Dividends: Why You Need Them

Dividends are key for any portfolio

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May 30, 2017
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As any seasoned investor will tell you, dividend stocks should form the base of any portfolio. Indeed, without dividend stocks, you are opening yourself up to a possible lifetime of underperformance as multiple studies have shown that, over the long term, it is dividends not capital gains that produce the majority of returns for portfolios.

According to a recent report from credit ratings agency Standard and Poor's, over the last 80 years dividends have been responsible for 44% of S&P 500 returns.

The bulk of returns

From the end of 1929 through March 2, 2012, an investment in the S&P 500 would have returned 5.2% per annum excluding income, a modest return. If you include income, the index has returned 9.4% per annum.

The effects of compounding mean that this additional 4.2% per annum return is enough to revolutionize your portfolio's performance. A hypothetical $100 investment made at the end of 1929 would be worth $6,566 by the end of March 12 based on price change alone. Add in the compounding effect of dividends, and the same hypothetical $100 investment would be worth a staggering $162,925  24.8 times greater, a return achieved by nothing more than dividend reinvestment.

Dividends are back in vogue

Luckily for income investors, companies are once again warming to the idea of dividends after several years of buyback preference. According to a recent research report from Bank of America, dividends are now the second-largest use of cash following Capex among S&P 500 companies, eclipsing net buybacks for the first time since 2013.

This trend seems set to continue with S&P 500 companies sitting on record levels of cash. Nonfinancial S&P 500 firms had over $1.7 trillion in cash or 10% of their market value at the end of 2016 leaving plenty of firepower for additional cash returns to investors.

Companies have been ramping up distributions since 2011. The S&P 500 dividend payout ratio hit a 110-year low (the farthest Bank of America's data goes back) during 2011 of 26%; the ratio has grown to 38% since. Nonetheless, while this gain represents more than a 40% increase, the payout ratio remains well below its historical average of 53%. Since 2007 aggregate dividends have grown by 61% while spending on buybacks has fallen by 9%.

The best way to play this trend, and indeed the best way to play the dividend trend overall, is to invest in dividend compounders, those stocks that have room to grow their dividend payouts substantially over the next few years.

Dividend compounders

A stock that currently yields 3% may not be attractive to income investors today, but if the company can continue to compound its dividend payout of 15% per year, it can double its yield on the original investment in just five years.

Some figures from Bank of America show just how significant this trend is. For example, today only 2% the companies in the S&P 500 support a dividend yield of more than 5%. But 23% of the index's constituents support a yield of more than 5% based on their share price 10 years ago and almost 70% support a yield of more than 5% based on the price 20 years ago.

If you acquire a company with a dividend yield of 3% today and it is planning to grow its payout by 15% for the next five years, by mid-2022 the stock will yield 6%. Per annum dividend payout growth of 20% will give a yield on cost of 7.5% within five years.

The bottom line

The best investment returns are only available if you prioritize dividends in your investment strategy. Without dividends, returns will be severely impacted; long-term investment performance will be substantially below the market average.

The best way to find the most durable long-term dividend champions is to find those stocks that offer a modest yield but have room for growth. Over time the yield on cost will grow steadily, and by using this approach, you won't have to pay over the odds for an income champion that may have limited room to increase its payout. To put it another way, dividends are an essential part of investing, but not all dividends are created equal.

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