Published January 27th, 2017 by The Financial Canadian
Looking at the dividend yields of many of the more popular dividend growth stocks, it can be questionable why shareholders are so fixed on dividends.
For instance, consider the dividend yields of some of the most popular dividend growth stocks:
- Johnson & Johnson (JNJ) dividend yield: 2.8%
- Coca-Cola (KO) dividend yield: 3.4%
- AT&T (T) dividend yield: 4.7%
While these yields are slightly better than the current 10-year U.S. government bond yield of <2.5%, they are not spectacular.
So why the fascination with dividends?
Dividends are the only way for an investor to profit from investing in a company without reducing or eliminating their ownership stake.
There any many other reasons why dividends benefit shareholders.
This article will discuss the shareholder importance of dividends in detail.
Relationship to Total Returns
One of the primary reasons why investors are interested in dividend payments is because of their relationship to total returns. More specifically, total returns exhibit a high degree of correlation with dividend increases.
To provide evidence of this, I took a Canadian sample of high-quality dividend paying stocks and examined the long-term (2000-2015) correlations between various financial metrics and total returns. My goal was to include metrics that were commonly believed to be related to business success.
Here are the results of that analysis.
Source: Publicly-available financial statements
In the above table, there is a column for each financial metric and a row for each company included in the analysis. The bottom row, separated from the rest of the table, is an average of the correlations for each company with that column’s financial metric.
Dividends had the highest correlation among any metrics. This means that increasing dividends is a better indicator of total returns than any other metric included in the table (even earnings per share).
After considering this data, it should not be surprising that dividend growth stocks have beaten benchmarks like the S&P 500 Index over the long run. One specific observation is the outperformance of the Dividend Aristocrats – companies with 25+ years of consecutive dividend increases.
You can see all 50 Dividend Aristocrats here. The following chart compares the total returns of the Dividend Aristocrats versus the broader S&P 500 Index.
Source: Dividend Aristocrats Factsheet
The Dividend Aristocrats have outperformed the S&P 500 by a wide margin. Looking at the 10-year time period in particular, the Dividend Aristocrats have returned 9.7% compared to the S&P 500’s 7.0% – an outperformance of 2.7%.
Clearly, one of the primary reasons investors care about dividends is because they are a strong indicator of total returns.
The Benefit of an Income Stream
Another reason why there is such a focus on dividends is because it allows investors to create a truly passive income stream.
With disciplined savings and a systematic, long-term investing strategy, it’s possible to fully replicate your day job income with dividend payments. In other words, it’s possible to create early retirement through dividend stocks.
A secondary benefit of this income stream is that it allows investors to have a longer holding period for common stocks, oftentimes longer than would otherwise be possible.
This lengthened time horizon is extremely beneficial – and I’m not the only one who thinks so:
“The single greatest edge an investor can have is a long-term orientation.”
– Seth Klarman
Seth Klarman is the billionaire founder of the Baupost Group hedge fund. His quote is true for many reasons.
First of all, long-term investing allows investors to ride out any temporary market turbulence.
While the market crashed during the financial crisis of 2008-2009, many quality companies continued to pay dividends, which returned capital to investors without requiring them to sell their stakes.
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
– Benjamin Graham
In most cases, the sale of securities would have been the wrong choice, as the stock market as measured by the S&P 500 has more than rebounded, delivering tremendous returns. As time passed, investors began realizing the true value of the businesses underlying these stocks as the market reverted to behaving more like a ‘weighing machine’.
Investors with long time horizons enabled by dividend payments benefitted the most.
A Reduction in Volatility
Dividend stocks in general tend to have lower volatilities than their non-dividend-paying counterparties. This is because dividend-paying stocks tend to be large, mature business operating in stable industries like consumer staples, utilities, or consumer defensive sectors.
For example, Johnson & Johnson’s stock has a notably low stock volatility.
Dividend payments further decrease the portfolio volatility (beyond just the low stock price volatility of these high quality companies). Since these cash payments arrive on a regular basis, quarter after quarter, portfolio returns are ‘smoothed out’ by virtue of these dividends.
Why is volatility important? Some investors would argue that with a long enough time horizon, the importance of volatility in portfolio management becomes null.
This is not actually the case. While a long time horizon might weaken the importance of minimizing portfolio volatility, it does not eliminate it completely. This is because lower volatility is associated with higher absolute returns, all other things being equal.
Since lower volatility benefits investors and dividend payments reduce portfolio volatility, then this provides additional evidence for the benefits of dividends.
Thinking Like an Owner, Not Just an Investor
The last benefit of dividend payments cannot be fully understood without thinking like a business owner rather than simply an investor. After all, publicly-traded shares are simply a conduit through which shareholders own a business’ assets.
“We (Warren Buffett & Charlie Munger) do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.”
– Warren Buffett, Berkshire Hathaway 2013 Annual Report
The last benefit of dividends that I’ll discuss in this article is related to the financial obligation that dividends represent to a company’s management.
Imagine that you own a small business with many outside investors. These investors are fully expecting you to continue to pay them rising dividend payments over the years.
While it’s not treated like this for accounting purposes, future dividend payments can be considered as a liability for your business – a future payment that is expected to be made.
The dependency of these outside investors on their dividend payments would make you (the business operator) make much more prudent business decisions.
This increased risk management can only be a benefit for you, your company, and your fellow business owners.
Clearly there are many reasons why shareholders care about the dividend payments they receive.
Most notably is the strong relationship between rising dividend payments and total returns. Dividend payments also allow investor to benefit from a longer time horizon without reducing or eliminating ownership. Dividend payments also smooth out portfolio volatility while incentivizing companies to make more prudent financial decisions.
Because of all these factors, I can say with confidence that dividends will continue to reward investors for a long, long time.