Dividends: the case for income-oriented investors

Transcription

1 INTERNATIONAL/ GLOBAL EQUITY FUNDS GLOBAL EQUITIES WHITE PAPER AUGUST 2012 Dividends: the case for income-oriented investors Today s low fixed-income yields and expectations of prolonged slower growth in developed countries could lead to the re-emergence of dividend-paying stocks as an important component of investors portfolios. This white paper will explore three core concepts: the intrinsic value of dividend-investing strategies; alternative sources of yield in a low-interestrate environment; and dividends as a potential inflation hedge. After 30 years of perpetually declining interest rates, we believe that the tailwind for fixed-income investments is waning. Given today s demographics older, more conservative investors seeking income we believe income alternatives such as dividend-paying stocks could come into focus. Thus, in this white paper, we build the case for dividend-paying stocks. In section 1, we first review the value of a dividend-investing strategy: We highlight the impact dividends have had on total equity returns in various market environments as well as the relatively attractive risk characteristics of dividend-paying stocks; we examine the opportunity global dividend-paying stocks present to enhance portfolios; and we look at the impact of inflation and deflation on equities and the implications of utilizing a dividend strategy. In section 2, we examine several potential buy signals for equities, including a turnaround in fund flow imbalances and attractive yields relative to bonds. Contributors»» Stephen Noll, CFA, senior product specialist»» David Wertheim, head of DWS U.S. product specialist team»» Kevin Walsh, product specialist»» Dr. Oliver Plein, head of DWS European product specialists (equities)»» Andreas Korsa, European product specialist (equities) OUTLINE 1 The value of a dividend-investing strategy (page 2) 1.1 Dividends: the basics (page 2) 1.2 Dividends: a compelling source of potential return for equities (page 3) 1.3 Dividends: attractive risk characteristics (page 5) 1.4 Dividends: a global opportunity (page 7) 1.5 Sustainability of dividends (page 9) 1.6 Dividends as inflation or deflation hedge? (page 10) 2 Potential buy signals for equities in times of low bond yields (page 12) 2.1 Slow growth in developed markets increases attractiveness of dividends (page 12) 2.2 Potential buy signal: flows (page 14) 2.3 Potential buy signal: equity yields vs. government bond yields (page 15) 2.4 Potential buy signal: equity yields vs. corporate bond yields (page 16) 3 Conclusion (page 18) Investment products: No bank guarantee I Not FDIC insured I May lose value

2 1 I The value of a dividend strategy 1.1. DIVIDENDS: THE BASICS Near-term changes in asset prices are difficult to predict, but in this section, we consider the potential long-term benefits of harnessing income by investing in equities. By investing in income-generating equities, investors can participate in real income growth coupled with long-term capital growth. There are a number of reasons to consider companies that pay regular dividends. First, dividends return cash to shareholders, thereby creating confidence in economic success. Second, scarce resources (such as earnings after dividends) tend to be used more efficiently (as we explain in more detail in section 1.5). Third, a consistent dividend policy sends a strong message about continuity and reliability. Fourth, dividends, unlike earnings, are rarely cut, and may offer a cushion on the downside. Do dividends matter? Yes, but investing in equities should not be a gamble, and therefore investment decisions need to be proven by evidence. According to T.H. Huxley, The deepest sin against the human mind is to believe things without evidence. Therefore it is vital to set forth a number of studies, largely from academia, analyzing the importance of dividends and the association of high dividend yields with attractive investment returns over long periods. Much has been written about dividends, and what is contained herein is not meant to be an exhaustive analysis, but rather a sampling of persuasive arguments examining the impact of dividends on total investment returns. We hope it will provide added insight and confidence, as it did to us long ago, in pursuing a yield-oriented investment strategy. One of the most important things corporations must determine is how best to utilize the free cash flow generated from their operations. Typically, they have four options: reinvesting in their business to generate future growth, repurchasing shares of their stock, paying shareholders via cash dividends or leaving the cash on their balance sheets. Which choice a company makes reflects how management views the company s growth prospects, which in turn depends on what industry the company is in, what stage of its lifecycle the company is in and where the economy is within the business cycle. Typically, young companies that are in the early stages of their growth path need to retain their earnings in order to reinvest in their business, and therefore tend to not pay a dividend. In contrast, mature companies that have achieved more stable cash flows may repurchase shares or pay dividends. Dividends are often associated with quality companies because paying regular dividends reflects the company s confidence that it will be able to support payments via expected earnings. Similarly, dividend policies tend to differ by industry. Companies in capital-intensive industries, such as airlines, engineering and construction, need to reinvest their cash flow in order to support their business models; they thus will rarely pay a dividend. Companies in industries with stable cash flows, such as telecommunications and utilities, typically pay high dividends. Decisions to pay cash as dividends will also be impacted by macroeconomic factors. During economic contractions, cash flows of many cyclical companies are greatly diminished, increasing these companies need to preserve capital in order to ensure their future existence. During the most recent recession, the availability of credit dried up, resulting in many companies hoarding cash. However, in the current economic environment, companies hold a record high amount of their net worth in cash. Potential uses are illustrated in Figure 1. FIGURE 1: POSSIBLE USES OF BALANCE-SHEET CASH Dividends Share purchases Cash on the balance sheet Wage increases Mergers and acquisitions Capital expenditures 2» Dividends: the case for income-oriented investors

