Research Report: In Praise of Dividends

BY: Richard Croft
U.S. equities continued to rally through the first quarter of 2021 supported by strong consumer demand, plus outsized monetary and fiscal stimulus combined with ultra-low interest rates. The S&P 500 Index has been up for five consecutive months and at the end of June had gained 15.2% YTD.



U.S. equities continued to rally through the first quarter of 2021 supported by strong consumer demand, plus outsized monetary and fiscal stimulus combined with ultra-low interest rates. The S&P 500 Index has been up for five consecutive months and at the end of June had gained 15.2% YTD.

More dramatic increases came from smaller companies in the Russell Microcap (+29% as of the end of June) and Russell 2000 Indices (+17.6% YTD). The tech-weighted Nasdaq 100 (NDX) underperformed with a relatively modest gain of 13.3% as of the end of June. However, considering the Nasdaq’s outperformance in 2020, tech gains have been more than respectful.

To that point, tech stocks outperformed in June as investors shifted from value to growth. A transition that was amplified by the 3.9% outperformance during the second quarter of the Russell 1000 Growth index versus the Russell 1000 Value index. Still, year to date, the Russell 1000 Value returned 16.9% as of the end of June versus 13% for the Russell 1000 Growth Index.

The recent outperformance of growth aligns with a more hawkish tone coming from the U.S. Federal Reserve (the Fed) on the back of higher-than-expected inflation data. We anticipate that theme will play out for the remainder of the year (see Deterrence Theory).

The Energy sector (SPDR Energy ETF symbol: XLE) continues to surprise, taking the top position in the performance parade during the first half of the year (+45.6%). In fact, the positive returns in June marked the eight consecutive monthly gain for the S&P 500 Energy Index… the longest bull streak in its 25-year history. Going into the second half of this year, there are fears that oil prices are not justified by the fundamentals. Not surprising then, that early in the second half the sector has begun to come down to earth, with a significant sell-off on July 19th.

Also in YTD returns as of June 30, the S&P Financials sector held second place (+25.6%) followed by S&P REITs (+22.6%), both classic reopening trades. Keeping with the regulatory warnings that “past returns are not indicative of future performance,” these were the worst performing sectors in 2020.

The rate-sensitive S&P Financials index ended May with a streak of four consecutive monthly gains and was higher in six of the prior seven months.   However, the index declined 3% in June following a hawkish FOMC meeting, which meaningfully impacted the fixed income markets. The group stabilized late in the month, heading into the release of the Federal Reserve’s stress test results on June 24th, but have rolled over during July when interest rates declined as investors bought bonds as a flight-to-safety trade.

Longer term, net interest margins will continue to weigh on profit margins for U.S. money center banks. And this will not change until we see more hawkish action – instead of simply talk of action – from the Fed, which is not likely until 2023. To that point, Chairman Powell attempted to dampen the committee’s hawkish talk by noting before Congress that the recovery needs substantial future progress while stressing any future changes to the asset purchase program will be “orderly, methodical and transparent.”

That said, the Fed did raise the reserve requirement[1] for money center banks by 5bps in what was widely viewed as an effort to establish a higher floor under the effective the Fed funds rate. The bond market responded accordingly, with the short end rising sharply and the long end falling. In less than three sessions following the June FOMC meeting, the 30YR – 5YR U.S. Treasury spread declined by 27bps, wiping out all its gains since November.

Second Quarter Earnings Outlook:

Outsized investor expectations are the overriding concern as we enter second quarter earnings. Note that only 21% of companies in the S&P 500 have issued earnings per share guidance (EPS) in line with the five-year average of 20%. On the top end, more than 66% have issued positive EPS guidance versus the five-year average of 37% offering upward revisions to EPS.

There are risks of course. Investors are concerned about whether above trendline inflation numbers will be transitory? Will vaccination hesitancy and rising cases of the Delta variant lead to a fourth wave of infections in the fall? Market breadth is also a concern. Equity markets are at record highs supported by a few tech giants. That is not sustainable which probably led to the July 19th sell-off. The question is whether Monday’s sell-off is a one off to correct excesses, or the first glimpse of things to come.

