GMO

HITE

APER

August 2010

A Man from a Different Time

James Montier

s those who know me can attest, I’ve never worriedabout being fashionable. Not for me, the fads andfashions of this contemporary age. Indeed, I’m knownaffectionately to some of my colleagues as “the Amish,”for my shunning of the modern world. Touch-screentechnology and person-less check-ins at airports hauntmy nightmares. Perhaps I am just a man from a differenttime.Given these predilections, it is little wonder that I oftensit and stare at the farce that passes for modern dayinvestment. The churn and burn of an 8-month averageholding period is anathema to me. Call me old-fashioned,but I like to focus on the things that matter, both in lifeand in investing.

Exhibit 1The Churn and Burn Age

(Average holding period for NYSE listed stocks, in years)

Source: NYSE, GMO

012345678910111920 1930 1940 1950 1960 1970 1980 1990 2000

Dividends still matter

To those who charge around in markets trying to guessthe next quarter’s make-believe earnings number, theconcept of dividends seems wholly irrelevant. However,to those with an attention span measured in longer thanmilliseconds – who are few and far between, to judgefrom today’s markets – dividends are a vital elementof return. Exhibit 2 illustrates this point graphically.Looking at the U.S. market since 1871, on a 1-year timehorizon, nearly 80% of the return has been generated by

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uctuations in valuation. However, as the time horizonis extended, “fundamentals” play an increasing role inreturn generation. For example, at a 5-year time horizon,dividend yield and dividend growth account for almost80% of the return.

Exhibit 2Return Generator by Time Horizon

(S&P 500)

Source: GMO

0%10%20%30%40%50%60%70%80%90%100%1 Year 5 Year

Dividend yieldDividend growthChange in Valuation

valuation

GMO

A Man From A Different Time – August 2010

Exhibit 3 shows the contribution that dividends havemade to total returns over various periods. On average,over the very long term, dividends have accounted forsome 90% of total return.

Exhibit 3The Importance of Dividends (S&P 500)

Source: GMO

-10-5051015201871-2009 1982-2000 2000-2009

Change in valuationGrowth in real dividendsDividend yield

earnings that are temporary in nature. Witness theexplosion and implosion of repurchases over the last fewyears (Exhibit 4).If repurchases were to truly bene

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t investors, then wewould expect to see the “growth” element in the abovedecomposition increasing. Yet, there has been noevidence of this. So the kindest thing one can say is that,so far, the idea of repurchases replacing dividends is theScottish legal verdict “case unproven.”The importance of dividends over the long term isn’t justa U.S. phenomenon. The same patterns hold true acrossa wide variety of global equity markets. For instance, inEurope, 80% to 100% of the total returns achieved since1970 have come from dividends (combining yield andreal dividend growth).

-2-1012345678

U S A U K G e r m a n y F r a n c e I t a l y N e t h e r l a n d s S w i t z e r l a n d J a p a n

Change in ValuationDividend growthDividend yield

valuation

Exhibit 5Dividends Matter Around the World

Source: GMO

European dividends: still priced for the GreatDepression

Now, what if I told you that you could purchase thesedividends at a fraction of their potential worth? You’dprobably think I was running a dubious advert in one of those magazines aimed at those who think they can getrich quick. But it really is possible – although patience isvital – this is no get-rich-quick scheme.There is a market for dividends. The reason it exists is thatinvestment banks and the like end up owning dividendsas a direct result of the structured products they create.Of course, with management incentivised to focuson the share price (via enormous option positions),dividends have fallen out of favor with CEOs as well as“investors” (although it pains me to use that term for theseeming ADHD-af

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icted speculators who dominate theinvestment scene today). Instead, the focus has been onrepurchases.However, I don’t regard repurchases as equivalent todividends, least of all in their permanence. Whilstdividends are generally raised and lowered relativelyslowly, repurchases seem to be used to distribute excess

Exhibit 4The Rise and Fall of Repurchases

(Net, U.S. $ millions, S&P 500)

Source: GMO

-$150,000$0$150,000$300,000$450,000

1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

GMO

A Man From A Different Time – August 2010

Effectively, when you see products such as capital-protected bonds, which offer exposure to the upside of theequity markets (and a

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oor on losses), they are written interms of capital gains. To hedge this exposure, the banksbuy equities. But they only want the capital part of thereturn, leaving them long dividends. Institutions havetaken to swapping these dividends in the same way that aplain vanilla

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xed for

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oating swap works.This market allows investors to trade dividendsindependent of the market. Effectively, we can isolatethe dividends and not have to worry about the multiplethat the market places upon that cash

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ow.Of course, as with all investments, the price you paydetermines the attractiveness of the opportunity. Thegood news is that European dividends appear to be pricedcheaply at the moment.Exhibit 6 shows the current pricing structure of Europeandividends (for the Eurostoxx 50, the vertical line marksthe point at which we switch from actual dividends tothe market’s implied view of dividends), and shows theexperience of U.S. dividends during the Great Depressionas a comparison. In essence, the market is saying thatdividends will have virtually zero growth betweennow and 2019. This is a worse outcome than the U.S.witnessed in the wake of the Great Depression!

Exhibit 6European Dividends Priced for a Depression

Source: GMO

607080901001101201301401501601702008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Great DepressionCurrent Europe

Implied dividendsHistoricaldividends

1930 1936193519341933 19321931 19411940193919381937

11% annually. Broader European indices (with longerhistories) show a dividend growth rate of around 8%annually.However, as Ben Graham noted, any estimate of future growth “must err at least slightly on the side of understatement.” So, we’ve constructed an intrinsicvalue estimate for European dividends based on threepossible paths: a poor outcome in which dividends growat only 2% annually (assigned a 25% probability); a basecase, which assumes dividends grow at a 6% annual rate(a 50% probability); and a bull case, where dividendsare expected to grow at an 8% rate annually (a 25%probability).The bear case of 2% annual growth may seem generouswhen one considers that the 10-year U.S. annual dividendgrowth rate has been below 2% about one-third of thetime since 1871. However, this would ignore the 33%decline we have already witnessed in European dividends.Looking at 10-year annual growth following periods of 33% declines in U.S. dividends, we see an average growthrate of 5% annually, making our bear case assumptionof 2% conservative. Even Japan has managed to growits dividends by just over 2% annually during its twodecades of post-bubble economic stagnation.Exhibit 7 shows the implied dividends and our conservativeestimate of intrinsic value. The implied margin of safetybetween the current price and our estimate is between40% and 60% on the long-dated contracts.

Exhibit 7European Dividends (Implied vs Intrinsic Value)

Source: GMO

80901001101201301401501601702008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Implied dividendsHistoricaldividends

Implied dividendsIntrinsic value

Of course, we need an estimate of intrinsic value to trulyassess the scale of opportunity that the dividend swapmarket presents. Historically (since 1988), dividends forthe Eurostoxx 50 have grown at an impressive nominalDividend swaps have two other noteworthy features.First, they offer an implicit in

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ation hedge. Dividendsare a nominal concept (paid as they are in today’s prices).