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Dividends: Sign of Healthy Company with Quality of Earnings
Fake cash and divergence between net income and cash flow are warning signs of high accounting risk. Lots of cash with extremely low deposit rates or excessive leverage are possibly indicators of fake cash on the balance sheet. Dividends paid out in cash help to assure investors that the cash is real.
Also, fake cash is “generated” from fraudulent earnings. Companies which fudge their earnings set off warning bells with extraordinarily high margins and a prolonged divergence between net income and operating cash flow. Again, a long-term dividend payment record can only be the result of real sustainable margins and cash flow generation.
Dividends Are a Significant Contributor to Total Returns
A 2007 study by two internationally recognized academics, Eugene Fama and Kenneth French, titled “The Anatomy of Value and Growth Stocks Returns,” broke down the average returns on value and growth portfolios for 1927 to 2006 into dividends and three sources of capital gain:
(1) growth in book equity
(2) convergence in price-to-book ratio
(3) upward drift in price-to-book ratio
According to the study, in the comparison between value stocks and growth stocks, dividends as a proportion of average returns were higher for value stocks from 1964 to 2006. In the comparison between large cap stocks and small cap stocks, dividends as a proportion of average returns were higher for large cap stocks from 1964 to 2006.
Also, according to a Citigroup research report titled “Dividends: Here, There and Everywhere” dated Sept. 29, 2010, the total return for Asian equities (excluding Japan) has been only 6% per annum in U.S. dollar terms (comparable to the dividend yields of certain stocks) for the past 10 years from 2000 to 2010. Also, over the last 10 years, dividends have accounted for 45% of the total return, compared with 30% for the past 30 years.
Dividends Are the Only Positive in Bear Markets
For most investors, the calculation of returns on investment is solely based on capital gains or capital appreciation. However, a more rational approach is to take into account the dividend income from the stock as well as the share price appreciation or loss. Let me use a variety of scenarios to illustrate this.
In Scenario 1, the investor enjoys both capital appreciation (sold his stock at a higher price than he bought at) and dividend income. His return will be greater than if he only enjoyed capital gains.
In Scenario 2, the investor sold his stock with a minor loss, but with the dividend income he received. He managed to earn a positive return overall.
In Scenario 3, the investor sold his stock at a huge loss. His overall loss is reduced by virtue of the dividend income he received.
Dividends Ease the Pain for Deep Value Stocks
Combining the idea of buying deep value stocks and dividend investing makes more intuitive sense. An investor buys a consistent dividend-paying stock and holds it for a period of time to receive dividend income. Once the dividend investor has recovered his capital (or at least a substantial part of it) through dividend income (it could take many years depending on the dividend yield), he could then choose either to continue to hold the stock to receive dividends or sell the stock for capital gains.
On the other hand, buying and holding a non-dividend-paying stock for it to reach its “intrinsic valuation” could be a long, fruitless wait, perpetuated by the fact that there are no dividends in between to tide the investor through. In the worst case scenario, the stock never reaches its “intrinsic” valuation or anywhere near, commonly referred to as a "value trap."
In Closing
Traditionally, equity investors have put too much faith into getting their capital back through “undependable” capital gains, which are subject to the ups and downs of the market. Value investors should favor dividend income as the preferred way of getting money back.
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