J. Andrew Concannon
Chief Investment Officer
Chief Investment Officer
Many investors are concerned with how to secure a reliable and growing stream of income. At Goelzer Investment Management, we believe the key to meeting your income needs, now and in the future, is making an income-oriented stock portfolio a core element of your investment strategy.
This may sound strange, for conventional wisdom dictates that you should invest in bonds for income and stocks for capital appreciation. Each day the financial media reinforces this view, with daily updates of stock prices, index levels, and interest rates with little or no mention of dividends. The bias in news coverage is understandable since dividend changes are less dramatic, while prices and interest rates can vary by the minute and create more exciting headlines.
During the bull market of the 1990s, two structural factors, both of which have since been reduced or eliminated, combined to create a focus on stock prices rather than dividends. First, the broad adoption of employee stock option programs during the 1990s provided those who participated, including senior-level corporate decision makers, with rewards for stock price increases while implicitly penalizing them for dividends. This factor has since diminished. Accounting rules now require the expensing of employee stock options, which has reduced their allure to issuing corporations.
Second, a combination of federal tax laws changes that took effect in 1997 lowered tax rates on capital gains relative to dividends.1 This led investors to favor price increases over dividends as the preferred form of stock returns. Tax law changes implemented in May 2003 leveled the playing field, however, by reducing the tax rate on qualifying dividends to 15%—the same as the tax rate on long-term capital gains. Further tax changes in 2013 maintained equal rates between capital gains and dividends, yet increased both rates to 20% for those in the highest income tax bracket.2
Despite conventional wisdom, history shows a diversified portfolio of stocks can provide a more reliable stream of income with greater protection from inflation than bonds and other fixed income securities. To illustrate this fact, we calculated the income from a $100 investment made January 1, 1975 in the Standard and Poor’s 500 Index (S&P 500) and the income available from a 3-month U.S. Treasury Bill (T-Bill) and a 5-year U.S. Treasury Note (T-Note). In our analysis, we did not reinvest dividends or interest payments, because we were interested in learning what occurred if you spent the income generated by your portfolio, much as a typical retiree might. We also did not adjust for inflation. The results of our research are displayed in Figure 1.
As the chart illustrates, the effect of investment choice on income levels is dramatic. At the end of 2014, 40 years after the initial investment, your income from the S&P 500 would be more than 11 times greater than it was in 1975. This is despite the S&P 500 experiencing the largest dividend decline in its 58-year history during 2009. What is shocking is that investors relying on T-Bills saw their incomes drop to zero in recent years, while T-Note income declined by more than 80% since the beginning of our study.
1 The Taxpayer Relief Act of 1997 reduced the maximum federal tax rate on long-term capital gains to 20% while maintaining the maximum rate of 39.6% on dividends.
2 The American Taxpayer Relief Act of 2012, which was enacted in January 2013, also introduced the Net Investment Income Tax for those in the highest income tax brackets. This amounts to 3.8% additional tax on capital gains, interest, dividends, and other investment income.
Throughout the 40 years, there were only three years when income from the S&P 500 decreased (2000, 2001, 2009), while the T-Bill and the T-Note had 24 and 22 years of decreases respectively. For an investor seeking a reliable and growing income, stocks have been significantly better than the highest quality bonds.
Although the S&P 500 has provided a more reliable income stream than both Treasury Bills and Notes, the lack of focus on dividends makes the index a sub-optimal portfolio for those seeking income. In fact, 79 of the 500 stocks in the index as of January 2015 paid no dividends.3 These non-dividend paying stocks do not help income-oriented investors achieve their goals. A well-defined income-oriented portfolio would be well served to exclude them. Further, changes in the stocks that constitute the S&P 500 have at times detracted from the dividend income provided to investors. For example, the number of non-dividend paying stocks within the index increased from 64 companies to 149 during the period of 1994 to 2004.4 These types of adverse income changes are not unique to the S&P 500.
Today, most professionally managed stock portfolios, mutual funds, and indices are constructed with little concern for dividends or changes in the level of dividend income provided to investors.