3 1.2. DIVIDENDS: A COMPELLING SOURCE OF POTENTIAL RETURN FOR EQUITIES One of the most notable statistics about dividends is the impact they have on long-term equity returns. The reinvestment of dividends has accounted for 43.5% of the total returns of the S&P 500 Index since Over this period, the average annual price appreciation of the S&P 500 Index was 5.56%. The return of the index with dividends, in contrast, was 9.84%. Moreover, by dissecting the returns of the S&P 500 Index by decade, we can see that dividends helped cushion the equity price declines of the 1930s and 2000s and also helped equity returns during periods of moderate equity price appreciation a scenario that may be more realistic than the strong price appreciation experienced in the 1980s and 1990s. (See Figure 2.) FIGURE 2: AVERAGE ANNUAL RETURNS OF THE S&P 500 INDEX (1/4/26 6/30/12) Total returns Since % 5.56% 9.84% 2000s 2.72% 1.77% 0.95% 1990s 2.89% 15.32% 18.21% 1980s 4.95% 12.59% 17.55% 1970s 4.25% 1.60% 5.86% 1960s 3.41% 4.39% 7.81% 1950s 5.77% 13.58% 19.35% 1940s 6.18% 2.98% 9.17% 1930s 5.27% 5.21% 0.05% 10% 5% 0% 5% 10% 15% 20% Dividends Price appreciation Source: Morningstar as of 6/30/12. Performance is historical and does not guarantee future results. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See page 19 for index definitions. Dividends: the case for income-oriented investors» 3

4 An even longer-term analysis appeared in the Financial Analysts Journal in In Dividends and the Three Dwarfs, Robert D. Arnott pointed out that from 1802 to 2002, dividends were by far the main source of the real return from equities, dwarfing the other constituents, which included inflation, rising valuation and real dividend growth. From 1802 to 2002, the average annual return of equities was 7.9%, which broke down as follows: 5.0% from dividends, 1.4% from inflation, 0.8% from real dividend growth and 0.6% from rising valuations. The numbers show that 63% of the total return of equities has come from dividends and a combined 73% from dividends and dividend growth. The author s conclusion: Unless corporate managers can provide sharply higher real growth in earnings, dividends are the main source of real return we expect from stocks. We admit that even for investors primarily focused on strategic asset allocation, 200 years might not necessarily be the correct investment horizon. Moreover, for yield hunters who charge around in markets trying to guess the next month s earnings number, the dividend-investing strategy seems completely irrelevant. However, for investors between these poles, dividends may be a vital and essential element of return. To illustrate the importance of dividends, we review a paper written by James Montier, a member of the asset management team at GMO, a privately held global investment management firm, entitled A Man from a Different Time. In it, Montier concludes that over a one-year time horizon, only roughly 20% of the total return of the S&P 500 Index has been generated by dividend yield and real dividend growth. In contrast, roughly 80% has been generated by fluctuations in valuations. If we switch to a five-year time horizon, the story looks very different: Fundamentals now play a prominent role in explaining total return, with the dividend camp accounting for roughly 80% of the return. (See Figure 3.) FIGURE 3: S&P 500 INDEX COMPONENT RETURNS BY TIME HORIZON (1971 AUGUST 2010) 100% 80% 60% 40% 20% 0% Change in valuation Dividend growth Dividend yield 1-year Change in valuation Dividend growth Dividend yield 5-year Source: GMO as of August Performance is historical and does not guarantee future results. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See page 19 for index definitions. 4» Dividends: the case for income-oriented investors

5 1.3. DIVIDENDS: ATTRACTIVE RISK CHARACTERISTICS High-dividend-yielding stocks have also provided better risk attributes than non-dividend-yielding stocks, including lower volatility and stronger downside protection when markets decline. As figure 4 indicates, the standard deviation of highdividend-yielding stocks has been significantly lower than that of non-dividend-yielding stocks over various long-term periods. Even more attractive has been the downside protection provided by high-dividend-yielding stocks. Since 1927, high-dividend-yielding stocks have held up better than the broader market during downturns. In fact, the downside capture ratio of high-dividend-yielding stocks has been 81% or lower over various long-term periods. Put another way, during months that the S&P 500 Index declined, dividend-yielding stocks declined by nearly 19% less than the broader market. (See Figure 5) While the data in Figure 4 makes a compelling case for high dividend-yielding stocks, one should not rely on screening for the highest-yielding stocks. There are several other characteristics that should also be considered, such as sustainability of dividend as well as growth of dividends. To illustrate, consider a recent study by Ned Davis Research, which looked at the performance of dividend growers vs. stable dividend payers (those with no change in dividends) and dividend cutters. From 1/31/72 through 6/30/12, companies that grew their dividends significantly outperformed companies that cut their dividends, with annualized returns of 9.46% and 0.41%, respectively. In addition, dividend growers outpaced stable dividend payers by an annualized 2.48 percentage points over the same period. FIGURE 4: STANDARD DEVIATION OF HIGH-DIVIDEND-YIELDERS VS. NON-DIVIDEND-YIELDERS (8/1/27 12/31/11) High-dividendyielders Non-dividendyielders Since % 30.34% 50-year 14.05% 24.59% 30-year 14.22% 22.90% 10-year 16.41% 19.96% 5-year 19.96% 21.99% FIGURE 5: DOWNSIDE AND UPSIDE CAPTURE RATIOS OF HIGH-DIVIDEND-YIELDERS (7/1/27 12/31/11) Upside capture ratio Downside capture ratio Since year year year year Source: Kenneth French as of 12/31/11. Performance is historical and does not guarantee future results. Standard deviation is often used to represent the volatility of an investment; it depicts how widely an investment s returns vary from the investment s average return over a certain period. The higher the standard deviation, the greater the volatility. Downside capture ratio measures a portfolio s performance in down markets relative to the investment universe (with down markets defined as those that have a negative monthly return); the lower the downside capture ratio, the better the portfolio performed during a market downturn. Upside capture ratio measures a portfolio s performance in up markets relative to the investment universe (with up markets defined as those that have a positive monthly return); the higher the upside capture ratio, the better the portfolio performed during a market upturn. Non-dividend-yielders include all U.S. stocks that do not pay a dividend at the time of reconstitution. The remaining stocks are divided by dividend yield into three categories: highest 30%, middle 40% and lowest 30%. High-dividend-yielders are represented by the highest 30% of dividend yielders. Portfolios are reconstituted annually. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See page 19 for index definitions. Dividends: the case for income-oriented investors» 5

