In recent years, dividends’ contribution to total return has been one of the most heavily-studied topics in the investment world. Several conclusions about the contribution that dividends make to total return have been claimed. However, these conclusions vary greatly. I have seen studies claiming that 90% of returns are attributed to dividends, several claiming 50% or more, and others arguing for a 30% contribution. Ironically, they all seem to be correct depending on the data-sets and/or timeframes being measured.
Nevertheless, I am on record of not being a fan of the typical academic study applied to finance. I have several problems with conclusions drawn from studies, but my major issue is with what I consider the over-generalized nature of how they are conducted. Consequently, I believe that although their conclusions may be valid based on the data as presented, I also believe they can be very misleading.
Here are but a few examples of conclusions that I contend can mislead investors. On Dec. 6, 2010, the heads of BlackRock’s global equity team suggested that 90% of U.S. equity returns over the last century have been delivered by dividends and dividend growth. A prominent money-management firm reported that according to Standard & Poor’s, the portion of total return attributable to dividends has ranged from a high of 53% during the 1940s, to a low of 14% during the 1990s. Standard & Poor’s themselves suggest that more than a third of the long-term total return of the S&P 500 can be attributed to dividends. And I have read other studies that conclude that dividend paying stocks dramatically outperform stocks that pay no dividends.
Now remember, the above are just a few samplings. In truth, there are numerous other studies that have presented varying conclusions about dividends’ contribution to total returns. As a result, I commonly come across investors quoting conclusions about dividends from studies or holding what I consider misguided opinions about dividends, dividend paying stocks and non-dividend paying stocks. Therefore, my objective with this article is to provide a more rational examination of the contributions, or their lack thereof, that dividends actually generate.
My primary position is that the contributions that dividends make vary greatly from one company to the next. This is aligned with my general position that it is a market of stocks and not a stock market. Therefore, rather than basing decisions on overly-generalized conclusions about the merits of dividend paying stocks over non-dividend paying stocks, I prefer a more individualized approach.
In other words, there are certain stocks where dividends matter a great deal, and there are certain stocks where dividends are completely irrelevant. My point being, that trying to associate dividends with returns is, in my opinion and experience, a flawed approach. Instead, I favor analyzing and evaluating the contributions that dividends have made to total return on a specific case-by-case basis.
At this point, I want it to be clear that I am not either for or against dividends in the general sense. If income is your primary investment objective, then obviously dividend paying stocks make a great deal of sense. Moreover, if highest total return is your objective, then growth stocks might be your best choice. But most importantly, I intend to demonstrate that total return is not a function of whether a company pays a dividend or not. There are many factors that drive total return, and dividends are only one of them.
Debunking the dividend paying stocks produces higher total returns myth and vice-versa
As I suggested in the introduction, dividends’ contribution to total return has been one of the most widely-studied topics in finance. When conducting research for this article, I reviewed several studies on dividends. However, for the purposes of this article, I am going to utilize a study (white paper) titled "Why Dividends Matter" produced by Dr. Ian Mortimer and Matthew Page, CFA fund co-managers of Guinness Atkinson Funds.
Like most studies and white papers I’ve reviewed, I felt this presentation was very well done and I thought it made some excellent and important points about investing in dividend stocks. Moreover, I believe that their data as presented was accurate, and therefore, the conclusions drawn also accurate as presented. However, I believe the results, although accurate, are too general in nature to support absolute conclusions regarding dividend paying stocks versus non-dividend paying stocks.
Nevertheless, for those investors that favor or follow investing in dividend paying stocks, this white paper will support their investment philosophy and beliefs. Personally, I felt this work covers many of the important salient points supporting investing in dividend paying stocks in the general sense. Therefore, I would wholeheartedly support much of what is written in this white paper.
My only problem is with the over-generalized insinuation that dividend paying stocks are superior to non-dividend paying stocks. In truth, with certain individual stocks that can be true, but I argue that it cannot, and should not be considered a universal principle. The truth is that some dividend paying stocks are superior to non-dividend paying stocks and some non-dividend paying stocks are superior to dividend paying stocks. The only true conclusion that I believe can be drawn is that it depends on the business characteristics of each individual company.
