Companies have been paying dividends to their shareholders since the 1600s and have given investors good reason to hold onto their shares for long time periods. For many investors, dividends not only provide a steady stream of income, they reinforce the reasons they invested in those companies in the first place. For those seeking income as a primary goal, many investors turn to “widow and orphan stocks”, a name given to higher-paying dividend stocks that were historically considered to provide income and be less sensitive to market volatility. Along the way, some investors disconnected the value of dividends and became more excited with price growth.
While watching stock prices move might be more newsworthy, the fact is that since 1926 dividends have contributed to at least 45% of the total return of stocks in the S&P 500. Investors often seek out high-paying dividends when interest rates are historically low, which drives prices higher in sectors like utilities, consumer staples and telecommunications. When investors roar back into these sectors, they typically grab the highest-paying dividend stocks, which may not be the best practice because not all dividends are the same. Companies that focus on growing their dividends have performed better historically and with less risk than those that pay no dividends, don’t increase them or cut them.
What are Dividends?
To really understand the role dividends play, it’s important to know exactly where they come from. Boards of directors follow a formal process to declare dividends that will be paid to shareholders. Dividends are most commonly given quarterly in cash from retained earnings, but they can also come in the form of stock. Companies are not required to pay any dividends at all, but they may choose to give portions of their earnings back to shareholders as an incentive to keep investing in their companies. Paying dividends also provides a long-term bond between an investor and the companies - a bond that may explain why investors are less likely to sell their shares when markets drop.
What Kinds of Companies Pay Dividends?
Companies travel through a relatively predictable life cycle and usually reinvest all profits back into the company during their early growth stages. As those companies mature and become more stable, they start paying back their shareholders with dividends. While most any type of company can pay a dividend, companies typically wait to pay dividends after less capital is required for reinvestment to grow the company. Companies pay a wide range of dividends from high to low. The most common reference to high-dividend stocks is blue chip, which tends to include larger, more established and even multinational companies.
The demand and attention growth stocks received in the late 1990s shifted many investors away from the boring, stodgy blue chip stocks into the waiting arms of the internet boom. The technology sector of the S&P 500 ballooned as money flowed out of income stocks into growth stocks. While growth and value/income stocks have natural flows in and out of favor, value/income stocks experienced an unprecedented fall from favor from 1996-2000, right up until the Tech Bubble burst. This burst created an almost immediate reversal back into defensive stocks that had been shunned during the Techmania. Once again stocks in energy, utilities and food regained their popularity for their more defensive nature - and those good old dividends.
We already know that dividends have played a large part in the total return of stock over long time periods, but they have also proven themselves in volatile market cycles. The chart below compares how dividend-paying stocks have rewarded investors over various time frames. Since there is usually a high correlation among stocks during bull markets, it’s not surprising that both dividend-paying stocks and non-paying stocks both performed well in up markets. Dividend-paying stocks really shine during bear markets, when they typically hold their value better and shareholders continue to receive income throughout the cycle. In the far right column, it’s very clear that over a 20-year period, dividend-paying stocks are on top. While the sexy and trendy stocks get all the media attention, except for a few long-term success stories of a few lucky growth stocks, it’s generally the blue chips on top.
Are All Dividends the Same?
Absolutely not. On paper, two companies can have the same divendend yield, but the reasons for those yields can vary. It would be very easy for an investor to think a stock paying a 5% dividend is better than one paying 3%. The reason more detailed analysis is needed is that not only have dividend-paying companies outperformed the general market, companies that consistently grew their dividends performed even better with less volatility. While the difference in total return is nominal between dividend payers and dividend growers, just paying a dividend at all added nearly a full percentage point of total return over time. Dividend growers not only added value, but experienced far less volatility during both bull and bear markets from 1996-2012. The most compelling proof indicates companies that cut their dividends over this time period were twice as volatile as those that increased their dividends.
The Bottom Line
For investors who focus on stocks the media swarms around or the trend of the day, dividends may not be important. While dividends are the more reliable portion of a stock's total return and often reflect the actual underlying health of the company, changes in price seem to grab the most attention. For investors with a long-term perspective, dividends clearly have not only added value to total return but have experienced less volatility. It is very important to point out that not all dividends are the same and require some review to determine which direction they are headed. A casual comparison of dividend yields is not the best way to choose stocks. While companies that pay dividends just to keep their shareholders complacent do well over time, it’s the companies that grow dividends that really shine over the long run.