The Importance of Dividends

Rick Welch |

Dividends play an important role in the total returns investors receive from their investment portfolios.  The formula for total return is the sum of stock price change plus dividends paid divided by the period beginning stock price.  When a company pays a dividend, it is returning a portion of the profits it earned to its shareholders via a cash distribution. Investors often view dividends as both a reflection of the company’s past performance as well as its potential for future growth. In 2017, among the constituents of the S&P 500 Index there were 419 companies which distributed a cash dividend to shareholders. At the close of 2017, 155 of those companies had dividend yields higher than the benchmark 10-year US Treasury (2.40%).  Since 2010, dividend paying S&P 500 stocks have an average annual total return of +14.05% versus +13.12% for non-payers.  During that period, the dividend contribution to total return was 17%. Over a much longer time period (1930 – present) we see that dividend contribution averaged 42%.  It is interesting to note that from 2000 to 2009, a period which many investors refer to as the “lost decade,” the total return for the S&P 500 Index was -1.0%, with price change of -2.8% and dividend distribution rate of 1.8%.

What can dividends tell us about a stock and the company paying the dividends? Actually, quite a lot. First, dividend paying stocks not only provide some income during periods of declining equity markets, they also tend to smooth out portfolio volatility as they often have a beta under 1.0. During periods of low interest rates, the promise of both a dependable return and lower volatility may suggest to some investors that dividend paying stocks are a proxy for fixed income assets, like bonds. This notion can backfire however as dividend paying stocks, while providing both stability and downside protection, will be more volatile and exposed to deeper losses than investment grade domestic fixed income assets. The ability to grow its dividend payments is often viewed as a reliable indicator of a company’s financial health and stability. Companies that consistently grow their dividends often exhibit strong fundamentals, clearly communicated business plans and a firm commitment to their shareholders.  Another school of thought is that the pressure to both pay and grow dividends imposes a fiscal discipline on companies that is a positive and meaningful one for all stakeholders.

With this new knowledge, should we now invest in the highest dividend yielding stocks we can find? Not so fast.  Studies have shown that, as a group, those stocks within the S&P 500 with the highest dividend payout are not often among the top performers when based on total return. There are several reasons for this finding. First, many top dividend paying stocks are found in slow growth sectors like utilities and telecommunications. In these sectors annual total return often comes more from the generous dividend than from stock price appreciation.  A second factor to consider is the dividend payout ratio which is calculated by dividing the yearly dividend per share by the earnings per share or more simply is the percent of total corporate profits that are paid out to shareholders in the form of dividends.  With the exception of real estate investment trusts (REITs) and Master Limited Partnerships (MLPs), both which have payout ratios over 90%, most analysts consider a safe forward-looking dividend payout ratio to be between 40% and 50%.  A payout ratio in this range provides income for shareholders while leaving ample cash to invest in research and development or expansion of the business.  Low payout ratios may suggest that the company prefers to use most or all of its profits for investment in its business or for the repurchase of shares.