FAJ Mar Apr 2003 Dividends and The Three Dwarfs

FAJ MarchApril 03.
book Page 4 Thursday, March 20, 2003 3:08 PM
EDITOR’S CORNER
Robert D. Arnott
Editor
Dividends and the Three Dwarfs

Do dividends matter? You bet. Unless corporate suffered no inflation but did partici-
managers can provide sharply higher real growth pate in the rise of equity valuation lev-
in earnings, dividends are the main source of the els. This investor would have seen the
real return we expect from stocks. Figure 1 contains $100 grow to $308 because dividend
the familiar graph of the growth of assets invested yields fell to 32 percent of their 1802
in U.S. stocks for the past 200 years. If no dividends levels, so price-to-dividend ratios rose
were spent, if no taxes were taken out, and if market to three times their 1802 levels. Price-
returns were earned without fees or expenses, $100 to-earnings ratios experienced a simi-
in 1802 would have grown to $766 million by the lar increase.
end of 2000, then cratered all the way down to $459 0.8% = Return from real growth in dividends.
million by the end of 2002. Still, $459 million isn’t Suppose an investor gave away all his
bad from a starting point of $100. Indeed, that sort or her income, had no inflation, and
of return is enough to make it worthwhile to stick did not participate in rising valuation
around for 200 years to enjoy the proceeds. levels but did benefit from the real
Figure 1 also breaks the 200-year total return growth in dividends. This investor
on equities, 7.9 percent, into its constituent parts: would have had $456 by August 2002.
5.0% = Return from dividends. Suppose an After 200 years. That dollar figure is
investor received only the dividend way less than most people would have
yield—no price appreciation, no expected.
growth in dividends, no inflation The importance of dividends for providing wealth
contributing to price and dividend to investors is self-evident. Dividends not only
growth. Then, at the end of the period, dwarf inflation, growth, and changing valuation
the $100 would be worth $1.8 mil- levels individually, but they also dwarf the com-
lion—still a pretty good return. bined importance of inflation, growth, and chang-
1.4% = Return from inflation. Suppose an in- ing valuation levels. This result is wildly at odds
vestor received only the inflation re- with conventional wisdom, which suggests that,
turn—no income, no growth in while the return from bonds is wholly dependent
income, no rising valuation multiples. on income, stocks provide growth first and income
The $100 would have grown to second. It is startling to realize that dividend
$1,804—not a terrible return, but then growth has averaged less than 1 percent above
again (by definition, because we’re inflation during the past 200-year period. And it is
looking at inflation here), that $1,804 shocking that real per-share dividend and earnings
would buy only what $100 would have growth on the S&P 500 Index since 1965 has been
bought in 1802. zero.
0.6% = Return from falling yields and rising val- What does this information mean for us today?
uation levels. Suppose an investor re- First, the yield today is 1.8 percent as opposed to
ceived no income, saw no growth, and the historical 5.0 percent. Second, assuming further
The Editor's Corner is a regular feature of the Financial Analysts Journal.

It reflects the views of Robert D. Arnott and does not represent the official views of the FAJ or AIMR.
4 ©2003, AIMR®
FAJ MarchApril 03.book Page 6 Thursday, March 20, 2003 3:08 PM
Financial Analysts Journal
Figure 1. Dividends and the Three Dwarfs: Growth of $100 Invested in U.S.
Equities, 1802–2002
U.S. Dollars
1,000,000,000
100,000,000
10,000,000
1,000,000
100,000
10,000
1,000
100
10
1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000
Equity Total Return Inflation
Dividends Valuation Expansion
Real Dividend Growth
Sources: Based on Schwert (1990) data for 1801–1870, a blend of Schwert and Siegel (2002) data for 1871–
1925, and S&P 500 Index data since 1926.
increases in valuation levels is dangerous. Third, tions can give us the real returns we want from
we can’t know what inflation (or deflation) has in equities.
store for us. Fourth, to get more than a 2.6 percent Stock buybacks can boost the per-share growth
real return from stocks, we need faster growth than rate, and entrepreneurial innovation and produc-
the 0.8 percent observed historically. So, when the tivity gains can boost this growth. But how far?
widely disparaged dividend provides one-third None of these supposed avenues to repeat the past
the return it once did and when the dividend has real returns from stocks is plausible. We can repeat
historically been the dominant source of equity those past returns only from a starting point of past
market real returns, only heroic growth assump- valuation levels. Dividends, unequivocally, matter.
References
Schwert, G. William. 1990. “Indexes of United States Stock Prices Siegel, Jeremy J. 2002. Stocks for the Long Run. 3rd ed. New York:
from 1802 to 1987.” Journal of Business, vol. 63, no. 3 (July):399–426. McGraw Hill.
6 ©2003, AIMR®

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FAJ MarchApril 03.

book Page 4 Thursday, March 20, 2003 3:08 PM

Dividends and the Three Dwarfs

The Editor's Corner is a regular feature of the Financial Analysts Journal.

Financial Analysts Journal

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