6 The importance of dividends becomes even clearer when you consider the power of compounding those dividends over time. An initial investment of $100 in non-dividend-yielding stocks starting in 1972 would have grown to $181 by 6/30/12. In comparison, the same amount invested in dividend-growing stocks would have grown to $3,886, or 21.5 times that of non-dividend-yielding stocks. In the end, we believe investors should favor dividend payers over non-payers and dividend growers over cutters, and should tilt their core equity strategy towards payers and growers. (See Figure 6.) FIGURE 6: U.S. DIVIDEND GROWERS AND DIVIDEND PAYERS HAVE GENERATED LONG-TERM VALUE (growth of $100 in S&P 500 Equal Weight Index stocks, 1/31/72 6/30/12) $5,000 $4,000 U.S. dividend-growing stocks have generated value, returning a cumulative 3,786% from 1/31/72 through 6/30/12. $3,000 $2,000 $1,000 $ Dividend growers: 3,786% cumulative return, 9.46% annual return Constant dividend payers: 1,435% cumulative return, 6.98% annual return Non-dividend payers: 81% cumulative return, 1.48% annual return Dividend cutters: 15% cumulative return, 0.41% annual return Source: Ned Davis Research as of 6/30/12. Performance is historical and does not guarantee future results. Returns are based on the monthly equal-weighted geometric average of total returns of S&P 500 Equal Weight Index component stocks with components reconstituted monthly. The index returned a cumulative 1,407% and an average annual 6.93% from 1/31/72 to 6/30/12. Index returns assume reinvestment of all distributions and do not reflect any fees or expenses. It is not possible to invest directly in an index. See page 19 for index definitions. 6» Dividends: the case for income-oriented investors

7 1.4. DIVIDENDS: A GLOBAL OPPORTUNITY The importance of dividends is not just a U.S. phenomenon; combining dividend yield and real dividend growth in different regions shows a similar pattern to that of the United States. In our opinion, dividends often matter even more when investing globally. In certain developed European markets, for example, nearly 100% of total returns have come from dividends because change in valuation has been slightly negative, according to GMO, a privately held global investment management firm. The importance of dividends to overseas stock markets has resulted in a culture of strong dividend policies, so the international equity markets also provide a broader universe of high dividend yielding stocks: While there were 129 U.S. stocks with a dividend yield greater than 5% as of 6/30/12, there were 996 non-u.s. stocks that met that criteria, according to Morningstar. Thus, we believe investors may want to consider the vast opportunities available via international stock markets when implementing a dividend strategy. As depicted in Figure 7, all regional stock markets outside of North America, developed and emerging, have offered higher dividend yields as of 6/30/12. Currently, the average dividend yield of developed Europe is more than double the average dividend yield of North America. Finally, an international or global portfolio may also improve a portfolio s diversification by sector. Many of the highest-yielding U.S. stocks tend to be concentrated in a few sectors, such as utilities and telecommunications. In contrast, many other sectors in other regions provide attractive yields, such as financials in developed Europe and information technology in emerging Europe. It is interesting to note that the region with the highest dividend yield varies by sector, but North America does not have the highest yield for any of the sectors. (See Figure 8.) While investors in developed markets often have a certain appreciation for dividends, this is not the case with most of them when it comes to emerging markets. Investors with relative high risk appetites tend to focus more on capital appreciation than income within the emerging-market universe. However, they may want to consider dividends, as income is generally more secure than capital appreciation. As Figure 9 illustrates, over the past 10 years, dividends have contributed 19.4% to total returns in emerging markets. On the other hand, risk-averse investors may consider emerging-market equity investments relatively risky. While the returns earned on well diversified and well structured portfolios in past years may not necessarily support this view, investors who consider emerging-market equity investments too risky but don t want to miss out on the upside potential of fast-growing markets and companies may want to consider combining emerging markets with dividend income. Fast-growing companies can also pay high dividends, and high dividends may provide a measure of downside protection in volatile equity markets. Thus, risk-averse investors who are attracted to potential dividends do not have to forgo growth opportunities. FIGURE 7: AVERAGE REGIONAL DIVIDEND YIELD 6% 4% 2% 0% 4.1% 4.0% 2.9% 2.8% 2.3% 1.8% Developed Europe Emerging Europe Developed Asia Emerging Asia Latin America North America Source: FactSet as of 6/30/12. Performance is historical and does not guarantee future results. Regions are MSCI regions. Diversification can neither ensure a profit nor protect against a loss. Dividends: the case for income-oriented investors» 7

