Past performance and dividend growth

“Past performance is not a guarantee of future results” is a refrain seen regularly in mutual fund marketing. But what if past performance could actually be damaging to future results? One of the psychological tricks our minds play in investing is to extrapolate the recent past in to our decision making process. If a particular asset (stocks, bonds, real estate, etc.) has been strong for a period of time, investors are more likely to view that asset favorably, thus further bidding up prices.

It is important to remember that Economics is a social science. The supply and demand for stocks is what moves markets. Too much demand with too few sellers will move markets higher and vice versa. However the source of demand (or lack thereof) is often driven by investor perceptions about future returns, which is in part driven by recent past performance.

In extreme cases this creates a bubble as more and more investors are drawn in to the asset by its strong returns. Eventually prices become so detached from economic reality that the “bubble bursts” and prices crash. True bubbles are rare, since they typically require participation in some manner by the majority of market participants (i.e. when the bubble bursts there is no one left to buy). More commonly, investors find themselves underperforming their own expectations. While not as dramatic as a bursting bubble, this outcome can create a negative feedback loop whereby the investor buys high after recent strong performance, becomes inpatient after the investment underperforms, sells low, then looks for another “strong performer” to invest in.

Unexpected timing of returns

One of our core principles is “the price you pay determines your return”. The lower the price paid the higher the expected return, all else being equal. For bond investors, this is fairly straightforward since they receive interest payments whose timing is known, then their principal is paid back at a predefined maturity date. The only real chance for returns to deviate from the investor’s expected return is if 1) the bond defaults or 2) the investor sells the bond prior to maturity. Both of these risks can generally be mitigated via credit analysis and portfolio structure.

In the case of stock investing, the timing of the return is mostly unknowable. We often equate this to Pareto’s 80/20 rule. In the case of investing, 80 percent of the returns come 20 percent of the time. For this reason we like focusing on stocks that have two sources of return: 1) capital appreciation potential — which is erratic and unknowable, and 2) dividends – which tend to be much more stable over time.

Dividend increases are important

Apple Inc. (AAPL) is a relatively new dividend payer.

While the price return has been great it has come in fits and starts with long periods of sideways or negative returns, followed by bursts on the upside. Trying to time these gyrations effectively based on news, charting analysis or any other method is futile. The good news is, it isn’t necessary. If you look at a price and dividend chart of Apple, you’ll see that dividends paid have a nice orderly stair step which represent annual increases in the dividend. Each of these steps represents a pay raise to the shareholder via a direct increase in cash flow to their account.

Regular increasing dividends also have the added benefit of buying the investor time during periods of low or sideways price returns.

Many market pundits are saying that the US stock market is overvalued and due for a correction.

When one compares valuation measure to those of four years ago, it certainly can be argued that the market is fully-priced and maybe overvalued. However this does not mean a crash is pending! Time will tell if corporate profits and the economy will benefit from the reforms being talked about in Washington.

While investors wait, we continue to view dividend holdings as a desirable feature in our domestic stock portfolios. Dividend cash flows to a portfolio during sideways or down periods is very attractive. Individual stocks with growing dividends or the S&P Dividend ETF can be an important aspect when wanting to mitigate valuation risk. Jim Rhodes is a Chartered Financial Analyst and Executive Director at American Money Management (AMM). His offices are at 300 S. Imperial #12, El Centro. For an appointment call 760-6046310. Michael Moore is Chief Investment Officer at American Money Management.