Two Tools Reps Can Really Use

The approximately 14,000 independent reps, B/Ds, and others using DST Fanmail are not being disrupted by Vision. Fanmail is a utility for downloading over the Web account data from DST. The downloaded data can be imported in a viewer or portfolio management system. Centerpiece, dbCAMS, E-Z Data, National Datamax, and other programs allow you to run reports using Fanmail data and see aggregated statements. Advisors using the software to view Fanmail data and create aggregated statements and who are not creating performance reports may find Vision is easier to use and cheaper.

Here are some predictions and observations. Stephen Wershing, COO at Wall Street Financial Group, a Rochester, New York, independent B/D with about 250 reps, says DST Vision could become a serious competitor to StatementOne, which has been adopted by several large independent B/Ds seeking to provide reps with a private-label system of account consolidation.

In three years, my guess is that AdvisorCentral and DST Vision will be providing performance measurement, and they may even aggregate client data on assets not managed by a rep and held at other brokerages.

Also, I’ll predict DST and Advisor- Central will be forced to rethink their strategy of giving their product away for free. StatementOne is not free. In a few years, assuming mutual funds can get advisors hooked on DST Vision and AdvisorCentral and that an agreement can be reached to allow all of the fund companies to be available on both systems, the fund companies may decide they no longer need to foot the bill for the service, and DST and AdvisorCentral may be forced to begin charging.

Arnott Asks, Why Not?

Rob Arnott questions some basic assumptions on equity performance and dividends

Rob Arnott, CEO of First Quadrant, an institutional money management firm in Pasadena, California, is striking blows to conventional wisdom about finance. The author of more than 50 articles in professional journals, three of them required reading for the Chartered Financial Analyst program, Arnott has won the Association for Investment Management and Research Graham & Dodd Scroll four times. His latest writings show that he is not just a great financial analyst, but he also can change the way we think about the most basic principles of investing.

Late last year, Arnott passed on to me a working paper he co-authored with Peter L. Bernstein, consulting editor at The Journal of Portfolio Management, about the equity risk premium. It will be published in The Financial Analysts Journal’s March-April issue. It makes a strong argument for lower expected returns, and challenges conventional wisdom in saying that the risk premium is nowhere near the 5% of the past and is indeed near zero today.

A recent working paper from Arnott, “Does Dividend Policy Foretell Earnings Growth?” co-authored with Clifford S. Asness of AQR Capital Management, is even more revolutionary. Arnott says that everyone who has been arguing that dividends have become irrelevant are wrong. Contrary to many analysts who have argued that dividends are an inefficient way to pass on shareholder value and therefore should be at their current low rate, Arnott says dividend policy does matter and that it is a good indicator of future earnings growth. While many investors have come to think of retained earnings as a good use of investor capital, Arnott shows it is not. I spoke with Arnott recently.

Explain the essence of your two most recent articles. The equity risk premium article suggests that the notion of a 5% risk premium has never really been normal. It’s been earned in the last 75 years mostly because market values have soared. If you strip that out of the historical results, the normal risk premium appears to be closer to half that, around 2.5%. A problem today is that dividend yield is very low, at 1.4%. If you want a 10% return out of stocks with a 1.4% dividend yield, you’d need at least 8.5% of return from growth. That would imply dividend and earnings growth far faster than is sustainable in the economy and is simply unrealistic. Another complication is that throughout the past 130 years of earnings history, whenever payout ratios are high, companies are careful about how they handle reinvestment, and subsequent earnings growth is terrific. But when payout ratios get low and companies retain lots of earnings, the reinvestment gets sloppy and subsequent earnings growth becomes atrocious. It’s drastically at odds with conventional thinking and finance theory.

What is the conventional wisdom on dividend payouts? Companies have a choice between paying out earnings as dividends so that you can reinvest where you choose, or retaining the earnings so that they can reinvest in projects they think are better than what might be at your disposal. The conventional wisdom is that if a company retains more earnings, it does it for sensible projects and its earnings growth should be improved. But the historical evidence [shows that to be] flat-out wrong.