8 FIGURE 8: GOING GLOBAL MAY INCREASE DIVIDENDS Sector Developed Asia Developed Europe Developed North America Emerging Asia Emerging Europe Source: FactSet as of 6/30/12. Performance is historical and does not guarantee future results. Sectors are MSCI/S&P sectors. Regions are MSCI regions. Yellow boxes denote highest regional dividend yield per global sector. Diversification can neither ensure a profit nor protect against a loss. Latin America Consumer discretionary 2.4% 3.8% 1.4% 2.3% 3.0% 1.6% Consumer staples 2.7% 2.8% 2.5% 2.1% 1.7% 1.3% Energy 3.2% 3.8% 1.1% 3.3% 3.7% 0.4% Financials 3.5% 4.8% 2.6% 2.7% 3.2% 2.1% Health care 2.8% 2.5% 1.0% 1.2% 1.8% 2.2% Industrials 2.7% 3.6% 1.9% 2.5% 2.8% 1.8% Information technology 2.2% 2.6% 1.1% 3.4% 4.5% 3.7% Materials 3.1% 3.0% 2.0% 3.3% 4.1% 1.8% Telecommunication services 4.9% 8.8% 3.4% 3.7% 11.0% 5.6% Utilities 4.1% 6.1% 3.7% 2.0% 3.5% 3.9% Regional average 2.9% 4.1% 1.8% 2.8% 4.0% 2.3% FIGURE 9: HISTORIC DIVIDEND AND CAPITAL RETURNS IN EMERGING MARKETS (10 YEARS ENDING 6/30/12) Annualized capital appreciation Annualized dividend returns Annualized total returns Dividends as % of total return MSCI Emerging Markets Index 11.35% 2.73% 14.08% 19.4% Source: Bloomberg as of 6/30/12. Performance is historical and does not guarantee future results. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See page 19 for index definitions. 8» Dividends: the case for income-oriented investors

9 1.5. SUSTAINABILITY OF DIVIDENDS In sports there is a saying that offense wins games; defense wins championships. We believe this also holds true for dividend-investing strategies as well. It is often suggested that by following an income-focused strategy, investors may suffer because they are investing only in companies that have low or no growth potential. The thinking is that dividend-yielding companies are distributing such large amounts of their cash flow as dividends or buybacks that they can t retain sufficient cash for future growth projects. We believe this argument is flawed. In our opinion, exposure to companies that are capable of growing their free cash flows and are trading at reasonable (growthadjusted) prices is a sound strategy. However, when discussing dividend-investing strategies, it is important to balance all relevant factors. We believe a successful long-term dividend strategy must get the most from dividends. Of course, income is important, but we are cautious about being overexposed to dividend yield. As illustrated previously in figure 6, investing in companies that are growing their dividends has historically been a winning strategy, while investing in companies that pay no dividends has led to less favorable results. But an additional factor that must be considered is if the dividend that a company is paying is sustainable. If it is not, you could end up owning a stock that falls in the dividend-cutters camp. Dividends are paid from a company s cash flow, not its operating earnings. While on the surface this may seem like a trivial distinction, it actually says quite a bit about the types of firms that pay dividends. Companies often manipulate earnings with accounting rules, which allows some discretion regarding earnings numbers. This can lead to distorted views of a company s success, and can make it appear that struggling firms are actually producing strong results. In contrast, cash flows do not allow the reporting discretion of earnings. If a company has more cash going out than coming in, this is clear in the company s cash flow statement. Dividends are paid in cash, so a company that has paid a consistent dividend over time likely has a steady stream of incoming cash. Therefore, dividend-paying companies most likely have solid business models that may allow them to navigate down markets more easily. Monitoring a firm s cash flows will give an investor a strong indication or whether or not the dividend is sustainable. Obviously, if firms have negative cash flows but are paying a dividend anyway, they should be regarded cautiously. Another important factor to consider regarding dividend sustainability is a company s dividend payout ratio, which is the fraction of net income a firm pays to its shareholders in dividends. While high dividends are important, if a company is paying out nearly all of its earnings in dividends, this may be a sign that the dividend is not sustainable. Also, a dividend payout ratio that increases over time may indicate that earnings growth is not keeping up with dividend growth and the dividend may not be sustainable. However, companies with strong cash flows and low to moderate dividend payout ratios may have room to grow the dividend and also tend to exhibit positive price appreciation. In a 2003 study published in the CFA Institute s Financial Analyst Journal, Surprise! Higher Dividend = Higher Earnings Growth, Robert D. Arnott and Clifford S. Asness argue that contrary to financial theory, empirical evidence suggests that companies with high dividend payout ratios have achieved higher earnings growth than companies with lower payout ratios. Dividend-paying companies have typically been viewed as fundamentally strong companies with potentially slower growth prospects. In essence, the company believes that paying out dividends will add more value to shareholders than utilizing cash for new projects. In contrast, non-dividendpaying companies have traditionally been viewed as highergrowth companies that can increase shareholder value by retaining earnings to reinvest in new projects or grow through mergers and acquisitions. Arnott and Asness concluded that the higher earnings growth experienced by dividend-paying companies most likely reflects better allocation of capital. High dividend payout ratios impose discipline on corporate management teams to only invest in those projects with the best chance of adding value, while low dividend payout ratios may lead to inefficient empire-building in which companies fund less-than-ideal projects or investments. Dividends: the case for income-oriented investors» 9

