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The Risk Reduction Characteristic Of Dividends

Three decades ago Sir John Templeton provided 22 rules for investment success to William Proctor who then shared these rules in his book, The Templeton Touch.  Templeton’s first rule was: “For all long-term investors, there is only one objective – maximum total real return after taxes.”  Around this same time, another famous investor, Warren Buffett, was developing his own investing rules.  Warren made it simple and clear.  When asked what his rules were, he replied, “Rule No. 1: Never Lose Money. Rule No. 2: Never Forget Rule No. 1.” This month we are going to share with you how we believe common stock dividends help in meeting both rules, but first I want to share some thoughts on a few major events that have taken place recently.

After the recent election of a new President, many of our fellow citizens reacted with their pocketbook, bidding up the average price of common stocks.  Other citizens gathered in the streets of major cities around the country to protest.  I have read so many articles telling us that the new President will save the country and set us on a road to greatness.  I have also read just as many articles as to why our new President will destroy everything that America stands for.  We all know that change will take place, but that change will take time.  I believe that whatever course our government takes, we as citizens of this country will create a better America.

I have shared my optimism of the future with you many times.  It has very little to do with elections and everything to do with our children and young adults, a few of whom will become our future leaders.  In the past few weeks, two other major events took place in the life of the Anderson family.  Both of my grandchildren celebrated a birthday, Carter on October 29th and Epiphany on November 9th.

Justin and Robyn’s son Carter turned 2 and celebrated with a party including a horse, a goat, a pig, a sheep, some bunnies and a few other barnyard critters.  Carter may or may not remember the occasion, but G-pa and G-ma, members of the G-Force, will for years to come.

Andrea and Paul’s daughter Epiphany spent her 11th birthday with some friends at home in Orlando.  It is one of the few times the G-Force was not there to celebrate with her.  But with the help of the telephone and UPS, we participated from afar.

Of course, as any proud grandparent I know that my children and grandchildren are special, and I assume that this is probably a universal belief for others in the same position.  This is my challenge to all who think that the future will not be wonderful.  Take a few moments out of your day and share that time with a child.  You will see excitement, love, pain, joy, respect, fear, greed, anger, sharing, and a desire to improve their own lives and everyone else’s around them.  Our country is one of the few in the world that gives each of us the freedom to be human and pursue happiness in our own way.  As long as that freedom is intact, we have every reason to believe that children will build on the positives and correct the problems of their parents.  Because of that, we should take the recent protests on college campuses and the streets as a positive, not as a negative as so many feel.  These young adults are taking a stance on what they believe is important.  One day they may find their way into politics or business, or pursue another purpose with passion as they reach adulthood.  Most will be parents and begin the cycle of life over again, leaving their legacy for future generations.  It’s going to be fun watching it all take place.

Now, onto the discussion of the two rules put forth by Sir John Templeton and Mr. Warren Buffett.  Sir John’s rule is to “maximize total return after taxes.”  Most of us will save money to meet some personal goals.  A fiduciary advisor will recommend an investment approach designed in a way that will give you a chance to meet those future needs.  The approach used will vary from advisor to advisor and is normally modified around a risk parameter that varies from conservative to aggressive.  Depending on your age, your current savings, your income, your tax bracket, your future dollar needs and any unique circumstances you may have, advisors will recommend a portfolio designed under these broad classifications: preservation of principal, income, growth and income, or maximum growth.  Seldom do you find an advisor that describes an objective as “maximum total real return after taxes,” yet all objectives are attempting to do just that – maximize the rate of return given your risk parameters and needs.

No matter why you invest, or what investment vehicle you choose to use, the equation for total return is the same:

original capital investment + cash flow from investment – investment cost and taxes

+ the gain or loss of capital upon sale or redemption – original capital investment

Here’s a simple example using a Certificate of Deposit, purchased by a taxable investor in a 15% tax bracket, paying 1% interest held until maturity one year later:

$100,000 (original capital)

+ $1000 interest (cash flow from investment)

– $150 (taxes)

+ $0.00 (gain or loss of original capital)

– $100,000 (original capital)

= $850.00 (total return)

To express that return as a percentage, just divide the total return by the original invested capital.  In our example:  $850.00 / $100,000 = 0.85%

