The chart below shows the performance of S&P 500 companies from 1973 through 2020, segmented by dividend payment policy. Three conclusions are worth noting:
- Dividends Pay: Investing $100 into stocks that paid consistent dividends (dark blue line) would have been worth $6,946. Investing in stocks that paid no dividends (orange line) would have only been worth $844, or 88% less.
- Dividend Growth Pays More: Owning stocks that grew dividends (light blue line) would have returned $11,346, or 63% more than picking stocks that paid consistent dividends.
- Cutting Dividends Stings: Owning stocks that cut or eliminated dividends (dark green line) would have been worth $56, indicating the risk of picking stocks unable to support their dividend.
Unfortunately, it’s not as easy as screening for high yielding stocks that have a history of growing their dividend. It’s important to recognize the difference between an attractive dividend and a stock under pressure because a high dividend yield can result from a falling stock price more than management rewarding shareholders.
Dividend yield is calculated by taking the dividend payment and dividing it by the stock price. For example, if a stock pays $4 in dividends annually when the stock price is $100, then the dividend yield is 4% ($4 ÷ $100 = 4%).
If this stock fell from $100 to $40, then 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 of publicly traded companies know the power of dividends. 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 that 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 back 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 prior to the fires in Northern California that devastated the wine country and a year prior to the Camp Fire in 2018 that killed 85 people.
These wildfires were sparked from electrical equipment that should have 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. Since its peak, the stock has fallen 85%3.
Simply put, dividend-paying stocks have delivered strong performance 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 they use 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 key point here 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 selling more goods and/or services. 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 places an emphasis on dividends or dividend growth.
It’s not much different than purchasing real estate for income. Price tends to be cyclical, but as long as rent is paid and there are no major impairments to the property, any dip in the price of the property 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 past 50 years. The chart below shows that going back to 1970, 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 insight into the minds of the executives that are committed to paying them. No rational management team would part with cash unless they felt supremely confident that they would not need it going forward.
Meaning, 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, then this is one “tell” that can be quite useful to a prospective investor.
But Pacific Gas & Electric taught us that it’s not adequate to conclude that a company paying dividends is less risky than the broader market. Furthermore, dividend-paying equities tend to have higher interest rate sensitivity than stocks that do not pay dividends. Putting an entire equity allocation into a dividend growth portfolio could create a wild ride if the Federal Reserve were to raise interest rates for an extended period.
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.
Sources
3 yCharts, Date as of 4/21/2021
Disclosures
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. Richard W. Paul & Associates does not provide tax, legal, investment, or accounting 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.