Sunday, March 6

Week 244 - Will You Profit From Owning Stocks?

Situation: People used to say “yes” whenever asked that question. Now, the answer is more problematic. Let’s assume that “the past is prologue” and calculate how much you’d profit from the “best-case scenario.” If on August 9, 1999, you purchased 25 shares of the lowest cost S&P 500 Index fund online, the Vanguard 500 Index Fund (VFINX), for $120.07/Sh ($3001.75), and spent dividends along the way, then sold your 25 shares 16 yrs later on 8/7/2015 for $192.03/Sh ($4800.75), you would have averaged a 3.0%/yr price return. According to the Buyupside website, your total return averaged 4.9%/yr, which included price appreciation of 3.0%/yr, plus an average dividend yield of 1.9%/yr. 

Your initial $3001.75 investment has grown to $6400.00. Of that growth, $1599.25 is due to dividends and $4800.75 is due to capital appreciation, as noted above. But the annual 15% tax on dividends has reduced the value of those payouts to $1359.36, and the 20% capital gains tax has reduced your gain from selling 25 shares to $4440.95. That leaves you with $5800.31, for an after-tax return of 4.2%/yr. Now let’s account for the 2.2%/yr average rate of inflation over those 16 years, which brings your gain down to 2.0%/yr. Transaction costs of 0.2%/yr are folded into the share price, so you’re left with an average profit from your initial investment of 2.0%/yr net of costs. So far, so good. But consider this: The average retail investor spends 2.2%/yr on transaction costs vs. the 0.2%/yr that you’ve spent. Your entire 2.0%/yr profit came from choosing an investment run by computers. 

There was no one at Vanguard Group to call on the phone when the S&P 500 Index crashed twice. You flew solo. That’s the best-case scenario, disintermediation. But no one you’ll ever meet invests that way. Why? Because the ups and downs of the S&P 500 Index cannot be looked upon with equanimity by anyone other than a professional trader. Another reason is human nature. People can’t seem to make a plain vanilla investment that all available evidence says is the best investment on the planet. Instead, they’ll entertain themselves by trying to beat the S&P 500 Index. 

Then there’s the 4% rule to consider. That’s the maximum amount you can sell each year from a balanced retirement portfolio (50% bond, 50% stock), after adding a percentage to account for recent inflation, without running the risk that you’ll out-live your money. VFINX is 100% large-capitalization stocks and pays only a 2% dividend. You’d have to sell some shares every year to collect the other 2%. The market might be down a lot when you sell those shares, so it might be preferable to find a way to live off dividends and preserve your principal. 

Our benchmarks for retirement savings are the Vanguard Balanced Index Fund and the Vanguard Wellesley Income Fund at Lines 27 & 28 in this week’s Table. Both have payouts less than 3%/yr, and payouts over the past 16 yrs have fallen because interest rates have fallen and those funds are hedged with bonds. The only way to reach 4%/yr in dividend payouts is to own stock in companies that grow dividends faster than inflation. 

Mission: Find a source of retirement income that reliably grows at least twice as fast as inflation and gives you a chance to live off dividends without eroding principal. That means you’re looking to own stock in companies that S&P calls Dividend Aristocrats (because they’ve increased their dividend annually for at least the past 25 yrs). 

Execution: Which of the 51 Dividend Aristocrats meet our quality criteria for inclusion in a retirement portfolio, and have grown their dividend more than three times as fast as inflation over the past 16 yrs, i.e., at least 6.0%/yr? And which of those have revenues high enough to be in the 2015 Barron’s 500 List, and S&P ratings of BBB+ or better for bonds and B+/M or better for stocks. Of the 30 stocks that emerge from that screen, which fluctuate in price more than the S&P 500 Index? During the most recent market correction (4/1/11 through 9/30/11), 8 were more volatile so we’ve excluded those. Four others have a dividend yield that is lower than VFINX, so we’ve excluded those. That leaves 18 companies that meet all criteria; those grew their dividends more than 11%/yr over the past 16 yrs (see Column H in the Table).

Bottom Line: Yes, you can profit from owning shares in the lowest-cost S&P 500 Index fund (VFINX) over two market cycles. But you can do better by owning a basket of stocks issued by companies that have increased their dividend annually for at least the past 25 yrs. These are companies that S&P calls Dividend Aristocrats. We’ve found 18 such companies that meet our quality criteria, and all but 2 (Coca-Cola and Wal-Mart Stores) have outperformed the lowest-cost S&P 500 Index fund (VFINX) over the past 23 yrs. As a group, they have a dividend yield of ~3.0% and grew their dividends 5 times faster than inflation. They all meet the 4% rule for annual withdrawals from a retirement fund. In other words, dividend growth is so rapid that you’re getting at least a 4% dividend yield on your original investment within a few years, and dividend yield is likely to grow more than twice as fast as inflation. 

Risk Rating: 4

Full Disclosure: I dollar-average monthly into ABT and XOM (neither have transaction costs at, and also own shares of MCD, JNJ, KO, PEP, and WMT.

NOTE: Metrics in the Table are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. VBINX, our key benchmark. Total Returns in Column C of the Table date to 9/28/1992 because that marks the onset of trading in VBINX.

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