Why Dividends Never Go Out of Style
James D. Ragan, CFA – Director of IIG Research
As fashion trends come and go, there are a few core elements of a timeless wardrobe that will consistently maintain their status as the epitome of vogue, whether it be that little black dress, classic navy blazer, or that favorite pair of worn Levi’s. Just as these items have remained reliable and constant over the years, so too have dividend paying stocks, which can be a core element of investors’ equity portfolios. Dividends can provide a meaningful contribution to long-term equity returns, as dividend growth reveals solid management and stewardship of capital and dividend reinvestment allows the power of compounding to produce a substantial increase in returns.
Dividends and Long-term Equity Returns
A study by Standard and Poor’s concluded that dividends comprised 34% of equity returns to investors from 1926 to 2012.1 While equity returns have trended positively over time, they have done so with considerable volatility, whereas corporate dividends tend to be significantly more predictable and stable. This is particularly evident during periods of low or even negative market returns as dividends from financially strong companies will be paid through up and down markets. The relative stability of dividend payments counterbalances the short-term variability of stock prices. A company’s financial strength and ability to pay its dividend commitments can be demonstrated by positive cash flow, manageable debt levels, and a comfortable dividend payout ratio as a percentage of earnings.
Dividend Growth Reveals Management Commitment
Many companies have paid dividends to investors annually, year after year, and some for multiple decades. A company’s long-term dividend payment record demonstrates a commitment to shareholders that considers dividends as a repeatable use of cash flow, planned in long-range capital allocation plans. By increasing dividends for at least ten years, a company is able to sustain those increases through multiple market and business cycles and points usually due to a strong management team and a confidence in business performance. Dividend increases in down markets help to stabilize total return. If the dividends are reinvested into the dividend paying stock, those shares will often be purchased at attractive prices.
Dividend Reinvestment and the Power of Compounding
A strategy of dividend reinvestment applied to a portfolio of blue chip type companies can significantly boost long-term returns. This is due to compounding: the dividends proceeds are used to buy more shares, which leads to more dividends — due to more shares owned — in the next period, and that cycle repeats every quarter or year. Over a long-term investing horizon, the compounding effect can produce a dramatic increase in returns. Another study by Standard and Poor’s evaluated cumulative returns of the S&P 500 from 1930 to 20121 comparing the price return with no dividends to a compounded return with dividends reinvested. From a starting value of 1.0, the price return index grew to a value of 66.5 over the period. On the contrary, the dividend reinvested strategy grew to a value of 1,832.5 over the same period, substantially greater than the 66.5.
The most famous investor promoting the long-term compounding effects of a dividend growth portfolio is Warren Buffett. Coincidentally, his clothing item of choice is an impeccably-tailored suit, another classic that has retained its popularity and stability over the years. From finance to fashion, while some fads may come and go, if the past is any indicator, dividends will never go out of style.
1. S&P Dow Jones Indices. “Dividend Investing and a Look Inside the S&P Dow Jones Dividend Indices.” Sept. 2013.