Don’t underestimate the power of dividends

Investors today are focusing on dividend-paying stocks as the search for income and market-beating returns intensifies during periods of economic uncertainty.

But although dividends have been the backbone of stock market returns for the better part of a century, dividend-paying companies have commonly been perceived as boring, low-return opportunities.

In reality, they’re a great way to pump up the returns of any portfolio. Combine that with the upside potential of owning shares in great businesses that are undervalued, and you have something powerful enough to get excited about.

For example, Johnson & Johnson has increased its dividend every year for the past 50 years. Over the past decade, the company has boosted payout at an average rate of 12.4% a year. Investors are well served by the predictability of dividends to help stabilize and boost their portfolio earnings. Even better than the return from a dividend payout is the potential of the stocks themselves.

Renowned Wharton finance professor Jeremy Siegel is an advocate for the long-term benefits of investing in dividend-paying stocks. He points out they beat non-dividend paying stocks and have outperformed the S&P 500.

A closer look

From 1999 to 2010, the median return from stocks with a market cap above $1 billion was -3.2%. By picking out stocks in that group providing a minimum dividend yield of 3%, those stocks fared much better and delivered an average 28% gain (not adjusted for dividend returns).

Also, between 1972 and 2010, dividend-paying stocks in the S&P 500 returned 8.8%per year, while their non-dividend-paying counterparts returned a mere 1.4%. Even better, reinvested dividends have accounted for nearly 50% of total equity return since the 1930s.

Reinvesting dividends allows investors to take advantage of market slumps by putting the money to work in the purchase of undervalued shares. A Value Line article entitled “Yielding to the Allure of Dividends” provides us with an example from the market crash of 1929, where investors who got in at the peak of the rally would have to wait 25 years after the crash for the market to reach its previous highs. On the other hand, those who reinvested the dividends they received reduced the necessary time by approximately 10 years. Given this newfound love for dividends, investment strategies such as the “Dogs of the Dow” have become wildly popular.

This simple value-oriented approach involves picking 10 stocks with the highest dividend yields (and therefore lowest stock prices) out of the 30 that make up the Dow Jones Industrial Average. The Dogs of the Dow are businesses that have been pushed down in price due to their less-than-stellar performances. Assuming that as a group the dogs aren’t much better or worse than those in the rest of the Dow, the idea may have some merit. Benjamin Graham wrote in The Intelligent Investor that large companies almost never completely fail. Instead, they go through varying periods of struggle and success.

History has shown us the market eventually realizes the full potential of undervalued stocks, so it comes as no surprise the Dogs have outperformed the Dow by an average 3% a year.

Siegel takes this concept one step further by applying it to the S&P 500 index. The top 100 yielding stocks returned 3% more than the index itself, whereas the lowest-yielding stocks lagged by almost 2% per year. Similarly, if you whittle down your selection from 100 to the 10 highest-yielding stocks, returns have historically averaged at least 4.5% per year more than the index. More importantly, companies that pay out dividends have an increased level of discipline in investment decision-making, and a generally higher level of efficiency in the use of capital. On the other hand, companies that simply hold on to profits have shown a propensity for excessive executive compensation, sloppy management and an overall unproductive use of assets.

The more cash a company keeps on hand, the more likely it is to overpay for acquisitions and, in turn, to damage shareholder value. In the dividend-paying kingdom of stocks, stability and growth rule. The highest honour of any dividend-paying company is to be able to say: “We have paid a dividend and increased it every year for the last 25 years.”

Companies that have achieved this feat are placed on the S&P 500’s Dividend Aristocrats List.

How to avoid a value trap

Using a trust to hold the family cottage may be appropriate when:

• Look for companies with a good record of profitability, strong fundamentals and healthy balance sheets.

• Avoid small-cap stocks and seek mature, fairly valued companies with stable payout histories.

• Look for responsible dividend payers (i.e., avoid companies who finance dividends with debt or pay dividends at any cost).

Of course, even the soundest businesses inevitably go through the ups and downs of economic cycles. But companies rarely tinker with their dividends. Even thinking about cutting dividends is considered an absolutely desperate move, although it might be the right one. Even in the aftermath of the economic crisis, very few companies dared to do this. For example, Citigroup and Bank of America were two companies that were near bankruptcy, but they still didn’t slash dividends until they were forced by regulatory mandate.

But a word of caution: not just any high-yielding dividend-paying stock will do. Abnormally high yields can be enticing, but also deceiving (see “How to avoid a value trap,” right). There are times when a company’s yield is high because a company’s stock price has significantly declined. To avoid a value trap, we suggest looking for dividend-paying companies that have a history of profitability driven by sustainable competitive advantages, strong business models, and an experienced management team. If you can then purchase them at a discounted price to their intrinsic worth, you have a winning combination.

Susy Abbondi is an equities analyst at Duncan Ross Associates.