Dividends in the Rear View Mirror

Many decades ago, long before the days of company issued earnings guidance, full disclosure, and Sarbanes-Oxley, the time was when dividends were the be all and end all of stock market selection. Over time, though, and particularly in the United States as the country’s economic might grew in the last century, price appreciation potential increasingly became the prime driver behind the populace’s view of what constituted a good “investment”. This became even more ingrained  during periods of rapid escalation in market prices, such as the Roaring Twenties, the Go-Go Sixties, and, within more recent memory, the Tech Bubble years that closed out the Nineties.

Excluding the occasional reversal along the way, dividend yields steadily drifted down over the decades, as stock prices largely marched upwards. Broader market yields peaked at over 9% at the depths of the Great Depression, then 5% payouts disappeared into the history books in the dark days of the late 1970’s, and, with the recent exception of 2008, we hadn’t seen 3% since 1991.

Little things mean a lot. Or, the longer the better.

Numerous studies have been conducted over the years comparing stock market performance with and without dividend reinvestment. Results naturally varied, depending on the different periods examined (whether started in bull or bear markets, when yields were high or low, length of time, etc). But, generally, it was found that despite these apparently diminishing returns, dividend reinvestment strategies provided superior performance over extended periods.

Though seemingly a trifle compared to price appreciation, over the last 100 years or so these small payouts have generated (on average) about one-third of total returns, and, thanks to the multiplying effect of compounding, this number approximates 50% over 10-year holding periods, and mathematically inches ever closer to 100% when using longer time frames. 

Downside Protection

As an added bonus, this income stream has traditionally provided downside support during weak markets and helped to accelerate recovery times. One classic example from the history books is the infamous crash of 1929. Investors unlucky enough to get in at the peak (and hang on) would have had to wait about 25 years for prices to make up their losses. Following the strategy of reinvesting dividends would have shortened the wait by roughly 10 years. Moreover, when the market did eventually get back to its old highs, these patient investors would have been up about three fold, even with their untimely entry.

Intuitively, one would think that this impact was more prominent in the past, when dividend payouts were greater, but even in today’s low-interest-rate environment, dividends can make all the difference.  The most recent decade’s performance provides a compelling example. Investors who bought into the S&P 500 at the start of 2000 and held on would, 10 years later, have found that the nominal value of their holdings had actually declined about 24%. (A rare occurrence for any decade, to be sure, but individuals rarely time their investment moves to coincide with 10-year calendar periods and, overall, the likelihood of any individual getting in at the wrong time is fairly large.) However, adhering to a discipline of reinvesting dividends (small as they may have been) at the end of each year would have pared the loss to about 9%. Moreover, just in the past five years ended in April 30, 2010, the S&P 500 returned a nominal average of 0.51% a year. Factoring in dividends lifted that to 2.63%, and this includes 2008, when the S&P had its worst drop since 1932.

More reasons to like dividends

In three words; dividends don’t lie.  Generally accepted accounting principles (GAAP) allow enough leeway for management to skew earnings to paint a better picture of performance. This “creative accounting” was taken to extremes in recent history, where companies were found to have significantly exaggerated their financial performance. On the other hand, unlike earnings, dividends cannot be disputed. They’re either paid out, or they’re not. As such, a consistent payout underscores a company’s cash generation capabilities, while dividend increases serve to demonstrate management’s confidence in the future. Moreover, if the company doesn’t have the cash and decides to borrow to keep up appearances (or demand for their stock in the capital markets), trouble usually follows.

Another positive factor for solid, dividend paying companies is the fact that income seekers have been driven to distraction by the low rates paid by savings accounts, money market instruments, and short-term bonds. Suddenly, the previously scorned few percentage points offered by equities are being seen in a new light, creating increased demand for good-yielding stocks. Adding to this, as baby boomers retire, they will increasingly seek out income generating vehicles.
Also factoring into the demand equation, all things being equal, lower share prices make for higher dividend yields, and value investors will take that opportunity to load up and lock in steady, attractive payouts, which adds downside support.

Some Caveats

As has been demonstrated repeatedly by the market’s gyrations, a year’s worth of dividends can be wiped out in minutes, or even seconds, of stock price action. As such, this is no path for the timid. Over the short run, price changes account for the bulk of performance,  so patience and time are required for compounding to work its magic.  Also, dividends can be cut in hard times. Indeed, 2009 marked the worst year in terms of dividend reductions (and the fewest increases) in the S&P since records were kept going back to 1955.

Another point to keep in mind is that higher-than-average dividends (compared to industry peers) are usually warning signs that the company (or the payout) may soon be in trouble. One advisable course of action is to seek out companies that have regularly increased their payouts for years, if not decades. Going under such royal-sounding monikers as Dividend Achievers, Aristocrats, and Champions, these include the likes of such household names as TheSherwin-Williams Co. (SHW), McDonald’s Corp. (MCD), Kimberly-Clark (KMB), Target Corp. (TGT) and Clorox Co. (CLX).

Also, while dividends provide superior returns in flat or down markets, these tend to be mature companies with slower growth prospects, and holding on to them can be disappointing when other stocks are really flying. However, investor expectations of eternal bull markets are changing.  Namely, the “lost decade” of 2000-2009 likely at least adjusted the common perception that stocks only go up over long periods.

Now Looks To Be As Good A Time As Any

The March 2009 lows hit by the major indexes seemingly provided a rare window of opportunity for this strategy, as yields on the S&P 500 Index jumped to around 3.4%, a level not seen since late 1990. Recovering stock prices have removed some of the luster, but the recent yield of around 2% compares favorably with the 1.56% average over the prior 10 years and with many fixed-income alternatives.

Unlike market timing strategies, this discipline tends to work best with a dollar-cost-averaging approach, whereby equal amounts are invested at regular intervals (monthly, quarterly, or yearly), thereby avoiding the mistake of putting all of one’s eggs into the basket when yields are too low. Investors can also take advantage of company-sponsored dividend reinvestment plans as a way to accumulate shares. For the more time constrained, the strategy can easily be pursued using mutual funds and ETFs that focus on stocks with rising dividends.