Why Dividends Matter
Over the past three years, the demand for dividend paying stocks by income hungry investors has intensified to levels not seen in many years. With the benchmark 10 year US Treasury bond yielding between just 1.5% and 3.0% (since June 2011), the search for safe and consistent yield has forced many investors to consider options not found in traditional fixed income asset classes. An argument can be made then for income hungry investors dividends do matter, but, what about growth oriented investors? If our goal is to raise the expected total return (price plus dividends) in all portfolios, regardless of risk profile, then our answer is an emphatic YES.
Dividends have played an important role in the total returns investors have received over the past three decades. If we look at the average annual total returns of S&P 500 stocks for the period of 1980 to 2010, we see that dividend paying stocks (with dividends reinvested) had a total return of approximately +8.80% while non-dividend paying stocks returned just +1.60%. Since 2010, the S&P 500 dividend contribution to total return has been approximately 21.0%. After a decade with little or no capital appreciation, investors are now placing a higher premium on the more tangible and immediate returns that dividends provide.
What can dividends tell us about a stock and the company paying the dividends? Actually, quite a lot. First, dividend paying stocks not only provide some income during periods of poorly performing equity markets, they also tend to smooth out portfolio volatility as they often have a beta under 1.0. During this period of historically low interest rates, this promise of both a dependable return and lower volatility has resulted in many investors considering dividend paying stocks as a proxy for fixed income assets, like bonds. The ability to grow its dividend payments is often viewed as a reliable indicator of a company’s financial health and stability. Companies that consistently grow their dividends often exhibit strong fundamentals, clearly communicated business plans and a strong commitment to their shareholders. Another school of thought is that the pressure to both pay and grow dividends imposes a fiscal discipline on companies that is a positive and meaningful one for all stakeholders.
With this new knowledge, should we now invest in the highest dividend yielding stocks we can find? Not so fast. Studies have shown that, as a group, those stocks within the S&P 500 with the highest dividend payout are not often among the top performers when based on total return. There are several reasons for this finding. First, many top dividend paying stocks are found in slow growth sectors like utilities and telecommunications. In these sectors annual total return often comes more from the generous dividend than from stock price appreciation. A second factor to consider is the dividend payout ratio which is calculated by dividing the yearly dividend per share by the earnings per share or more simply, is the percent of total corporate profits that are paid out to shareholders in the form of dividends. With the exception of real estate investment trusts (REITs) and Master Limited Partnerships (MLPs) which both will have payout ratios over 90%, most analysts consider a safe forward-looking dividend payout ratio to be between 40% and 60%. Earlier this year blue chip favorite AT&T came under some increased scrutiny as its dividend payout ratio rose above 85%, a level that some question as unsustainable in light of ever increasing competition within its sector and significant capital spending needs going forward.