10 1.6. DIVIDENDS AS INFLATION OR DEFLATION HEDGE? Many investors believe we are on the path to a great inflation spike driven by reckless printing of money by the world s central banks. We would therefore like to discuss the influence of inflation on stocks, especially on highdividend-paying stocks. Historical data shows that equities have generally performed best when inflation, as represented by the Consumer Price Index (CPI), has ranged from 3% to 3%. (See Figure 10.) At the extremes, equities have tended to perform poorly (which is mainly caused by a compression of price-to-earnings (P/E) ratios, as we show later in Figure 11). If we look at growth of equity prices, earnings, dividends and P/E ratios in different inflationary backdrops, we see that dividends have tended to grow more than equity prices in inflationary periods. This is due to the fact that they are affected by nominal variables and get a lift from rising inflation, but do not suffer the same declines as P/E ratios, which is normally the result of rising bond yields, which most equities endure. As Figure 11 indicates, dividends continued to grow during periods of high inflation. As global growth is likely to fall back to trend following one of the most severe financial crises in history, a serious risk exists for the developed world to fall into a Japan-like deflation. Although we don t expect to see deflation, it is a serious risk that one should consider hedging against because while equities do not like high inflation, they do not like deflation, either. The first way in which deflation affects stocks is corporate profitability. When interest rates are near zero, a drop in expected inflation causes real interest rates to rise and increases the cost of capital, which in turn hurts corporate profitability. Consumers and companies respond to the increase in real interest rates by reducing spending, which in turn hurts growth. FIGURE 10: AVERAGE ANNUAL S&P 500 PERFORMANCE IN DIFFERENT INFLATION REGIMES ( ) Year-over-year CPI growth % time occurred Year-over-year S&P 500 Index growth 15% to 10% 3% 0.9% 10% to 3% 12% 1.9% 3% to 0% 9% 15.4% 0% to 1.5% 15% 7.7% 1.5% to 3% 21% 10.7% 3% to 5% 17% 2.4% 5% to 8% 14% 0.3% 8% to 15% 7% 5.6% 15%-plus 3% 6.3% Source: JPMorgan as of June Performance is historical and does not guarantee future results. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See page 19 for index definitions. 10» Dividends: the case for income-oriented investors

11 FIGURE 11: EQUITY PERFORMANCE IN PERIODS OF HIGH INFLATION (>5%) Inflation period S&P 500 Index return Earnings growth Dividend growth P/E ratio growth May 1872 to November % 4% 9% 8% October 1879 to September % 28% 26% 4% August 1881 to August % 6% 8% 3% January 1893 to June % 15% 2% 2% June 1899 to August % 19% 32% 19% April 1902 to March % 14% 4% 13% October 1906 to October % 8% 13% 28% February 1909 to July % 25% 13% 24% April 1912 to February % 11% 2% 13% March 1916 to November % 18% 13% 1% August 1941 to September % 4% 13% 22% July 1946 to October % 155% 31% 66% December 1950 to December % 13% 1% 35% March 1969 to January % 11% 1% 4% April 1973 to October % 95% 116% 39% August 1990 to February % 2% 3% 3% Median 4% 1% 9% 6% Source: JPMorgan as of June Performance is historical and does not guarantee future results. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See page 19 for index definitions. In addition, wage rigidities mean that deflation reduces output prices by more than input prices and puts additional pressure on corporate profitability. The Japanese experience of the 1990s provides an example of the erosion in corporate margins in a deflationary environment. Overall, equities have delivered subdued returns in these instances, with earnings and dividends performing particularly poorly. However, companies with strong pricing power, longduration asset bases, unleveraged balance sheets and strong earnings momentum have performed well in deflationary environments. Cyclical stocks have tended to perform poorly compared to defensive stocks during periods of falling bond yields. Therefore, defensive, bond-like sectors such as telecommunications, consumer staples and health care may be preferable, as well as high-dividend-paying stocks. Last but not least, investors may want to remember that deflation fears could turn into inflation risks very suddenly. Dividends: the case for income-oriented investors» 11

