Don Coxe & "The Deficient Frontier"!

Location Date: 
September 22, 2011

Don Coxe's Strategy Journal is always a must-read for me. Coxe has the incredible gift of being able to distill decades of market experience and knowledge of history and the arts, into a thoughtful, prudent and sensible investment strategy.

His latest September 16th release is a wonderful example of his process. In particular, he tackles an issue that has enormous importance for many readers of this blog - a strategy for dividends. 

Coxe has tweaked his model by adding dividend stocks to the fixed income component of his recommended asset allocation. He recommends "bullet-proof", dividend-paying stocks. That is, those that not only have good dividends, but also have a history of solid dividend growth. His initial allocation is 10%. Companies like Bristol Myers, Johnson & Johnson, Walmart etc. are these types of firms. Somewhat controversially, Coxe is not fond of stock buybacks especially in today's environment. On buybacks, he states: 

"The justifications used for such programs are inherently contradictory: they are said to be returning money to stockholders, but they actually give funds only to those who want to sell their shares. If the companies also have generous stock option schemes for top executives, the programs could easily be construed as being, at least in effect if not in design, cover-ups about the real cost of such dilution, and as extra enrichment to the insiders by financing the purchase of their low-cost shares at higher prices. Dividends go only to those who choose to remain as partners in the enterprise. Stock buybacks go only to those who want out-in whole or in part-or those who are selling the stock short."

This, in most instances, makes sense to us.

His rationale for the dividend strategy is predicated on taking a 5-year view (a "private equity" approach). Do not worry much about the market-to-market volatility - which will be hard for individuals. He implicitly references the 1950s when pension funds valued their equity more on dividend streams to better match long-term assets and liabilities. Back then, dividend yields were higher than government bond yields, but that was a function of the belief that equities were inherently more risky and so they should pay out more. A lot has changed since then - tax policy of income versus capital gains and importantly, executive compensation (especially stock options). He suggests that company CEOs promoting dividend growth will attract a new investor class. In some respects, it reminds me of the income trust model once offered in Canada; the pitch was implicitly that it is not management's money so give it back to the shareholder - of course without the tax angle! 

Ultimately, Coxe argues that it is the breakdown of the Capital Asset Pricing Model ("CAPM"). In this model, the "risk-free rate" is assumed to be government bond yields - those yields are now best described as "return-free risk". The Efficient Frontier that many allocators use to create and optimize portfolios based on CAPM are now inherently much more risky. This is compounded by the role of central banks in manipulating these yields that makes adapting one's investment policy to these new realities a necessity. Given the big sell-off this morning, now might be a decent time to start accumulating positions in these companies. 

Jim McGovern

P.S. Given the wild state of markets today, you should also read Mr.Coxe's view on gold and his idea for government's use of their gold reserves - very intriguing!!