The May issue of Good Housekeeping features a quote from Scottsdale and Phoenix-based investment advisor Kevin O'Reilly. The article discusses how to stick to a budget, and Kevin provides some thoughts on tracking ongoing expenses.

A key question looming on the minds of dividend investors and the stock market in general surrounds the taxation of dividends in 2011.

By way of context, dividends are taxed at the corporate level – as income, as well as at the individual level. This results in double taxation, and has long been fodder for philosophical debate over the fairness of the system. One school of thought holds that individuals should not pay taxes on dividends at all, because they’ve already paid as partial owners of the companies in question.

 In 2003, President Bush signed a tax reform bill into law that brought the dividend tax rates down from the standard wage tax rate.  For “qualified” dividends, taxes were paid at a rate of either 5% or 15%.  Lower income taxpayers saw qualified dividend rates drop to 0% in 2008-2010.  This rate structure mimics the long-term capital gains rates.  Note:  qualified dividends are paid on stocks held for all of the 120 day period around the ex-dividend date, which is the date on which the shareholder base is determined with regard to who will receive dividends.  In other words, if a shareholder owns the stock on or before ex-dividend date, he or she will receive a dividend for that period.

The 2003 cuts were significant, as the top tax bracket had dividend taxes cut from 35% to 15%.  Perhaps more importantly, the two lower brackets dropped from 10%/15% to not paying any taxes on dividends.  Unfortunately, the dividend tax rate is set to expire beginning January 1, 2011.  At that point, taxes on dividends will revert to the rates paid on wages.  Right now it is unclear what will actually happen at that point, however.

Simply extending the lower dividend rate seems like an option.  However, that would be considered a tax cut, which would require Congress to justify under PAYGO rules.  In short, the higher rates are factored into our federal revenue projections, and we’d have to pay for lower rates – even in the case of an extension – by cutting spending or raising revenue somewhere else.

Undoubtedly, any plan to raise taxes on dividends is designed to raise revenues to help pay for the dramatically increased government spending that has taken place over the last decade.  However, in its most extreme form, an unintended consequence could be to weaken the balance sheets of US corporations, such that they are less well equipped to deal with economic downturns.  That is because raising taxes on dividends could incent corporations to use debt instead of equity.  At least, it may dis-incent them to use equity, as the tax would be the same on interest payments as on dividends.

Furthermore, the recent health care bill already includes an additional 3.8% tax on investment income beginning in 2013.  This includes dividends.  So the rate is going up, one way or another.

What makes this a particularly stick situation is that the dividend tax decision impacts the wealthy as well as lower-income taxpayers.  Per a  Wall Street Journal report, the Tax Policy Center estimates that six million lower-income households will return to paying taxes if the Bush administration changes are simply allowed to lapse. Most Republicans, many Democrats, and President Obama have all stated that they believe dividends should be taxes at the lower capital gains rate, rather than standard income tax rates.

Bottom line

It is still anybody's guess as to how this will play out for taxpayers.  How will it play out for investors? Certainly, dividend stocks are more attractive under the current taxation plan than they were when dividends were taxed at the standard income rates.  However, the outsized returns achieved by dividend stocks that I highlighted in a previous blog post were  were largely gained under non-preferential tax rates.  Consequently, the argument for dividend stocks outperforming the market over the long-term remains strong, regardless of the direction of dividend taxes.  Within reason, of course.

"If you are predisposed to be patient, disciplined and psychologically appreciate the idea of buying bargains, then you're likely to be good at it.  If you have a need for action, if you want to be
involved in the new and exciting technological breakthroughs of our time, that's great, but you're not a value investor, and you shouldn't be one."

 - Seth Klarman

Scott Adams advises us to buy companies we hate.  They'll perform better:  http://tinyurl.com/dilbertinvest.

Pretty much all finance students are confronted early in their educational career with the question of whether or not dividend policy matters to the value of a stock.  Specifically, a paper written by Professors Merton Miller and Franco Modigliani argues that it does not matter.  Without boring anybody with the gory details, it’s worth exploring what that means for investors.

Many in the investing world view dividend stocks as the province of “widows and orphans”.  At least some of the time, it is an accusation.  Fair enough.  It’s hard to argue that these equities don’t serve as a source of stability in bad markets.  After conducting a study of his own, Wharton professor Jeremy Siegel finds dividend stocks to be effective “bear market protectors”.

What’s particularly powerful is that not only do dividends provide a measure of protection in the form of a consistent payout, they act as a “return accelerator” when they are reinvested in down markets.  That is because the stocks are priced lower than they would be in a bull market, so the reinvested dividend is buying shares at a relatively low price.  Those additional shares in turn accelerate the investor’s performance when strong markets return.