To capture the benefits of an income-oriented stock portfolio, an investor must adopt a more patient attitude towards the short-term fluctuations in equity prices. An income investor’s goal is reliable and rising income over many years, not fast profit from buying and selling stocks. Therefore, the investor should focus on the dividends paid by the stock portfolio along with the ability of the underlying companies to maintain and grow them. Price movements become more relevant as the need to sell a stock arises, but a constant eye on price leads to unwarranted elation or desperation. The focus on short-term price changes, when negative, can lead to unnecessary worry and poor selling decisions. Focusing on positive short-term price changes can also be detrimental, leading to overconfidence and poor purchasing decisions. Focusing on growing income and preserving capital, while allowing opportunity for long-term capital appreciation, should provide the consistency that income-oriented investors want.
3 Standard & Poor’s
4 Standard & Poor’s
Since 2005, Goelzer has managed an income-orientedstock portfolio designed to provide the benefits of a rising income stream coupled with the opportunity for capital appreciation. The portfolio also avoids the potential reduction in current income that results from the inclusion of non-dividend paying stocks. The Goelzer Rising Dividends Portfolio has been designed as a broadly diversified portfolio that includes well-researched companies from each of the major industry sectors. These companies deliver strong cash flow in excess of the amount needed to fund and grow their businesses. Through their history, they have used their excess cash to pay their shareholders a regular and growing dividend. From this group we purchase the most attractively priced stocks to construct the Goelzer Rising Dividends Portfolio. The result is a well-diversified portfolio with a significantly higher dividend yield than the overall market, made up of companies that our research suggests have strong balance sheets, growing cash flow, and a demonstrated commitment to paying dividends.
You do not need to sacrifice total return to achieve your income objective. In a study conducted by Dr. Jeremy J. Seigel, Professor of Finance at the Wharton School of the University of Pennsylvania, the stocks that made up the S&P 500 during the period of 1957 to 2003 were sorted into quintiles based upon their dividend yield. The study revealed that the stocks that made up the first quintile—i.e., those stocks with the highest dividend yields—produced an average annual rate of return of 14.27% during the period versus an annual rate of return of 11.18% for the S&P 500 as a whole. Meanwhile, the stocks that made up the fifth quintile—those with the lowest or no dividend yield—provided an annual rate of return of 9.50%.5 Another study conducted by Standard & Poor’s focused on creating a portfolio that included only those stocks within the Standard & Poor’s 500 Index that had increased their dividend for twenty-five consecutive years. The study concluded that over the fifteen year period this portfolio provided an annual rate of return of 13.45% versus 11.00% for the Standard & Poor’s 500 Index as a whole6.
We believe the Goelzer Rising Dividends Portfolio can be an important core component of your income-oriented investment plan. This does not, however, suggest the exclusion of bonds and other fixed-income securities as another key component of a properly diversified portfolio. Despite the income volatility bonds and other fixed-income securities have experienced, as illustrated above, the benefits of capital preservation and liquidity make them an important component of an income oriented portfolio. The inclusion of high-quality, short-to-intermediate maturity fixed-income securities can provide a source of liquidity during those times when stock prices have declined, thereby allowing you to leave your stock portfolio intact to participate in future price and dividend increases. At Goelzer we provide professional management of both taxable and tax-exempt bond and fixed income securities portfolios to complement your stock portfolio.
In addition, Goelzer has developed a non-traditional investment strategy to provide further diversification beyond stocks and bonds. This strategy includes investments with low to moderate correlation to stocks and bonds while avoiding the pitfalls of many nontraditional investments, namely high fees, lack of liquidity, poor transparency, and heightened risk of capital loss due to leverage.
We believe an income-focused stock portfolio with the added diversification of bonds and nontraditional investments is a proven strategy for securing and growing your income. By implementing this strategy, our experienced team of investment professionals can help you achieve your income goals.
5 Jeremy J. Siegel. The Future for Investors. 2005
6 Standard & Poor’s
Our team looks forward to helping you Dream, Invest, and Live.
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