The hawkish tone from the June FOMC minutes and recent interviews – notably from the Fed President Rob Kaplan during a Bloomberg interview – who opined that tapering should begin before the end of 2021, has impacted financial markets. But in the interest of full disclosure, Kaplan is not a voter this year, and only two members of the voting committee are “plotting” a rate hike before 2024. And considering that Chairman Powell has set a high bar before pulling back on stimulus, early tapering is not the most likely scenario.

Finally, we need to recognize that the third quarter is subject to seasonality effects. Since 1950 the S&P 500 has returned on average, a gain of 0.7% in Q3 well below the Q1 and Q2 averages of 2.2% and 2.1%, respectively. Q4 has averaged 4% gains historically, supporting the old adage that one should “sell in May and go away until Labor Day.”


There is a generic party line cited by the world’s largest central banks: Inflation is transitory! A lynchpin thesis that while open to interpretation, supports accommodative policies such as continued quantitative easing and near zero interest rates.

Strategically this is a first-rate line of attack. A full employment objective tied to one’s definition of transitory. Do we focus on year over year numbers, month over month, three or six month smoothing averages? What about the components within most consumer price indexes? Is the surge in used car prices and the cost of rental cars a blip caused by chip shortages which have hampered new car production?

All of which explains the breadth of inflation expectations amongst economists. It all hinges on what data source you choose to apply. Under that light, both hawks and doves can make compelling arguments supporting diametrically opposite conclusions.

The hawks argue that North America’s year over year inflation trajectory (3.6% in Canada and 5.4% in the US) is substantially above central bank targets, financial market forecasts and historical precedent.

Some economists argue that it may be worse than the published numbers suggest. Since the beginning of 2021, the Canadian inflation rate has been running at 6.4% (4.0% seasonally adjusted). Some economists have argued that inflation could run hot for years… certainly above the 2% year over year target of most central banks. A point on which both the U.S. Federal Reserve and the Bank of Canada agree.

There lies the rub that supports the brilliance of Central Bank policy. If the numbers come in higher than expected, then simply adjust the timeline that defines “transitory.” The risk, according to economists, is that Central Banks will reset their inflation boundaries to fit with the current state of affairs. Effectively overshooting inflation expectations which will require excessive measures to correct. After all, these are the same people who undershot inflation expectations prior to the emergence of the pandemic.

The flip side is equally compelling. The doves point to the muted reaction in the bond market. After an initial first quarter spike in ten year yields, rates have receded to an apathetic level approximating 1.3% on both sides of the border. They argue that markets are comforted with hypothesises that tout base year effects, supply-chain constraints and pent up consumer demand which should wane over time.

Coming full circle, we arrive at a point of view that will define how inflation unfolds in the years to come. Or more importantly, how consumer behavior will impact the inflation trajectory and ultimately set in motion either a carrot or sledge hammer control strategy that could have serious consequences for global economies and financial markets.

Consumer expectations will determine inflation’s reality. If consumers believe the transitory argument they will behave in a rational manner and inflation will move to the sidelines, and financial markets will focus on economic output and corporate profit margins. If consumers question that position because inflation remains above target for a prolonged period impacting wealth creation, it will cause them to re-think their view of wage-price parity. In that light, labor costs will rise, leading to higher prices as corporations pass through increased costs to protect profit margins. At that point, inflation becomes a self-fulfilling prophecy.

This is what influences Central Bank policy and underpins economist fear that bankers may be late to the game. To counteract that concern, Central bankers should adopt a policy of “deterrence theory.”

According to Wikipedia, “deterrence theory is based upon the concept which can be defined as the use of threats by one party to convince another party to refrain from initiating some course of action. The doctrine gained increased prominence as a military strategy during the Cold War with regard to the use of nuclear weapons and is related to but distinct from the concept of mutual assured destruction, which models the preventative nature of full-scale nuclear attack that would devastate both parties in a nuclear war. Deterrence is a strategy intended to dissuade an adversary from taking an action that has not yet started by means of threat of reprisal, or to prevent it from doing something that another state desires.”