By way of example, Siegel cites the fact that it was not until 1954 that the S&P 500 returned to the level of values it held prior to the Stock Market Crash of 1929.  However, those who reinvested their dividends through that period were 60% better off in 1954 than they would have been had the crash never happened.  That’s a powerful accelerant.

Great, you say, but what about bull markets?  Well, one school of thought would be that preserving capital during bad markets in exchange for slower growth during good ones is a reasonable tradeoff.  I would agree with that.  Take, for instance, the investor who lost 60% in 2008, but gained 103% in 2009.  (That is the precise performance of a small-cap fund I reviewed for a 401k plan this morning).  If an investor had $10,000 on January 1, 2008, he would have had $4,000 on December 31, 2008.  After the spectacular run up in this particular fund in 2009, the investor would have ended the year at…$8,120.

In reality, though, over long periods of time, in good markets and in bad, dividend stocks outperform the overall market.  In Jeremy Siegel’s study, he was surprised to learn that the highest yielding stocks, or those paying the highest dividends, generated between 2.5% and 4.5% higher returns than did the overall market.  If that difference seems paltry, I invite you to review an earlier post outlining the dramatic difference that small increases in return can produce.

In a 2003 article in the Financial Analysts Journal title Dividends and the Three Dwarfs, Robert D. Arnott demonstrates the importance of dividends to the long-term benefit of owning stock.  Arnott points to numbers that detail stock returns from the 1802-2002.  How’s that for a long-term test?  The average annual return for stocks over the 200-year period was 7.9%, of which dividends accounted for 5%.  That’s 64% of the return!  Other studies cover other periods of time but still reach the same conclusion:  high-yielding stocks perform better than the overall market.

Do dividends matter?  In a word, yes.

The most recent issue of Bloomberg Businessweek (that’s just awkward) lists the top 10 undergraduate schools in terms of how many of their graduates now lead S&P 500 companies.  To be clear, “lead” means that the graduate is the CEO. 

First off, let me point out that my alma mater – Indiana University – is on the list.  Lest you think this post is merely an advertisement for that fact, there are a couple of other things that jumped out at me.  One is that a school that shares the #1 spot is not a school at all.  Fully twelve CEOs did not earn an undergraduate degree.  Of course, that is only 2.4% of the entrants, so I wouldn’t draw too many conclusions if you’re a senior in high school.

The more important takeaway, though, is the fact that 6 of the top 9 CEO-producing schools are public institutions.  It probably wouldn’t surprise too many people to see the Ivy League represented on this list in the form of three schools, but it’s nice to see the Big Ten match that number.  Nicer, though, is the fact that state schools are accessible to a much broader number of students than are Ivy League and other private schools.  Those schools tend to be much more expensive, and in many cases admissions standards are much more difficult.  The latter point is a double-edged sword.  There is no doubt that the public institutions on this list are among the elite public schools nationwide, but they accept many more students than do schools like Harvard, Dartmouth and Princeton, especially residents of their respective states.  To a greater degree, I suspect, what you get out of your education is largely a function of what you put in at a public school.  Nonetheless, it’s clear that most of the members of this list got a lot out of their undergrad experience. 

Of course, not everybody wants to work in the corporate world, and not everybody wants to rise to the top of it.  However, I think this list illustrates the fact that it does not require an Ivy League education to get to the top of one’s chosen profession.

The list: 

1. University of California (12 CEOs)

 2. School of Hard Knocks (12 CEOs) 

3. Harvard College (11 CEOs)

4. University of Missouri (11 CEOs) 

5. University of Texas (11 CEOs)

6. University of Wisconsin (11 CEOs)

7. Dartmouth College (10 CEOs)

8. Princeton (9 CEOs)

9. Indiana University (8 CEOs) 

10. Purdue University (8 CEOs)

By virtue of alphabetic superiority, Carol Loomis asked the first question of the meeting, and it pertained to the SEC's recent complaint against Goldman Sachs.  Every year the Berkshire meeting begins with a movie that is a kind of Berkshire collage, featuring unpaid cameos by famous people from all walks of life.  For instance, there was a Desperate Housewives skit this year that featured the stars of that show.  Loomis pointe out that every year the movie includes a clip from a 1991 Congressional hearing into Salomon Brothers (which Buffett was temporarily leading in the wake of a crisis) in which Buffett states that he admonished Salomon employees that if they "lose money...I will be understanding; lose one shred of our reputation and I will be ruthless".  Given that, and the fact that Goldman's reputation clearly has been tarnished, what advice would Buffett give Goldman management?

The paraphrased, summarized response:

The nature of the transaction has been generally misreported.  There were four losers in the Abacus transaction, and Buffett focused on two of them.  Goldman Sachs was an unintentional loser.  The main loser in terms of cash was ABN-AMRO.  They lost money because they guaranteed the credit of ACA - they fronted the transaction.  Berkshire does this alot, and lost money in the 70s in a case where they ran into dishonest people.  ABN guaranteed $900m of ACA at a price of $1.6m.  It's hard for Buffett to be sympathetic because ABN-AMRO made a dumb deal.