To illustrate my point, I will provide excerpts from the above document followed by examples of some companies via FAST Graphs that support and some that refute the conclusions drawn. My first excerpt includes the introduction to the article, followed by some general conclusions and a supporting graphic of dividends’ contribution to the S&P 500. It is this kind of evidence that erroneously leads many investors into believing that dividend paying stocks perform better and account for higher total returns. And frankly, on the surface, the arguments appear compelling.
“Why Dividends Matter
Investors seem to be rediscovering the power of dividends as an important element in the pursuit of long-term total returns. Following the financial crisis of 2008/9 and the resultant fall out, traditional sources of income such as government and corporate bonds and cash, lost their luster. In this paper we aim to show that, for the long-term investor, the power of dividends from equity investing has never been diminished and has in fact been slowly and surely working away, behind the scenes, adding not just appreciation in the form of total returns but can mitigate the effects of both market falls and inflation. PROFITS ARE A MATTER OF OPINION, DIVIDENDS ARE A MATTER OF FACT. Dividends are paid from real earnings and in ‘hard’ dollars – they cannot be manipulated by creative accounting. A dollar paid out to the investor is just that.
“Figure 3 below shows how the importance of dividends to total returns increases with time horizon. For an average holding period of 1 year, dividends accounted for 27% of total returns for the S&P500 since 1940. If we increase the holding period to 3 years, dividends account for 38%, 5 years it increases to 42%, over a 10 year period it rises to 48%, and with a 20 year holding period dividends account for some 60% of total returns. It is important to note, too, that here we are just looking at the S&P500 as a whole and not focusing purely on companies that actually pay a dividend. If we did, we think these results would likely be even more striking.”
This next excerpt argues in favor of companies like those found in the Dividend Aristocrats universe. I am personally invested in many Dividend Aristocrats precisely for the reasons stated below. However, I rarely invest in Dividend Aristocrats in order to achieve the highest possible total return. Instead, I invest in Dividend Aristocrats because they typically produce an above-average and consistently-growing income stream.
“If a company has a long history of paying a dividend and is very likely to continue to do so in the future, then it is highly likely that management will begin each new year by first deciding the dividend payout and then thinking about how best to use the rest of the free cash flow. This leaves no room for vanity projects or frivolous uses of shareholders capital. A focused management team that uses the cash available to them efficiently is central to creating a well run - and profitable - company that is able to grow and thrive in the future. Steady and constantly growing dividends can give us a good indication that these elements are in place.”
Procter & Gamble is an extremely high-quality company, and as the performance results below illustrate, it has moderately outperformed the S&P 500 on both a total cumulative income and capital appreciation basis since fiscal year-end June 1996.
On the other hand, since fiscal year-end June 2010, Procter & Gamble has dramatically underperformed the S&P 500 on a capital appreciation basis, but did moderately outperform on a total cumulative dividend income paid basis. Nevertheless, Procter & Gamble’s total return was significantly lower than the total return of the S&P 500 over this timeframe. Just because a company pays a dividend, it does not automatically follow that it will be an outperformer.
Low yield above-average growth
Not all dividend paying stocks are the same. Some have high yields and pay out a significant portion of earnings, while others offer lower yields with lower payout ratios. Lower yields and lower payout ratios can often be associated with faster-growing businesses that require cash to fund their growth. This next excerpt from the paper cited above addresses these needs or requirements. But most importantly, if you read it closely, it also indicates the diversity that exists among dividend payers.
“Dividend payments can act as a useful barometer to identify companies that are disciplined and efficient in their capital allocation and cash flow management. There exists an argument, however, that companies who pay a dividend are just struggling to find new growth opportunities and uses for their cash.
We think quite the opposite. In the early stages of a company’s life, it is quite right that cash is used to establish the business. It is often right that the company continues to re-deploy cash into the business as it moves through the early growth phase and into the maturity phase. Once at maturity, however, when competition has entered the market place and the opportunities for such high growth have diminished, we think it entirely sensible that the company takes stock, and carefully decides to allocate cash to only those projects where it can achieve high returns - and gives the rest back to shareholders. Why would we want management to plough back all the company’s cash regardless of the returns available?”
Multinational developer and marketer of medical technologies, CR Bard, is also a Dividend Aristocrat; however, it possesses growth and dividend payment characteristics that are significantly different from what we saw with Procter & Gamble. CR Bard offers investors a very low yield and a low payout ratio. This is an example of a company that is growing at above-average rates and continues to need capital to fund that growth.
