7. Dividends, Dividend policies and sustainability.
Dividend stocks – Why they’re the better investment decision and why firms should pay out.
Last month, the dividend yields on American AAA corporations rose above the yield on 30yr Treasury bonds - an unprecedented occurrence. Similarly the dividend yield of the S&P 500 Index is now higher than the 10-year Treasury yield, countering the belief that dividend yields are ‘like watching paint dry’.
Dividends are becoming an increasingly decisive factor in investment decisions and firms would do well to pay out on their stock. Although the percentage of companies who pay dividends has fallen, it still stands at over 70% of S&P 500 companies.
There are arguments for and against dividend policy, with many reputable economists in favour of a no-dividend policy. However no Nobel Prize winner will convince me of this approach. In theory it makes sense for companies to reinvest all of their earning straight back into the business, compounding the growth rate of the firm. In reality however the money is often wasted on failed acquisitions, taking on too much risk and irresponsible investment decisions. The money that should have been in your pocket is being paid to lawyers, middlemen and the government through taxes on new investment projects, which have no relevance to you. The earnings that a company makes should be shared among the owners of the firm, who can then decide whether they want to re-invest of spend THEIR money on themselves. The companies that reward you with these earnings show confidence in their ability to generate future cash flow increases, which may be passed on as dividends. Furthermore companies paying out dividends show shareholders that those earnings are real and not manufactured by accounting techniques, techniques which were commonly used in the loosely regulated financial markets in the years leading up to the crash.
But what do dividends matter? They are only part of the potential capital gain received if one was to sell a stock for a profit due to increased growth – fuelled by retained earnings. Research has shown (1) that dividend paying stocks do in fact outperform non dividend paying stocks – well only over the past 35 years as I’m sure some would argue. The study even goes as far to say that those who increase their dividend payment consistently will perform even better! While the late 90’s argument that companies should “reinvest the capital rather than pay it out” was en vogue for a time, there has been little or no proof that this works in practice. It’s more likely that companies will engage in what Peter Lynch referred to as “Diworseification” – i.e. a dumb acquisition. (2) This leads me to question how a theoretical economic model can be favoured over empirical evidence.
Clearly, there are strong arguments in favour of dividends; a strong financial image, better performing stocks, added incentive for investors and the fact that highly priced stock (associated with dividend paying firms) will give a company the option of raising a lot of capital through a share issue. However all of this is contingent on actual demand by investors in the stock. What makes shares in a company more desirable than say bonds, gold or earning interest in a deposit account? There are countless reasons to invest your money in a dividend paying stock and I believe they should form the base of any portfolio.
1) Performance
As the Great Ned Davis Dividend Study has shown, (3) dividends matter. S&P companies that pay dividends have historically provided greater returns over the years. They have steadily grown during bull markets and have managed to reduce losses during recessions – a decisive factor in today’s investment decisions.
2) Dividends are a big chunk of your profits
Although the S&P’s 500-stock index currently yields 2.02%, (4) dividends have historically accounted for 43% of the US stock market’s long term return. Furthermore dividends tend to be more predictable than share prices.
3) They can grow
Unlike most bonds, dividends have the potential to increase in the future depending on the company’s fortunes and dividend policy. With most bonds you receive the same interest rate to maturity however with a stock; the interest payments (dividends) you receive can be increased. Over the past 25 years the dividends paid out by companies in the S&P 500 have grown at a compounded rate of 3.2% per year.
4) Less volatile and stay afloat
Dividend paying stocks are usually less volatile than nonpayers. Volatility can be measured by beta, and a beta of 1 tends to follow the S&P 500 index closely. Over the past 5 years the average beta of dividend-paying US stocks has been .98 while that of nonpayers has been 1.50. Similarly dividend paying stocks generally do better when the stock market tanks, like it did in 2008. Dividend paying stocks lost an average of 39% compared to the 46% fall for nonpayers. The contrast was even starker in 2002 with the falls calculated at 15.8% and 30.3% respectively.
5) More diverse
A company that does not pay dividends only has 1 channel of profit – capital gains. The addition of dividends diversifies the investment as it has two streams of growth; dividend yield and capital appreciation.
6) Shareholder friendly
A company that pays out dividends can be seen as one that is shareholder friendly. A great company may not necessarily make a great stock as it could be overvalued in terms of share price or it might not care about creating shareholder value. Companies that pay dividends are looking after the shareholder’s needs.
7) Company diligence
With less retained earnings, companies will have less money to invest in future projects. This isn’t always a bad thing. New investment decisions will have to be carefully selected, with only investments that are expected to be the most efficient and profitable chosen. Similarly paying a dividend requires a sold cash flow. This means a company has to have its financials in order to know how much it can reasonably pay over the long term.
8) Simple
Stocks that pay a dividend don’t have to be constantly checked and traded. The cash flow from the dividend is relatively stable (depending on the company) and will not fluctuate in the short term. Dividends also provide stable investments that can be life-long. The dividend every year will increase demand for the stock, thus increasing its price. Holding a stock like this from its youth can provide both a steady cash flow, and an opportunity to make a capital gain at some time in the future by selling the share.
9) Management projection
The payment of dividends increases the transparency of a firm. Management’s confidence of future earnings or trends can be hinted at by their dividend policy. If they are unsure or pessimistic about the future of the company, dividends are likely to be kept conservative and vice versa.
With investors searching for safe, reliable investments and companies aiming to maintain a good relationship with their investors in the turbulent economic climate, the concept of paying dividends is appealing. As empirical evidence shows, dividend paying stocks do in fact perform better than stock with no dividends which in my opinion is the only reason a company needs to pay out and similarly the only reason an investor needs to include these stocks in their portfolios.
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