ACA was a bond insurer.  They started out as municipal bond insurer, but margins got squeezed in that space.  Instead of sticking to their knitting, they moved outside their realm of understanding.  As Mae West once stated, they started out "like Snow White, but drifted".  Not long ago, Berkshire entered the business of muni bond insurance, but always stayed away from things they didn't understand.

Buffett then went into an example of a portfolio of state bonds that Berkshire insured.  He showed a chart of the states involved.  Berkshire was paid $160m to insure $8.25b for ten years.  The deal was presented to them by Lehman Brothers.  Berkshire did not select the bonds...more specifically they did not "dream up this list".  In fact, Lehman Brothers did.  Buffett and his chief insurance guru Ajit Jain analyzed them and proposed the $160m price.  If any of the bonds defaulted, Berkshire was on the hook to make good on the commitments on behalf of the defaulting state.  They didn't know if the ultimate counterparty was Lehman, and what the counterparty's interest in proposing the trade was.  The counterparty could have owned the bonds and merely wanted some protection, or they could have been betting that there would be defaults.  Berkshire didn't care.  They did what ACA should have done: they evaluated the bonds and determined the proper premium.  ACA initially agreed to 50 bonds of 120 that were presented to them.  Through additional negotiation, they agreed to insure 30 more.  In the Berkshire/Lehman case, it was totally Lehman's list - they didn't throw any out.  It was Berkshire's problem to determine creditworthiness.  If they lose money, they're not going after the counterparty due to superior knowledge or anything.  The fact that John Paulson apparently selected specific bonds and asked Goldman to propose the deal (and probably knew more about those bonds) is irrelevant.

The central point of the SEC's complaint seems to be that Paulson had superior knowledge of the overall deal, and Goldman worked with him to structure it and sell it to counterparties, and the counterparties may or may not have known about Paulson's involvement.  The bonds underlying the deal blew up, and the counterparties lost a lot of money while Paulson got rich.

When Warren asked Charlie about his view on the matter, he pointed out that the SEC commissioners were split 3-2 on whether or not to sue, and it's very unusual to take action of this magnitude without a unanimous vote.  He seemed to feel that was unfortunate, and said he would have voted with the minority.

My view

I view this transaction from two angles, and I think it is helpful to have a tiny bit of background on one of the legal issues in question.  This point is central to my business, and I view it as the point on which the whole Goldman transaction turns.  It speaks to the fiduciary duty that Goldman held, in this case.  There is a significant difference between brokers and advisors, and Goldman was a broker in this case.

In layman's terms, I view a broker as being similar to a car salesman who sells cars "As Is - No Warranty".  The buyer in this case has the responsibility to evaluate the vehicle and determine if it is worthy of the price being asked.  The seller undoubtedly has more knowledge of the car than the buyer, and that gap must be bridged to make the deal worthwhile.  If the buyer doesn't have the requisite knowledge to evaluate the car, a mechanic should be hired to provide a recommendation.

An advisor, on the other hand, has a legal, fiduciary duty to act in the best interests of his client.  The advisor would be more like the mechanic.  If he advises the buyer that the car is in great shape, and the car breaks down three days after being purchased, they buyer has a legitimate complaint with the mechanic.

Given that background, the moment I heard about the SEC suit I was skeptical that there was a legitimate legal case there, and I remain skeptical.  To the general public, it likely sounds like Goldman hoodwinked their customer.  To Warren Buffett and to others that are more familiar with these types of transactions, I think it sounds like ACA, ABN-AMRO and others who ended up on the short end of this deal just didn't do their homework.

That's the legal view.  It is now sounding like Goldman Sachs is discussing a settlement, and I think that's unfortunate from the standpoint of proper administration of our legal process, but it's probably a smart move for them.

The ethical angle is far less clear to me.  A follow on to the initial question asked about Buffett's thoughts on the impact to Goldman's reputation.  He feels that the allegation and related press alone cause Goldman to hurt and it hurts morale, but he doesn't really see it as a loss of reputation.  He does believe that the approach now should be to "get it right, get it fast, get it out, get it over."  Standard reputation management in a crisis.  Charlie, on the other hand, added that the standard should be higher than what's legal and convenient.  He feels they shouldn't have dealt with "scuzzy securities", and that plenty has been wrong with Wall Street.  The bottom line is that Berkshire has had a 44 year relationship with Goldman Sachs, and they have bought more companies through them than anybody else.  They trade with them, and Goldman doesn't tell them what their position is, i.e. shorting or trading from own inventory.  They act in a non-fiduciary capacity when they trade with Berkshire.