In terms of economics, it comes down to perception. How will Central Banks react to labor demands for higher wages which could stretch their definition of transitory? The idea is to enlighten markets as to what tools Central Bankers would employ in order to quell situations that would prolong inflation expectations.

At this point Central Banks have relied on the quantitative easing mantra. The current view is to slowly reign in their accommodative stance to appease stimulative excesses as the economy recovers. Something that economists have been touting for some time and so far seems to be working.

The second step would be higher rates, which are expected in late 2022 or early 2023. The speed at which rates are pushed higher is again a matter of perception. Ideally, Central Banks will take the moral high ground and share their willingness to do whatever is necessary to suppress inflation expectations. Following the military adage that the “opposite of war is not peace… the opposite of war is strength.”


Do not underestimate the power of dividends. Blue chip stock bearing quarterly gifts that can be used for income or re-invested to buy additional shares. Too often overlooked by investors, often mis-understood in terms of its impact on wealth creation.

Dividends can impact investor behavior. Those who focus on growth of capital to the detriment of dividend growth end up seeing stocks as a giant casino rather than a wealth creator. Short term gains and losses become the norm long term positioning is ignored. Fear and greed drive investment decisions and cause investors to focus on short term moves.

In my mind, dividend re-investment programs are the backbone of wealth creation along the life cycle trajectory. Re-investment during the accumulation phase, rising cost yield when it comes time to take income from the portfolio.

The numbers add more substance to the story. Longer term, dividend re-investment attributes 60% or more of one’s performance. More with blue chip value plays, less so with dividend paying growth stocks.

Dividends play a major role in determining the value of companies. The idea being that at some point, management will return excess profits to shareholders. A growing company typically establishes a reasonable payout ratio (referred to as the dividend payout) and the dividends will increase along with corporate profits. The model takes into account the present value of a series of dividends and solves for a price that is reasonable based on investor expectations.

The so-called dividend growth model attempts to estimate a fair value for a stock and compare the output with the stock’s current value. If the model determines that a stock is under-valued it may be one that deserves a place in your portfolio. If the stock is over-valued, it might be better to wait for a more attractive entry point.

The dividend growth formula is as follows:

To put some wheat on this shaft, consider a specific example. In this case I will look at BCE Inc. which is currently trading at $61.25 and pays a $3.50 per share annual dividend. The dividend has been increased about 5% annually, so we will use that as our dividend growth input.

The required rate of return is more subjective. It reflects investor expectations as to what one would expect to earn – capital gains plus dividends – given a specific risk tolerance. It is similar to the measure corporations use to identify profitable projects and corporate investments. Another way to think about it is to measure a stock’s value against the weighted average cost of capital.

BCE Inc. is an interesting case study, because the shares are trading below where they were three years and only slightly above where they were five years ago. Not what one would look for when in search for capital appreciation. However, based on the investors objectives and risk tolerance, it may be exactly the right security.

There lies the rub! The investors’ required rate of return has an outsized influence when calculating the fair value for the stock. An investor with a 15% required rate of return would probably not choose BCE Inc. as it would be overvalued at today’s price.

On the other hand, a 10% required rate of return input would result in a $70 fair value for BCE Inc. suggesting that it is a reasonable buy at today’s price of $61.25. The accompany table looks at three different inputs for the required rate of return.

The bottom line is that dividends should play a role in every investment portfolio. Dividends go a long way to easing investor angst. Re-investment programs add value in terms of dollar cost averaging additional purchases. And rising dividends provide tax-advantaged income during your retirement years. And isn’t that what long term investing is all about?


A statistical concept with a real world application

It is difficult to make money trading options. If you doubt that statement, you probably haven’t been trading long enough.

Of course, recognizing that point of view is not cause to avoid a market altogether. The trick is to mitigate losses as much as possible, by utilizing option strategies that generally have higher than normal expected returns.

