The chart below shows the performance of S&P 500 companies from 1973 through 2021, segmented by dividend payment policy. Three conclusions are worth noting:
- Dividends Pay: Investing $100 into stocks that paid consistent dividends was worth $8,942. Investing in stocks that paid no dividends was only worth $989, or 89% less.
- Dividend Growth Pays More: Owning stocks that grew dividends returned $14,405, or 61% more than picking stocks that paid consistent dividends.
- Cutting Dividends Stings: Owning stocks that cut or eliminated dividends was worth $80.
Unfortunately, it’s not as easy as screening for high-yielding stocks with a history of growing their dividend. It’s important to recognize the difference between an attractive dividend and a falling stock price.
Dividend yield is calculated by dividing the dividend payment by the stock price. For example, if a stock pays $4 in dividends annually when the stock price is $100, the dividend yield is 4% ($4 ÷ $100 = 4%).
If this stock fell from $100 to $40, the yield would increase to 10% ($4 ÷ $40 = 10%). This could be an opportunity or a reminder that stocks can be cheap for a reason. Only deeper analysis can help an investor conclude one way or the other.
It’s equally important to avoid stocks with unsustainable payouts. Executives know the power of dividends, and this can create perverse incentives to grow a dividend at the expense of the greater good of the firm (especially when bonuses are tied to the stock price).
Stocks must be carefully analyzed to ensure the company can support the dividend. If a company earns $10 million this year and has committed to pay $15 million in dividends, then management may put the financial health of the company at risk if they continue to pay.
Investors must also be sure that management is not paying dividends at the expense of needed reinvestment into the business. For example, Pacific Gas & Electric (ticker: PCG) raised their dividend by an impressive 8.2% in July 20171. This California utility had also paid out close to $5 billion in recent years leading up to this dividend increase2. These actions drove the stock to an all-time high in September of that year. This was just weeks before the fires in Northern California that devastated the wine country and a year before the Camp Fire in 2018 that killed 85 people.
These wildfires were sparked by electrical equipment that needed to be repaired. Allocating billions to dividends rather than critical maintenance created such a large liability for the company that the dividend was suspended, the CEO stepped down, and management ultimately filed for bankruptcy protection. Shortly thereafter, the stock cratered 91% in late 2019 and remains 80% below its peak today3.
Simply put, dividend-paying stocks have performed in aggregate, but navigating the risks associated with the sustainability and stability of the dividend requires specialized skill and experience.
Give it time
When a company pays a dividend, the value of that firm falls by the amount of the dividend paid. For example, if a firm is worth $500 million and uses cash to pay a dividend totaling $50 million, then the resulting value of the firm is $450 million ($500 - $50 = $450).
Since the firm now has $50 million less in the bank, the stock price must reflect this return of capital. The critical point is that shareholders do not gain or lose at the time of payment. The value lost from the decline in the stock price is equal to the amount of cash received from the dividend.
Investors must then wait for the company to rebuild that $50 million in value by generating more profits. This cycle requires any investor interested in dividend strategies to be patient. A good rule of thumb is to have a minimum five-year time horizon for any portfolio that emphasizes dividends or dividend growth.
It’s not much different from purchasing real estate for income. Price tends to be cyclical, but if rent is paid and no major impairments to the property, any dip in the property's price should be tolerated since the income being generated remains intact.
Said another way, would you sell a rental property with a good tenant who paid on time simply because local housing prices began to fall? Or would you rather collect the rent check and wait for the housing market to recover?
The Bottom Line
Dividends have played a significant role in equity returns over the last 60 years. The chart below shows that going back to 1960, approximately 84% of the total return of the S&P 500 Index can be attributed to reinvested dividends and compounding.
Dividends do more than put money in an investor’s pocket. They can also provide valuable insight because executives know their company better than any analyst on Wall Street. If they feel good enough about their future to return excess cash to shareholders, this is one “tell” that can be useful to prospective investors.
But Pacific Gas & Electric taught us that it’s incorrect to conclude that a company paying dividends is less risky than the broader market. Furthermore, dividend-paying equities may have higher interest rate sensitivity than stocks that do not pay dividends, so it’s often better to mix a dividend strategy together with other styles of equity investing for diversification.
The bottom line is that, like most things in life, moderation is warranted with dividend and dividend growth strategies. If your financial advisor determines that you are a good fit, allocate a modest amount, commit to staying invested, and focus on collecting those rent checks.
3 yCharts, Date as of 4/21/2021
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.