<soapbox>I think there are a lot of distasteful things that take place on Wall Street every day.  However, the SEC is making a show of attacking Goldman Sachs on points of dubious legality when they were trading with institutions that are very sophisticated investors.  At the same time, individual investors are being duped on a daily basis because they are not even aware that a distinction exists between brokers and advisors, and that their "advisor" is actually acting in his or her own best interest.  I'd like to see the SEC let the professionals make their own mistakes, and spend a bit more energy on protecting the rights of individual investors from people like Bernie Madoff as well as the Wall Street firms.</soapbox>

This past week has been pretty busy for me, as I attended the Berkshire Hathaway annual meeting last weekend, and the Wesco annual meeting on Wednesday.  Wesco is run by Warren Buffett's partner Charlie Munger.  Whereas the Berkshire meeting has the atmosphere of a very popular circus, the Wesco meeting features about 1% of the attendees of the Berkshire meeting, and it allows for more unfiltered Mungerisms, which makes it well worth the effort.

Last year I took voluminous notes at the Berkshire meeting, and barely shared any of them.  The process felt daunting and I was very busy.  That's no different this year, but I think there is a lot of value in what was communicated, and that value is definitely worth sharing.  Nonetheless, I plan to do this in digestible pieces, which should make it more readable and more feasible for me.

One point about the logistics of the meeting:  beginning last year, the Q&A process alternated between those being asked by three journalists, and those being asked by members of the audience.  The journalists were Carol Loomis, Becky Quick and Andrew Ross Sorkin.  They each receive thousands of questions from the investing public, and whittle them down into broad themes and form specific questions accordingly.  I took notes on most questions asked by the journalists, but not on all questions asked by the audience.  Some just didn't hold much interest for me.  Other questions didn't strike me as worthy of particulary insightful responses.  Consequently, my sharing will be selective.

First up (next post):  Warren Buffet's view of the recent troubles at Goldman Sachs.

I found an interesting article in the NY Times from a couple of years ago on the admission prospects for twins and triplets when they apply for the same college.

The basic question the article seeks to resolve is "does the candidacy of one sibling of the same class negatively impact the candidacy of another"?

It has always been my perception that selective schools seek geographic and demographic diversity.  For obvious reasons twins and triplets will be the least diverse prospects imaginable, at least on paper.  In fact, my kids have very different personalities, and that is consistent with other multiples that I know.  Nonetheless, environment plays a significant role in shaping one's views, and I think to some degree the college admissions process is a statistical crap shoot, so assuming a lack of diversity seems pretty rational.  If the siblings go to a small high school in a small town, and all apply to an Ivy League School, it seems logical that the likelihood of all being selected is low, even if their applications are very similar.  I'm not sure the article dispels that theory, although Harvard's Dean of Admissions suggests the diversity quota is a myth.  Interestingly, Duke University considers twins individually and as a unit.  I'm not sure how the average twin or triplet would view being evaluated for college admission as a package with a sister or brother, but at least nobody would be ruled out strictly by virtue of one being admitted.

Speaking from experience, one of the daunting things facing parents of multiples is paying multiple college bills simultaneously.

In an earlier post, I listed some of the college scholarship options available to twins, triplets and other multiples.  Another consideration is the impact on the Expected Family Contribution (or EFC) of having several children in college.  As the name suggests, the EFC describes the amount of money a family is able and expected to chip in to pay for the cost of college, as calculated in the federal student aid application process.  It is used to determine "financial need" in this process. After taking the EFC into account, a loan and/or grant package can be developed to bridge the gap and help pay for schooling.  Of course, the lower the EFC, the higher the financial need.  Families that can show high financial need are eligible to receive more financial assistance.

The "silver lining" in the case of multiple siblings attending college at the same time is that the EFC is a family-level calcuation.  In other words, if it is determined that a family can contribute $21,000 per year to college and there is one child in school, it will be expected that all $21,000 of that EFC will be available for that child.  If three kids are in school, it will be assumed that roughly $7,000 is availabe for each student.  If those kids are triplets that all complete their schooling in four years, and they all have a $21,000 total bill for school each year, each student will be eligible for $14,000 per year of aid.  On the other hand, if three children were each born two years apart but otherwise followed the same path and paid $21,000 each (ignoring inflation), the family would a) have eight years of college ahead of them, and b) in four of those years they would not be eligible for traditional federal aid at all.  In the middle four years they would only be eligible for $10,500 per student of such aid.

It should be noted that the calculation of the EFC and financial need is a somewhat complex process.  In reality, the numbers will not work out this precisely.  Although this is a simplistic example, the message is valid regardless of the numbers used.

This all may seem like cold comfort to my fellow triplet parents, but why not look on the bright side when there is one?