During the dotcom boom of the late 1990s, the notion of dividend investing was laughable. Back then, everything was going up in double-digit percentages, and nobody wanted to fool around with the meager 2% to 3% gain from dividends. After all, we were in the "new economy"—the rules changed and companies that paid dividends were "too old economy."
After the bull market of the '90s ended, the fickle mob once again found dividends attractive. For many investors, dividend-paying stocks have come to make a lot of sense. Although we've seen several market surges since the '90s, more and more of the breakneck growth in stocks is happening in the hands of private investors as venture capital continues to grow. This has made those boring dividend stocks one of the best games in town for regular investors.
In this article, we'll explain what dividends are and how you can make them work for you.
The What and Why of Dividends
A dividend is a cash payment from a company's earnings. It is announced by a company's board of directors and distributed among stockholders. In other words, dividends are an investor's share of a company's profits and are given to him as a part-owner of the company. Aside from option strategies, dividends are the only way for investors to profit from ownership of stock without eliminating their stake in the company.
When a company earns profits from operations, management can do one of two things with the profits. It can choose to retain them—essentially reinvesting them into the company with the hope of creating more profits and thus further stock appreciation. The other alternative is to distribute a portion of the profits to shareholders in the form of dividends. Management can also opt to repurchase some of its own shares—a move that would also benefit shareholders.
A company must keep growing at an above-average pace to justify reinvesting in itself rather than paying a dividend. Generally speaking, when a company's growth slows, its stock won't climb as much, and dividends will be necessary to keep shareholders around. The slowdown of this growth happens to virtually all companies after they attain a large market capitalization. A company will simply reach a size at which it no longer has the potential to grow at annual rates of 30% to 40% like a small cap, regardless of how much money is plowed back into it. At a certain point, the law of large numbers makes a mega-cap company and growth rates that outperform the market an impossible combination.
Dividend: My Favorite Financial Term
Together Again: Microsoft and Apple
The changes witnessed in Microsoft in 2003 are a perfect illustration of what can happen when a firm's growth levels off. In January 2003, the company finally announced it would pay a dividend: Microsoft had so much cash in the bank that it simply couldn't find enough worthwhile projects to spend it on. After all, you can't be a high-flying growth stock forever!
The fact that Microsoft started to pay dividends did not signal the company's demise. Instead, it indicated that Microsoft became a huge company and had entered a new stage in its life cycle, which meant it probably would not be able to double and triple at the pace it once did. In September 2018, Microsoft announced it was raising its dividend by 9.5% to 46 cents per share.
This same story unfolded at Apple. Apple has long positioned itself as the anti-Microsoft with no better use for cash than piling it back into the company or into acquisitions. In 2012, however, Apple started paying a dividend and surpassed dividend darling Exxon in 2017 to pay the biggest dividend in the world. As of November 2018, Apple paid shareholders a dividend of 73 cents per share.
Dividends Won't Mislead You
By choosing to pay dividends, management is essentially conceding that profits from operations are better off being distributed to the shareholders than being put back into the company. In other words, management feels that reinvesting profits to achieve further growth will not offer the shareholder as high a return as a distribution in the form of dividends.
There is another motivation for a company to pay dividends — a steadily increasing dividend payout is viewed as a strong indication of a company's continuing success. The great thing about dividends is that they can't be faked. They are either paid or not paid, increased or not increased.
This isn't the case with earnings, which are basically an accountant's best guess of a company's profitability. All too often, companies must restate their past reported earnings because of aggressive accounting practices, and this can cause considerable trouble for investors, who may have already based future stock price predictions on these (unreliable) historical earnings.
Expected growth rates are also unreliable. A company can talk a big game about wonderful growth opportunities that will pay off several years down the road, but there are no guarantees it will make the most of its reinvested earnings. When a company's robust plans for the future (which impact its share price today) fail to materialize, your portfolio will very likely take a hit.
However, you can rest assured that no accountant can restate dividends and take back your dividend check. Moreover, dividends can't be squandered away by the company on business expansions that don't pan out. The dividends you receive from your stocks are 100% yours. You can use them to do anything you like—pay down your mortgage, spend it as discretionary income or buy the stock of a company you think has better growth prospects.
Who Determines Dividend Policy?
The company's board of directors decides what percentage of earnings will be paid out to shareholders, and then puts the remaining profits back into the company. Although dividends are usually dispersed quarterly, it is important to remember the company is not obligated to pay a dividend every single quarter. In fact, the company can stop paying a dividend at any time. But this is rare—especially for a firm with a long history of dividend payments.
If people were used to getting their quarterly dividends from a mature company, a sudden stop in payments to investors would be akin to corporate financial suicide. Unless the decision to discontinue dividend payments was backed by some kind of strategy shift—say investing all retained earnings into robust expansion projects—it would indicate something was fundamentally wrong with the company. For this reason, the board of directors will usually go to great lengths to keep paying at least the same dividend amount.
How Stocks That Pay Dividends Resemble Bonds
When assessing the pros and cons of dividend-paying stocks, you will also want to consider their volatility and share price performance compared to those of outright growth stocks that pay no dividends.
Because public companies generally face adverse reactions from the marketplace if they discontinue or reduce their dividend payments, investors can be reasonably certain they will receive dividend income on a regular basis for as long as they hold their shares. Therefore, investors tend to rely on dividends in much the same way that they rely on interest payments from corporate bonds and debentures.
Since they can be regarded as quasi-bonds, dividend-paying stocks tend to exhibit pricing characteristics that are moderately different from those of growth stocks. This is because they provide regular income that is similar to a bond, but they still provide investors with the potential to benefit from share price appreciation if the company does well.
Investors looking for exposure to the growth potential of the equity market, combined with the safety of the (moderately) fixed income provided by dividends, should consider adding stocks with high dividend yields to their portfolio. A portfolio with dividend-paying stocks is likely to see less price volatility than a growth stock portfolio.
Know the Risks
Dividends are never guaranteed and are subject to company-specific and market-related risks just like share prices. During times of turbulence, management will have to make a decision about what to do with its dividends.
Take the banking sector during the financial crisis of 2008-2009. Before the crisis, banks were known for paying high dividends to their shareholders. Investors considered these stocks to be stable with high yields. But when the banks started to fail and the government intervened with bailouts, dividend yields surged while share prices fell. For example, Wells Fargo offered a dividend yield of 3% in 2006 and 2007 but hiked it up to 4.5% in 2008. The bank was forced to drop its dividend from 38 cents to 5 cents in 2009.
The Bottom Line
A company can't keep growing forever. When it reaches a certain size and exhausts its growth potential, distributing dividends is perhaps the best way for management to ensure that shareholders receive a return from the company's earnings. A dividend announcement may be a sign that a company's growth has slowed, but it is also evidence of a sustainable capacity to make money. This sustainable income will likely produce some price stability when paid out regularly as dividends. Best of all, the cash in your hand is proof that the earnings are really there, and you can reinvest or spend them as you see fit.