Miller and Modigliani published a paper in 1960 that earned them a Nobel Prize. They said dividend policy doesn’t matter. If you have a portfolio of stocks and they pay the earnings to you in dividends, you will reinvest those dividends in a market-like portfolio of reinvestment opportunities. If they retain their earnings for internal reinvestment, then across a portfolio they will earn a market-like return on those assets. That assertion has framed our view today of the dividend payout policy of corporations. Miller and Modigliani’s theory holds true if investors are rational and there are no tax considerations. But we know that you are subject to double taxation if you receive dividends. So the tax-efficient solution is a stock buyback and retained earnings, if the retained earnings are reinvested at no less than a market rate of return. But history demonstrates that across the market as a whole, retained earnings do not produce a market return.

A number of articles have skirted around the issue in various ways. I’m not aware of any that have focused as directly on the issue as we do. It’s an important finding. It suggests that the conventional view that retained earnings are a good thing is simply wrong. To be sure, you have got to have some retained earnings. But a policy of retaining all the earnings only works if you have internal reinvestment opportunities that are real and that won’t be written off in three years. But history shows that when the market as a whole has a high payout ratio, and very little earnings are retained, earnings growth is terrific. And, when the market as a whole has low payout ratios, with most of the earnings retained, subsequent earnings growth is terrible.

Why do companies retain earnings? Management reinvests most of the earnings in whatever initiatives they think are best. And comparatively little thought is given to the question of, “Can we do a better job of investing this money than if we distribute it to shareholders?” I’m not a cynic who would say management consciously sits back to build empires at the expense of shareholders. I don’t think that happens. But comparatively little thought goes into whether earnings can produce more growth for shareholders if earnings are retained or if they’re distributed to shareholders to be reinvested. It’s an issue that falls off the radar screen for most boards of companies. Basically, I think management owes it to shareholders to distribute the earnings in the form of stock buybacks, unless they are highly confident that their internal reinvestment opportunities are more compelling than anything their shareholders are likely to find available in the marketplace. And that’s a high hurdle.

We all know that dividends these days are low because it is inefficient, taxwise, to use dividends to distribute returns to investors. Why should anyone care about dividend policy? You should care about dividend policy only to the extent that retained earnings are being reinvested wisely. If retained earnings are being reinvested wisely, whatever you don’t get in dividends you will get in growth. But history tells us that simply doesn’t happen.

Explain the historical data set you used to study whether dividend policy matters. We used market data on S&P 500 earnings and dividends going back to 1926. And we used earlier data from [Robert] Shiller going back to 1871, which would be data similar to the S&P 500. And we asked a simple question: When companies retain most of their earnings, does the shareholder benefit from improved growth? The short answer is, they do not.

Aren’t earnings and return data going back to 1871 irrelevant? You could say it’s irrelevant. [Prior to the 1930s,] we had unregulated markets, a much more turbulent economy, and stock market booms and crashes came on a more regular basis. But it is still very interesting to see that the same behavior we find before modern markets applies during modern markets. The last 20 years are very interesting because over this period, stock buybacks have become a much more popular way to pay dividends, and that is something I endorse. It’s a great way to pay a tax-efficient dividend. Also, over the past 20 years, you have more people pointing out the perils of double taxation in order to support retaining earnings to fund future growth. So we broke out the last 20 years as a separate time period and found more or less the same result that we found in the prior 110 years. The world has not changed as much as people think. An interesting thing about stock buybacks is that the companies doing stock buybacks are also the ones paying dividends. There is a corporate culture that supports the idea that the shareholder should get rewarded. Companies that don’t pay dividends for the most part don’t buy back their stock, either. And many that do buybacks do so in order to reissue stock for stock options for management. So buybacks are a tax-efficient way to get wealth back in the hands of investors. Internal reinvestment should also be a tax-advantaged way to improve shareholder wealth, but it doesn’t turn out that way.