12 2 I Potential buy signals for equities in times of low bond yields 2.1. SLOW GROWTH IN DEVELOPED MARKETS INCREASES ATTRACTIVENESS OF DIVIDENDS The world has changed dramatically for investors, with the subprime crisis, stimulus packages, ultra-loose monetary policy and European sovereign debt crisis dominating discussions. It feels as if we are living in a bipolar world. (See Figure 12.) How does this influence the big picture going forward? Emerging-market countries continue to deliver structurally better economic growth prospects than developed-market countries. Therefore, monetary policies around the globe differ remarkably. In our opinion, loose (or what some would call ultra-loose) monetary policies of the United States, Japan, the United Kingdom and the European Union will likely continue, while tighter monetary conditions will persist in the emerging markets. This is partially due to differing outlooks on consumer prices. Signs of higher inflation clearly exist in the emerging markets, primarily as a result of commodity prices and the heavy weight they hold in price indices. But in the developed markets, there is a danger of deflation, or at least strong disinflation. This also reaches into currency markets, as emerging-market currencies are believed to be undervalued and are expected to appreciate relative to their peers in the developed markets. Last but not least, investors are more than worried about sovereign debt in the developed markets, especially in the Eurozone, and the debt problem should not be ignored in the United States, Japan or the United Kingdom. In contrast, sovereign debt and budget deficits are not a problem in the emerging markets, as it appears that emerging-market countries learned their lessons well during the Asian crisis. With governments and central banks around the globe attempting to repair defective credit markets and prevent recession, yields on most asset classes have changed significantly. Most notably, interest payments on various fixed-income instruments have fallen precipitously. In the United States, the only time 10-year bond yields were lower than they were during periods in 2010, 2011 and 2012 was in the 1940s (according to according to Bank of America Merrill Lynch using data dating back to 1800). FIGURE 12: DOES A LOW-GROWTH WORLD EQUAL A LOW-RETURN WORLD? Emerging markets Advanced markets High (structural) growth Low sovereign debt Strong currencies Increasing inflation Low (structural) growth High sovereign debt Weak currencies Increasing deflation 12» Dividends: the case for income-oriented investors

13 The strong demand for government bonds likely reflects five factors: fear of a double-dip recession, fear of deflation, extreme liquidity levels in the global financial system, high risk aversion and short-term investors buying bonds in anticipation of more quantitative easing, primarily from the U.S. Federal Reserve Board (Fed). However, for this last factor, we must consider that these investors are buying bonds for capital gains rather than income. If the growth outlook improves, all of these factors may prove transitory and yields could rise. Due to structural effects (such as de-leveraging) that resulted from the financial crisis, yields could remain low for longer, especially in real terms. Post-crisis adjustment processes have previously shown that these adjustments often take time and that deleveraging is typically coupled with subdued economic growth. Also, when thinking about long-term growth prospects in the developed markets, we must consider that many countries are facing severe structural debt problems and huge demographic shifts. Not only have government bond yields fallen significantly, but so have corporate bond yields. Appetite for yield has been so great that investors have entered virtually any fixed-income asset class that offers higher yields. Credit spreads have tightened significantly as yield-hungry investors have chosen to take on credit exposure. Credit yields are usually higher than dividend yields in a growing economy, as coupons are fixed while dividends grow. So, a negative yield differential implies that the market anticipates dividends will be cut over time. As long as dividend streams are sustainable, as we believe they will be, investors may want to consider equity dividends instead of bond yields. Given today s yield environment, equity dividend yields appear more attractive than bond yields. This is true regardless of whether we are comparing equity dividend yields to government bond yields or investment-grade corporate bond yields. While some fixed-income asset classes offer higher yields, such as emerging-market bonds or high-yield bonds, the risk-return profile of these assets is more comparable to equities than to conventional bonds. Are dividend yields attractive in current and expected capital market conditions? We believe they are, because it appears a tug of war is taking place between debtors (who have high expected return rates) and creditors (who are simply seeking the highest and most secure yields available). The longer interest rates stay low, the more investors will come under pressure to generate an adequate return. Thus, since there is little opportunity within fixed income, we believe many investors will have to turn to equities namely, stocks with high dividend yields. Dividends: the case for income-oriented investors» 13

14 2.2. POTENTIAL BUY SIGNAL: FLOWS After two major equity bear markets over the past 10 years, investors have flooded into the perceived safety of fixedincome products. Net flows into fixed-income funds outpaced net flows into equity funds for nine consecutive quarters from the third quarter of 2008 through the third quarter of 2010, resulting in a total flow imbalance of nearly $600 billion. The last time bonds drew in greater net flows relative to equities for nine consecutive quarters was during the recession of the early 1990s, as highlighted in Figure 13. FIGURE 13: FLOWS INTO EQUITIES AND FIXED INCOME, IN BILLIONS (Q TO Q3 2010) $150 $120 $90 $60 $30 $0 $30 $60 $90 Q Q Q Q Q Q Q Q Q Q Q Q Equity flows Fixed-income flows Source: Simfunds as of 6/30/12. By the fall of 2010, this flight to safety, combined with expectations that the Fed will maintain low rates for an extended period of time, had pushed the yield on the 10-Year U.S. Treasury bonds below 2.5% for the first time since 1954, according to DeAM. The conclusion of the previous period of robust bond flows (the third quarter of 1992 to the third quarter of 1993) proved to be a compelling entry point for stock investors, as the MSCI World Index returned 20.24% over the one-year period, 47.95% over the three-year period and % over the five-year period on a cumulative basis, according to Morningstar as of 6/30/12. Of course, past performance does not guarantee future results. 14» Dividends: the case for income-oriented investors

