cash flow, we build a margin of safety into the accounts.  The interest and dividend payments provide clients with the ability to wait out this difficult market, and still be positioned for growth going forward.
 
Let's talk about the cash flow from bonds first.  Although some parts of the bond market have been roughed up, high quality corporate bonds, US government bonds and municipal bonds have held up well.  Generally, these are the types of bonds owned for retired clients.  The interest payments range from about 3.5% on municipal bonds up to around 5% for corporate bonds.  These interest payments provide a steady and stable steam of cash for your distribution needs.  Plus, the more stable nature of the bond holdings helps to preserve your total portfolio value during down markets.
 
On the stock side, the income comes from the dividend payments.  While there have been a number of dividend cuts over the last year, the majority of those cuts have come from financial services firms, such as banks and insurance companies.  As Dick Kopp has noted in his article, many companies continue to maintain and even increase their dividends in this environment.  On average, the dividend payments on the S&P 500 are about equal to where they were last year, which is around 3%.  That is because the dividend cuts from some firms have been offset by increases from others. 
 While dividends are not guaranteed, with a diversified portfolio, we can have a reasonably high degree of confidence about the amount of dividends that will be paid for the year.  Now this is an unusual economic environment, and we anticipate additional dividend cuts in the markets, but we are working hard to own securities that provide a steady dividend flow.
 
In today's environment, when we add up our anticipated bond interest and dividend payments, the cash flow comes pretty close to about 4%of the portfolio's value (a little less for clients with more municipal bonds).  This is a pretty healthy and stable stream of income that is not dependent on whether the stock market goes up or down.  This cash flow serves as the foundation for retirement income distributions.
 
Eventually, when the stock market recovers, additional distributions can be made from those gains.  We of course would like to see better stock market returns sooner rather than later.  But given the current environment, if it takes longer for the economy and markets to recover, the cash flow serves as a good safety net.