Please explain your data in the table on the previous page. How do you show that the conventional wisdom is flawed? We looked at the past 50 years, and payout ratios were broken into four quartiles, from the lowest to the highest payout ratios, and we then looked at the subsequent 10 years of earnings growth. We found that when payout ratios are very high, meaning that retained earnings are very low, on average the earnings growth over the next 10 years was 3.2% faster than inflation. When payout ratios are very low, the next 10 years of earnings growth is actually 70 basis points lower than inflation, which of course means that there is negative earnings growth. So when companies retain most of their earnings, their earnings growth subsequently falls off a cliff. Statistically, it’s about a 77% correlation, which is highly significant.

You went out of your way in this study to show that it’s not different this time, that the last 50 years are not all that different from what historically has occurred. Specifically what you did was break out the last 50 years and then do a separate study from 1871 to 1949. Explain what you found. We did that because we wanted to test whether the last 50 years were somehow different from longer-term history. What we found was that the last 50 years were not different, that this is a very strong relationship that has prevailed over the last 130 years. Stock buybacks, double taxation, regulated markets, markets that are no longer ostensibly prone to boom and bust cycles of the 19th and early 20th century–for all those reasons people tend to look at the last 50 or even the last 20 years as different from the past. To address those concerns, we simply tested whether the results in the recent past are different from the long-term past. They’re not, meaning that those who argue that things are different this time are probably wrong. They cannot point to anything in recent history that would support their view.

You also examined whether dividend payout ratio is a better indicator of earnings growth than price/earnings ratio. Please explain what you found. Dividend payout ratios are in a sense a measure of management’s confidence in future earnings growth. If you have low payouts, it arguably might suggest that management doesn’t have a great deal of confidence that earnings will be maintained at current levels. Earnings yield (earnings-to-price ratio) tells us whether the investment community has confidence in future earnings growth. When P/Es are high, the market is tacitly saying, “We think earnings will grow rapidly.” When P/E ratios are low, the market is tacitly saying, “We are not sure these earnings will grow.” So we wanted to test whether earnings yield might be a better predictor for earnings growth than payout ratios. We found that earnings yield is a poor predictor relative to payout ratio. Payout ratios are dramatically stronger over all time spans we tested.

Your study challenges some of the underpinnings of the recent Roger Ibbotson and Peng Chen work. Please explain why. They suggest that when P/E ratios are high, the market is expecting higher earnings growth, and that the market is right. They suggest that whatever earnings are not paid out in dividends will come back to the investor in the form of increased growth. We’re suggesting that both of those hypotheses are theoretically sound, but that history does not support them. We find that retained earnings do not improve future earnings growth and in fact degrade future earnings growth.

Your ideas seem to have big consequences for financial plans, pension plans, and financial planners. The average pension plan is assuming it will earn a 9.3% return. If in fact they earn far less, that represents a shortfall and more contributions will be needed and that means corporate earnings are lower than they seem. You’ve got about $2 trillion in defined benefit assets and the average fund assumes a 9.3% return now. If they only earn a 6% return, that’s a $66 billion difference per year compounded. So if the returns on assets are going to be in the 6% range, it means corporate earnings in the U.S. are overstated by about $66 billion and pension contributions are too light by about $66 billion per year.

Ten years ago, the average allocation by pension funds was about 75% in fixed return assets and 25% in stocks. Today, that’s flipped to 75% in stocks. Financial planners need to be very careful in automatically assuming that stocks will have superior returns over bonds and other investments. I think there’s a real risk with many investors in extrapolating the past. Stocks have been wonderful but that doesn’t mean they will continue to be wonderful. Stocks have gone from very cheap 20 years ago to very expensive today, using P/E, P/B, dividend yield, and other measures to judge valuation. From a planner’s perspective, it makes sense to counsel broad diversification. And a portfolio that’s invested in five categories of stocks–but all stocks–isn’t diversified. I think stocks are priced at levels that will produce returns similar to bonds. If bonds are yielding 6%, then it’s a safe assumption that stocks will do about the same.