Dividends are every investor's best friend. Indeed, if you don’t own dividend stocks, it’s likely that you’ll underperform the market over the long term. Several studies have shown this to be true.
According to a report from credit rating agency Standard and Poor's, over the last 80 years dividends have been responsible for 44% of S&P 500 returns. Specifically, 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.
But over the years the concept of the dividend has changed. It used to be the case that investors evaluated a company entirely on its dividend payout. Investors want to be compensated for the risk they are taking. What’s more, the clear difference between investment and speculation is that investing is buying a stream of cash flows, i.e., dividends, while speculating is betting on a higher stock price. As Benjamin Graham described in 1946:
“When I came down to the Street in 1914, an investment issue was not regarded as
speculative, and it wasn’t speculative. Its price was based primarily upon an established dividend. It fluctuated relatively little in ordinary years. And even in years of considerable market and business changes the price of investment issues did not go through very wide fluctuations. It was quite possible for the investor, if he wished, to disregard price changes completely, considering only the soundness and dependability of his dividend return, and let it go at that – perhaps every now and then subjecting his issue to a prudent scrutiny.”
The concept of the dividend has also changed from management’s point of view. Historically, the payout would be covered several times by earnings to give the most flexibility; today, dividend payouts are usually covered only once or twice by earnings.
The high yield (low cover) is not always the better choice. There’s plenty of research that shows that the best dividends come from those firms that have a high level of cover, with room for growth – bad news for yield chasers.
”‹Don't chase yield
According to research conducted by Société Générale, on average, the spread between the expected dividend yield (the payout analysts expect) of a particular stock, and the realized yield (the payout that investors receive) starts to widen above 4%. The figures show that historically if a stock’s expected dividend yield is greater than 4%, the chance of the actual payout being less than the market expects increases with every 100bps increase in yield.
The power of compounding ensures that over time, a low dividend yield becomes a large one. At the beginning of this year I covered some figures from Bank of America (BAC, Financial) that show that today only 2% of 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.
In other words, if you’re prepared to wait, buying the low-yielding equity will pay off over time.
”‹The lower the better
Further research supports the high payout ratio, low yield view. Credit Suisse considered the returns of dividend stocks with high yields and low payout ratios and those with high yields and high payout ratios between 1990 and June 2006. The bank’s research revealed that those stocks with a high payout ratio and high dividend yield returned an annualized 11% while stocks with a low payout ratio and high dividend yield returned a staggering 19.2% annualized.
The study didn’t reveal exactly why this pattern existed but considering the low payout companies had more room for dividend growth and extra cash available for investment into operations to drive growth; it’s easy to conclude that the high payout ratio companies performed better purely because they had more room to grow.
Disclosure: The author owns no share mentioned.