Even with its low yield and low dividend payout ratio, fast-growing CR Bard has significantly outperformed the S&P 500 on both capital appreciation and total cumulative dividends paid. But importantly as it relates to the thesis of this article, the majority of total return has come through capital appreciation. In other words, earnings growth, not dividends are what created such a high return.
High-yield moderate growth
To further illustrate how different various dividend paying stocks can be, I offer two additional Dividend Aristocrats offering high-yield but moderate growth. The first is a healthcare REIT and the other a utility stock. Both of these dividend paying stocks represent examples of investments where a significant portion of total return comes from dividends. However, with both examples, capital appreciation lagged the S&P 500.
Growth morphing to dividend growth
My next two examples represent well-known growth stocks that have only recently morphed into dividend paying stocks. When you analyze the past performance of these two examples, there are two interesting things to note. Both of these companies have outperformed the S&P 500 on a total cumulative dividends paid basis since their 1997 fiscal year-ends. This is in spite of the fact that they’ve only paid dividends in recent years. However, the majority of their total returns have been generated through capital appreciation and both have soundly outperformed the S&P 500.
Note: The timeframe for this performance calculation is slightly different than my other examples because of the company’s September fiscal year-end. Therefore, the S&P 500 performance calculation is also calculated over a slightly different timeframe.
Performance: S&P 500 non-dividend payers
These next excerpts from the paper cited above claims that dividend paying stocks outperform non-payers. The language in the second excerpt is especially strong indicating that dividends have been the main contributors to total return in equity investments. However, I have already presented several examples that prove that this conclusion is not universally valid.
“There are always exceptions to any rule, and there will always be examples of companies that have such a unique product or service that they can continue to grow for much longer than the average company. Simple mathematics, however, dictates that even these companies cannot grow forever. Indeed, if we look at the historical evidence for the benefits of company management focusing on dividends we can see a strong relation between total return performance and the company’s approach to dividend policy.”
“The evidence for this can be seen in Figure 1(not shown here). If we split all the companies in the S&P500 into separate buckets depending on their approach to dividends, we can see that dividend payers have outperformed the broad market, and dividend nonpayers significantly underperformed. HISTORICAL PERSPECTIVE Over the long term, dividends have been the main contributors to total return in equity investments.”
Since Dec. 31, 1997, the non-dividend payer Monster Beverage Corporation has been the best performing stock in the S&P 500. No dividend paying member of the S&P 500 did better. Consequently, the broad statement “dividend payers have outperformed the broad market, and dividend nonpayers significantly underperformed” is categorically false with this example. The performance generated by Monster Beverage is solely attributed to its extremely high earnings growth achievement.
On the other hand, Tenet Healthcare Corp. is one of the worst performing stocks of the S&P 500 and is also a non-dividend payer. The reason this particular S&P 500 constituent underperformed is because its business underperformed. The lack of paying a dividend was really not a significant factor.
Summary and conclusions
I believe that investors should have realistic understandings and beliefs about their investments. Therefore, even though the notions that dividend paying stocks outperform non-dividend paying stocks or that the majority of returns come from dividends are widely studied and promoted, they are not true in the purest sense. There are many non-dividend paying stocks that are superior performers, and there are many dividend paying stocks that are also superior performers. To over-generalize and state that dividend paying stocks outperform is an erroneous belief, even though there are studies that suggest it to be true.
The best reasons for choosing a stock is when you believe and understand that it is capable of meeting your specific investment objectives. Retired investors might logically choose dividend paying stocks for the income they produce. However, they should not delude themselves into believing that this will lead to outperformance or the highest possible total returns. There are many benefits to investing in dividend stocks, and many do in fact produce attractive capital appreciation.
However, I believe it is illogical to assume that the majority of your return will automatically come from dividends, or that dividends produce higher returns. In some cases they do, but in many cases they do not. Rather than make investment decisions based on generalities, I believe it makes more sense to conduct a deep analysis of the individual companies you are interested in investing in. Moreover, when you do that, you can determine how much of your return might come from dividends, and how much from potential capital appreciation. And, you are likely to discover that every company is unique and different in its own right.
I believe it is a market of stocks and not a stock market. More importantly, I believe that portfolios should be built one company at a time, and only include companies that meet your unique investment objectives. Investment returns come from numerous factors, and dividends are only one contributor.
Disclosure: Long PG, ED, AMGN.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.