15 2.3. POTENTIAL BUY SIGNAL: EQUITY YIELDS VS. GOVERNMENT BOND YIELDS We believe equities, especially dividend-paying equities, appear attractive relative to bonds. Yields on a number of fixed-income investments, particularly government bonds, have fallen recently. Typically, government bond yields exceed the dividend yield of equities. In fact, dating back to 1953, the earliest records kept by the Fed, the median spread between the yield of the 10-year U.S. Treasury bond and the dividend yield of the S&P 500 Index was 326 basis points. However, as of August 10, 2011, the yield of the 10-year U.S. Treasury bond dipped below the dividend yield of the S&P 500 Index. Historically, a convergence between U.S. Treasury yields and equity yields has been a robust buy signal for equities. Since 1953, U.S. stocks have returned an average 23.53% over the one-year period following a yield convergence to 50 basis points or less. (See Figure 14.) An additional factor that must be considered is the duration risk that exists in bonds. Since 1981, when the 10-year U.S. Treasury bond rate has exceeded 15%, we have been in a decreasing-interest-rate environment. This has led to a nearly 30-year bull market in bonds. Now we face a much different situation: There is little room for interest rates to move lower, and we believe we could see interest-rate increases over the next several years. Since bond prices have an inverse relationship with interest rates, this could have a devastating effect on bond prices. For yield-hungry investors, this makes dividendpaying stocks all the more attractive, as stocks don t have duration risk. The perceived safety of bonds has been based, in part, on a favorable interest rate environment. When we factor in the duration risk, equities suddenly don t look much riskier than bonds. This should only increase the crossover effect that we anticipate seeing. FIGURE 14: DIFFERENCE BETWEEN 10-YEAR U.S. TREASURY BOND YIELD AND S&P 500 INDEX DIVIDEND YIELD (4/30/53 6/30/12) 10% 8% 6% 4% 2% 0% Median spread 3.22% Yields as of 6/30/12 S&P 500 Index=2.21% 10-year U.S. Treasury bond=1.67% 2% 4% Potential buy signal spread 0.50% 7/1953 7/1963 7/1973 7/1983 7/1993 7/2003 6/2012 Average one-year return following Best one-year return following Worst one-year return following When spread is less than 50 bps 23.53% 53.62% 10.78% Source: DeAM as of 6/30/12. Performance is historical and does not guarantee future results. Yield spread refers to the 10-year U.S. Treasury bond yield minus the S&P 500 Index average dividend yield. Fixed-income investments are subject to interest-rate risk, and their value will decline as interest rates rise. The values of equity investments are more volatile than those of other securities. This data is for illustrative purposes and does not represent any DWS fund. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See page 19 for index definitions. Dividends: the case for income-oriented investors» 15

16 2.4. POTENTIAL BUY SIGNAL: EQUITY YIELDS VS. CORPORATE BOND YIELDS Not only have government bond yields fallen significantly, but the same is true for the yields on corporate bonds. Appetite for yield has been so great that investors have entered virtually any fixed-income area that offers higher yields. Credit spreads have tightened significantly as yieldhungry investors have chosen to take on credit exposure. Usually credit yields are higher than dividend yields in a growing economy, as coupons are fixed while dividends grow. A negative yield differential implies that the market anticipates dividends to be cut over time. As long as dividend streams are sustainable, as we believe they will be, investors should consider equity carry opportunities. These opportunities combine yield with growth, and exploit a cross-asset anomaly. As of July 12, 2012, 210 companies in the S&P 500 Index (42% of the index) were paying higher dividend yields on their stocks than coupons on their own intermediateterm bonds, according to FactSet. (See Figure 15.) This marks a dramatic increase of the number of stocks with equity yields greater than their own bond yields. At the conclusion of 2009, this figure had not yet reached 100 companies. Another metric that is often used to show the relative attractiveness of equities relative bonds is the earnings yield of the S&P 500 Index. Earnings yield, which is the inverse of P/E ratio, shows the percentage return of each dollar invested in the stock that was earned by the company. Since earnings yield is expressed as a percentage, it can be compared to the yield on other investments, such as bonds. According to FactSet as of June 2012, the S&P 500 Index earnings yield was 8.16%. This is 5.09 percentage points above the 3.07% yield of the Barclays U.S. Corporate Index. Historically, the earnings yield on the S&P 500 Index has averaged 0.23 percentage points lower than the yield of the Barclays U.S. Corporate Index. (See Figure 16.) FIGURE 15: NUMBER OF S&P 500 INDEX STOCKS WITH DIVIDEND YIELDS ABOVE THEIR OWN CORPORATE BONDS YIELDS (as of 7/12/12) Financials Consumer staples Consumer discretionary Industrials Utilities Health care Information technology Materials Energy Telecommunications These 210 stocks make up 42% of the S&P 500 Index Source: FactSet as of 7/12/12. Performance is historical and does not guarantee future results. Fixed-income investments are subject to interest-rate risk, and their value will decline as interest rates rise. The values of equity investments are more volatile than those of other securities. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See page 19 for index definitions. 16» Dividends: the case for income-oriented investors

