Having one’s cake

Donald Coxe January 28 2002

Having one’s cake

Donald Coxe January 28 2002

Having one’s cake

Donald Coxe

Last week, we considered the sad plight of conventional savers (those who save through bank savings accounts, GICs and money-market funds). They are the collateral casualties in the central banks’ war against recession.

In previous campaigns against such slumps, the U.S. Federal Reserve and the Bank of Canada dropped interest rates, but the authorities were limited in how low they could go for fear of spurring inflation. Now that deflation is the primary challenge to the price system, there is almost no constraint on the monetary authorities. Result: Americans and Canadians have watched interest rates on their deposits and money-market funds fall to the two-per-cent range.

The pain of pitifully low interest income falls disproportionately on the elderly. They have long experience with savings accounts and GICs. According to The Wall Street Journal, more than 60 per cent of the money in U.S. certificates of deposit, similar to GICs, is held by persons over 60. They have watched their incomes fall by more than half in the past year.

What alternatives are out there for people suffering from short-term-rate shock? The most obvious is bonds. Indeed, long-term bonds are now better value relative to shortterm instruments than at almost any time since inflation switched from being a serious disease to being a mild nuisance. Investors get paid more than twice as much interest on long bonds as they earn from short-term treasury bills. Moreover, the holder of a long bond has locked in that interest rate until maturity, and is therefore hedged against further deflation.

Another choice is high-quality preferred stock. Canadians get a tax break we American residents can only envy: the dividend tax credit is a splendid inducement to buy high-yielding stocks. In the U.S., dividends are taxed at the same rate as interest income. That means that an Illinois resident in the top tax bracket pays 41-per-cent tax on a dividend, whereas an Ontario resident in the top bracket pays 31.3 per cent.

Common stocks are also worth a close look for incomeoriented investors now that short-term interest rates are roughly the same as the average dividend yield on the broad stock market indices. During the years when common stocks were being heavily promoted as surefire routes to riches, the drumbeaters routinely cited statistics showing the nineto 10-per-cent returns earned over the long term through investment in the Standard & Poor’s 500. What they didn’t tell the suckers was that, over the past 70 years, dividends reinvested have provided more than half those gaudy returns. Indeed, for substantial periods, such as from the market’s peak

With interest rates still falling, there are low-risk alternatives to savings accounts, money-market funds and GICs

in the 1960s to 1983, dividends were the only positive return the long-term investor earned.

Stocks have an advantage bonds and preferred shares lack: their payouts climb over the years. A portfolio of high-quality dividend-paying companies will deliver consistently rising income. Major banks and integrated oil companies are examples of firms that have splendid records for increasing dividends in line with earnings. Investors can acquire balanced portfolios of such low-risk, high-yield investments through mutual funds. In the U.S., they tend to be called equity income funds; in Canada, they are usually called dividend funds.

High-quality dividend-paying companies were not the kind of stocks that were driven to insane valuations during

_ the bubble era. When investors were

mesmerized by stories of stocks doubling every year, they were obviously contemptuous of companies offering 2.5to three-per-cent dividend yields with records of regular dividend increases. Result: shares of such companies never got wildly overpriced. They have outperformed the stock market since its peak, and they look like better value today than the broad market.

Those 20-per-cent-plus returns U.S. stocks delivered in the late 1990s now look like a historical aberration that is unlikely to be repeated for a long time. That’s what experts of the stature of Warren Buffett and Sir John Templeton say. They think investors should expect total returns (dividends and capital gain) of six to seven per cent from stocks in this decade.

If that’s all there is, then dividends will come back into popularity among American investors. They have discovered that gaudy capital gains from non-dividend-paying high flyers have shown a disconcerting tendency to turn into ghasdy capital losses. Through all the carnage of that long bear market, holders of quality dividend-paying shares continued to cash their dividend cheques, saw their income increase modesdy— but faster than the rate of infladon—and also saw their portfolios outperform the stock market. That’s the investment equivalent of having one’s cake and eating it too.

The case is even stronger for Canadians because of the tax code. With after-tax yields on many high-quality Canadian stocks now higher than returns from money-market funds, dividend funds look better—on a relative basis—than they have in a long time. And Alan Greenspan won’t drive down the dividends in his battle against recession. EH

Donald Coxe is chairman of Harris Investment Management in Chicago and Toronto-basedJones Heward Investments.