Before getting into this concept, it is important to understand there is a difference between expected return and actual return. To emphasize that point, we cite a long-held view that “markets can remain speculative longer than investors can remain solvent.”

In its purest form, expected return defines the outcome one would expect from a specific strategy over a large number of trials. We would expect, for example, that a typical coin flip would come up heads half the time. That doesn’t mean heads will come up half the time. In fact, there may be long stretches where either heads or tails could hit in succession. However, there are only two possible outcomes, so statistically, heads should ultimately hit half the time.

The same theory can be applied to stocks, although with a much wider range of possible outcomes. The volatility of the underlying stock and the profitability of the position are incorporated into an expected return calculation leading to a mathematical expectation of profit. Taking one trade at a time, things could turn out very differently. However, in the long run, the same strategy should generate a return that approximates its expected return.

Not that any of us will be around long enough to invest in the same position repeatedly over time. However, if our goal is to focus on a specific option strategy – buying calls, covered call writing, bull call spreads, calendar spreads etc. – then we need to seek out strategies with a positive expected return. And be ready to grin and bear it if you run into stretches where the actual return is significantly different than the expected return.

So how do we do this? To use a simple example, let’s calculate an expected return on a bull call spread. To begin, we assume the following prices exist:

XYZ trading at $52

XYZ 90 day call $50 call is at $4.75

XYZ 90 day $60 call is at $1.25.

The bull call spread involves purchasing the XYZ $50 call and selling the XYZ $60 call for a net debit of $3.50 ($4.75 less $1.25 = $3.50). The maximum potential profit for the XYZ bull call spread is $6.50 (assuming XYZ is above $60 at expiration) with a maximum loss of $3.50 (assuming XYZ is below $50 at expiration).

Our approach is to calculate the probability of XYZ being above or below specific price points. We

begin by entering the current value of XYZ ($52) and the implied volatility on the options. The net cost for the XYZ 50 – 60 call spread is $3.50 which means that the spread will be profitable if at expiration, XYZ is trading at any price between $53.50 and $60.

So what is the probability of XYZ being above say $54 at expiration? According to the model there is a 41.40% chance that XYZ will be at or above $54 at expiration. At a stock price of $54 the bull call spread generates 50 cents per share profit. Multiply 50 cents by the 41.40% probability and we get an expected profit of 21 cents per share.

The next step is to sum the expected profit at the $2.00 intervals between $50 and $60 per share. The end value is an expected profit of 76 cents per share. Finally, divide the expected profit (76 cents) by the total outlay $3.50 which equals 21.6%. That represents the annual potential return of the bull call spread strategy over long periods.

Recognizing, of course, this this is a statistical concept that does not necessarily apply in the real world. However, it can be very useful as a tool to compare various option strategies with different expiration dates.

Armed with the expected return calculation let’s apply some real world trading techniques to the XYZ example. We begin by looking at the aforementioned trade and fast forwarding 30 days and assume that XYZ is trading at $56 per share.

The XYZ $50 call would theoretically be worth $7.15 and the XYZ $60 call about $2.00. The spread would have widened to $5.15, generating a profit of $1.60. At this point the $1.60 profit is greater than the $0.76 total expected return.

Given this scenario you should think about exiting the position, or at least selling a portion of the spread. By taking profits, you are recognizing that expected return is a statistical concept derived from a large number of transactions. By seeking opportunities to take profits in specific positions, you are using real world trading to augment statistical certainties.

In that sense it is much like the poker game Texas Hold’em. Assuming you have enough capital to stay in the game long enough you will eventually get a flop where the statistical probability of winning is better than 50%. The trick is to throw away the losing hands before you run out of funds. Expected return is a useful concept but not infallible. If nothing else, it provides some comfort, knowing that every losing trade puts you one step closer to benefiting from the mathematics of expected return.

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Richard Croft, Chairman & CIO

[1] The Reserve Requirement is the percentage of capital a bank must maintain with the Fed, which impacts the percentage of the capital that can be used to offer consumer and commercial loans.

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