The same formula can be used for a dividend paying common stock.  Let’s see what the results are for the same investor for $100,000 in a common stock purchased at $100 per share with a dividend payment of $2.00 per share annually and sold at $101.00 one year in the future:

$100,000 (original capital)

+ $2,000 (cash flow from investment)

– $1000 (cost of brokerage and management fee)

– $450 (taxes on dividend and share gain)

+ $1000.00 (gain from the sale of the shares)

­- $100,000 (original capital)

= $1,550.00 (total return)

As a percentage:  $1,550 / $100,000 = 1.55%

Granted, these examples are simple.  Because of their simplicity I can almost hear the words of the many sophisticated and experienced investors saying “but what if …?”  My purpose is just to make sure you recognize that total return requires an end point, which is the ultimate sale or redemption of every investment.  You can calculate it one investment at a time, or on your total portfolio including all of your investments.  Throughout Sir John Templeton’s life he used the simplicity of total return to amass great wealth for himself and thousands of others.  He believed it was so important that he wrote it down as his “rule number one” for all investors.

Warren Buffett’s very simple rule of “never lose money” shows us that he understands Sir John’s first rule.  Buffett has practiced a total return approach to investing for over six decades.  It is not a coincidence, since both Sir John and Warren were taught investing by Benjamin Graham.  They both understood that you must look at things the way they really are, and not how you hope or think they may be.

Today most investors look at dividends not for what they really are, but for what they think they are – income.  Dividends are universally considered income because they are paid in a check that can be spent without selling the underlying shares and because our congress decided by the stroke of a pen that they are taxable income.  As we will show, however, dividends are not income; they are a return of capital and as such they reduce the risk of common stocks that distribute these payments.

In order to better understand this we should review the concept of risk.  For most individuals, financial professionals, and academics, risk is market volatility only.  As we have mentioned many times, however, we look at risk as a permanent loss of capital.  This doesn’t mean we disregard market volatility.   Instead we embrace volatility, as it provides an opportunity to make an investment at a low price and sell at a high price.  As I noted in our earlier discussion on total return, an actual sell or redemption is required to determine actual returns.

The easiest way for me to show you that dividends are a return of capital is to look at an actual accounting of dividends through the published financial statement of a company that many of you, including myself, own shares of.  The company is Stryker Corporation, and the report we will review is the “Consolidated Statements of Shareholders’ Equity” as reported on Form 10-K for the year ending 2015.

Dividends

Dividends

As you can see, cash dividends are a direct deduction from shareholder equity.  This is the equity we own as investors and as such, a dividend payment reduces our capital investment dollar for dollar against our original investment.  The reports we send to you show the current market value of your holdings.  However, we monitor your holdings internally in light of recognizing risk as a permanent loss of capital.  When accounting for a dividend paying security, we reduce our capital investment by the amount of dividends received.  This allows us to easily calculate what our total return for each investment would be if we chose to sell the security at the current market price.

I will provide some actual details for a purchase of 100 shares of Stryker Corporation. We will use our original purchase date of July 10, 2006 for a taxable investor in the 15% tax bracket.  I do need to remind all of you that these details will only reflect the returns from this date for 100 shares.  Because we have bought shares at various prices and various times over the years, it is unlikely that any individual results will be the same or similar.

Original Capital Investment:  $4,326.00

Less Dividends Received:     ($841.00)

Capital at risk:                         $3,485.00

By recognizing dividends as a return of capital, our carrying cost of the investment in 100 shares of Stryker is reduced from $43.26 per share to $34.85.  In other words, we could sell Stryker shares at $34.85 without a permanent loss of capital.  It also goes a long way towards meeting Mr. Buffett’s rule number one: never lose money.

Just for fun, let’s look at our investment in Stryker Corporation on a total return basis if we had sold our holdings as of November 18. 2016.  If you recall our equation for Total Return is:

original capital investment + cash flow from investment – investment cost and taxes

+ the gain or loss of capital upon sale or redemption – original capital investment

Plugging in the details of Stryker Corporation:

Dividends

I do want to remind each of you that this example is hypothetical as we have not sold the shares of Stryker Corporation.  You should also take the time to read our disclosure statement below.

Until next time,

Kendall J. Anderson, CFA

Article by Anderson Griggs