Several major banks announced dividend raises this week after the Federal Reserve’s CCAR annual stress test, which determined the banks are all very well capitalized and capable to withstand a drastic economic downturn. 

Portfolio name Morgan Stanley (MS) emerged as the big winner at the start of Tuesday's trading (before fading the gains alongside a 2% decline in the S&P500) after announcing on Monday an 11% dividend increase and a new $20 billion share buyback. Another portfolio holding, Wells Fargo (WFC), hiked its dividend by 20%. Meanwhile, Goldman Sachs raised its dividend by 25%, Bank of America did a 5% dividend increase. JPMorgan and Citigroup made no dividends or buyback announcements.

While pleased to see our holdings rank among the top in terms of shareholder capital allocation, the Morgan Stanley repurchase authorization, nearly 15% of its entire market capitalization as of Monday’s close, was the most meaningful. 

The dividend hikes and share buyback programs are worth celebrating. For the most part, income-oriented investors have two options: they can seek out dividend-paying stocks or purchase bonds. While the former may offer a slightly higher payout, the latter offers more protection of principal. 

Looking only at the payout level and capital structure ranking, however, fails to account for the instrument’s ability to protect buying power — or the amount of money available to spend. Consider: With a 10-year Treasury, an investor locks in a rate of return without the risk of the lender, in this case the U.S. government, cutting that payout. But locking in a rate can expose an investor to the risk of loss of buying power. That’s the trade-off for the safety bonds offer. For example, had an investor locked in a 1.5% yield in the 10-year Treasury at the beginning of 2022, they would be looking at a negative real yield now due to inflation hitting 8% year over year. That’s a negative 6.5% real return. Furthermore, that yield isn’t going to be reviewed annually and potentially raised to account for the inflationary environment. Currently, the 10-year Treasury yield is around 3.2%, more than double the rate earlier in the year.

On the other hand, dividend payouts, which are often tied to net income, are reviewed on a regular basis. The risk is that a company can cut its payout at any time without consequence — as we saw during the Covid pandemic. But if you own a high-quality company that can sustain through the tough times, you are often rewarded with dividend increases that counter inflationary trends. Take the dividend increase we saw from Wells Fargo. While inflation may be trending at around 8% right now, that 20% dividend hike means investors turning to WFC for income are actually seeing their buying power increase this year about 12%, when accounting for the 8% inflation hit. Of course, you have seen your principal take a beating far worse than what you may have with in Treasuries. But if you believe that shares of WFC will eventually recover and can ride out the volatility, you are in the long run better rewarded for accepting the volatility of equities.

This dividend dynamic is in addition to buybacks, which reward holders by pulling shares out of the market and leaving the remaining shareholders with a greater claim on future income. Remember, earnings per share — which is what great companies are valued on — is net income divided by outstanding shares. If a company reduces the shares outstanding, earnings per share will increase even if total net income remains the same. In this way, the share price can grind higher even if the market cap does not. Now, we are always looking for sales and revenue growth, even in our value names. In the case of Morgan Stanley, not only are shareholders getting an 11% dividend boost but also a greater claim on future earnings. That’s because at current levels, that $20 billion buyback will pull nearly 15% of shares out of the market.

In the end, risk and reward are tied at the hip. Income-oriented investors can go for the safety of principal offered by bonds, though they risk inflation outpacing the yield they ultimately lock in. Or they can go with the increased volatility of equities in exchange for the potential for companies to increase dividends over time and therefore protect their buying power should inflation run hotter than expected.

Which approach is more appropriate is a decision for each investor. Our portfolio does not invest in bonds. We only invest in stocks, accepting the risk and reward of owning pieces of great companies that often pay dividends, do buybacks or both — while at the same time, growing businesses and seeing their stock prices rise. Understanding the dynamics of how equities can reward shareholders over time can make stomaching market volatility a bit easier. It once again allows us to keep our eyes more on the longer-term picture and less so on the shorter-term price swings.