17 FIGURE 16: EQUITIES ARE HISTORICALLY ATTRACTIVE VS. CORPORATE BOND YIELDS (9/1/87 6/30/12) 14% 12% 10% 8% 6% 4% 2% 0% 2% 4% 6% /12 Barclays U.S. Corporate Index yield to worst S&P 500 Index earnings yield S&P 500 Index earnings yield minus Barclays U.S. Corporate Index yield Average S&P 500 Index earnings yield minus Barclays U.S. Corporate Index yield Source: FactSet as of 6/30/12. Performance is historical and does not guarantee future results. Fixed-income investments are subject to interest-rate risk, and their value will decline as interest rates rise. The values of equity investments are more volatile than those of other securities. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. It is not possible to invest directly in an index. See page 19 for index definitions. Dividends: the case for income-oriented investors» 17

18 3 I Conclusion Yields on government and corporate bonds are so low that dividends, in many cases, offer more income than In this white paper, we have explored the implications of corporate dividend policies, the attributes of dividendpaying and non-dividend-paying stocks, equity dividend yields relative to fixed-income yields and global dividend-investing opportunities. bonds. As we have noted, almost half of S&P 500 Index companies currently pay a dividend that exceeds the yield on their intermediate-term corporate bond. This means equity holders not only have the opportunity to benefit from price appreciation; they are also receiving more income than bond holders. We believe that dividend yields are attractive in the current capital market environment because it appears a tug of war is taking place between debtors (who have high expected return rates) and creditors (who are simply seeking the highest and most secure yields available). The longer interest rates stay low, the more investors will come under pressure to generate an adequate return. Given this backdrop of extremely low fixed-income yields, we believe there is a strong potential for crossover buyers to enter the equity markets. In other words, investors who have historically sought the perceived safety and steady income of bonds may be drawn into equities. At a time when many analysts believe that equity prices are attractive, it makes sense to think that investors who would typically flock to bonds might be attracted to dividend-paying stocks. In addition, many of these investors have seen significant deterioration of their portfolios in recent years. While they might be hesitant to enter the equity markets, they might also realize that they need to be in stocks if they have any hope of regaining their wealth. Thus, in our opinion, many investors will have to turn to equities namely, stocks with high dividend yields and this will lead dividend-paying stocks to re-emerge as an important component of investors portfolios. 18» Dividends: the case for income-oriented investors

19 INDEX DEFINITIONS The Barclays Capital U.S. Corporate Index tracks the performance of the investment-grade, fixed-rate, taxable, corporate bond market. One basis point equals 1/100 of a percentage point. Credit spread refers to the excess yield various bond sectors offer over Treasuries with similar maturities. When spreads widen, yield differences are increasing between bonds in the two sectors being compared. When spreads narrow, the opposite is true. Duration, which is expressed in years, measures the sensitivity of the price of a bond or bond fund to a change in interest rates. The MSCI Emerging Markets Equity Index tracks the performance of stocks in select emerging markets. Price-to-earnings ratio (P/E) ratio compares a company s current share price to its per-share earnings. The S&P 500 Equal Weight Index is the equally-weighted version of the S&P 500 Index, which is capitalizationweighted; the index has the same constituents as the S&P 500 Index, but each company is allocated a fixed weight of 0.20%, rebalanced quarterly. The S&P 500 Index tracks the performance of 500 leading U.S. stocks and is widely considered representative of the U.S. equity market. The yield curve is a graphical representation of how yields on bonds of different maturities compare. Normally, yield curves slant up, as bonds with longer maturities typically offer higher yields than short-term bonds. Yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting. The opinions and forecasts expressed herein by the authors do not necessarily reflect those of DWS Investments, are as of 9/1/11 and may not come to pass. Dividends: the case for income-oriented investors» 19

20 The opinions and forecasts expressed herein by the fund managers and product specialist do not necessarily reflect those of DWS Investments, are as of 6/30/12 and may not come to pass. IMPORTANT RISK INFORMATION Any fund that concentrates in a particular segment of the market will generally be more volatile than a fund that invests more broadly. The fund may use derivatives, including as part of its global alpha strategy. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. Investing in foreign securities, particularly those of emerging markets, presents certain risks, such as currency fluctuations, political and economic changes, and market risks. Dividends are not guaranteed. The fund lends securities to approved institutions. Any decline in value of a portfolio security that is out on loan by the fund will adversely affect performance. Financial failure of the borrower may mean a delay in recovery or loss of rights in the collateral. Stocks may decline in value. See the prospectus for details. OBTAIN A PROSPECTUS To obtain a summary prospectus, if available, or prospectus, download one from talk to your financial representative or call (800) We advise you to carefully consider the product s objectives, risks, charges and expenses before investing. The summary prospectus and prospectus contain this and other important information about the investment product. Please read the prospectus carefully before you invest. Investment products offered through DWS Investments Distributors, Inc. Advisory services offered through Deutsche Investment Management Americas, Inc. DWS Investments is part of Deutsche Bank s Asset Management division and, within the U.S., represents the retail asset management activities of Deutsche Bank AG, Deutsche Bank Trust Company Americas, Deutsche Investment Management Americas Inc. and DWS Trust Company. DWS Investments Distributors, Inc. 222 South Riverside Plaza Chicago, IL inquiry.info@dws.com Tel (800) C DWS Investments Distributors, Inc. All rights reserved. PM R (8/12) DIV-WHITE