Introduction: This article is inspired by several anti-dividend articles and Instablogs on Seeking Alpha:
- Critique Challenges Dividend Investing’s Appeal, by Larry MacDonald, February 2, 2010
- WHY I HATE DIVIDENDS, by ForMyOwnAccount, December 9, 2009
- THE DUMBNESS OF DIVIDENDS, by Arnold Landy, November 21, 2009
- Why Dividend Paying Stocks Are a Mistake, by David Jackson, June 1, 2005
The latter article was written by the founder of Seeking Alpha, David Jackson. After I inquired whether his thoughts had changed since he wrote the article, David added a new comment to his 2005 article.
The Case Against Dividends: At the risk of over-simplifying, here is a summary of the most important points made in the above sources. (If any of the authors feel I am misrepresenting what they said, please comment.) Not all authors, of course, made all of the points below, but taken together, they make the case against dividend stocks:
- Retained earnings produce growth. Money sent out as dividends cannot contribute to growth.
- Retained earnings, if not re-invested for growth, are better spent in share repurchases than in dividends.
- Share repurchases and re-investments in the business should fuel future price appreciation. Dividends do not. In fact, dividends reduce price appreciation.
- Dividends reduce the value of the underlying shares by the amount of the dividend.
- Studies do not find that dividend stocks “do better” than non-dividend-paying stocks.
- Dividend investing runs counter to optimal diversification, because most dividend-paying companies are concentrated in a few industries.
- It is more tax efficient to generate income from selling shares than from dividends.
- Dividends’ appeal lies largely with an uneducated shareholder base. Companies use dividends to bribe shareholders and to exploit shareholder ignorance.
- Would you want Warren Buffett to distribute dividends rather than keep doing what he’s been doing for decades?
The Case for Dividends: Here, I’d like to make the case for dividend-paying stocks. In the process, I will try to refute or cast a different light on the arguments above. Note that I am not trying to show that dividend stocks are always the best investment. But I am trying to show that dividend stocks can be the basis of a very intelligent and successful investment strategy. Dividend stocks are not just for retirees or clueless investors.
The Dual Nature of Dividend Stocks: Many investors, and it would seem all of the authors noted above, think of stocks as assets that you trade with a focus on price: Buy low, sell high. If you mention income production, they think of bonds. But dividend-paying stocks are instruments with the power both to produce income and to rise in price. A good dividend stock is an equity security like all others, but with unique income characteristics.
I have written three e-books on dividend investing, the most recent of which is The Top 40 Dividend Stocks for 2010: How to Generate Wealth or Income from Dividend Stocks. What I call the Sensible Dividend Investor is not stupid or ignorant. But he or she often comes to see stocks differently from growth investors. Stocks become like cash machines that generate streams of income. Dividend investors do not lose all interest in the price of their shares, but price doesn’t matter as much. If prices fall, the dividends keep coming. Price declines often present attractive buying opportunities for those who are still in the wealth-accumulating stage of their lives.
The idea that dividends are the principal reason for owning a stock is not a new concept. In 1934, Benjamin Graham and David Dodd wrote in their classic Security Analysis, "The prime purpose of a business corporation is to pay dividends to its owners [emphasis added].” This statement is more than a quaint reflection of its time. It is a fundamental view of what owning shares in a company is all about, as valid today as 75 years ago.
Stock Prices Tell Only Half the Story: The total return from stocks is comprised of two elements: price appreciation and dividends. Studies show that dividends have accounted for half or more of the total return of the stock market over very long terms. This may be surprising considering how little publicity dividends get. The widely followed Dow, S&P 500, and NASDAQ indexes reflect price changes only, and therefore they give only a partial picture of “how stocks are doing.” There is no equivalently publicized “dividend index” that I know of.
Let’s look at the price appreciation component of total return. A company creates value by generating profits. It ingests investors’ capital and/or borrowed money to get started, and then it utilizes the skills of its people, research, development, manufacturing, marketing, and other functions to bring in more money than it spends. The net pileup of profits and assets, and the company’s ability to utilize those to bring in ever-larger earnings, increase the enterprise’s value over time.
In turn, the company’s stock price goes up if the market recognizes the increased value of the company. Historically, through a wisdom-of-crowds “price discovery” process, investors have tended to recognize and pay for increased earnings capabilities. They do this by placing an appropriate multiple on a company’s earnings per share. If the multiple stays constant, increased earnings alone will cause a share’s price to rise. Sometimes, prices rise also because the market places a higher multiple on the shares of a particular company.
The Dividend Half of the Story: Let’s look at dividends’ contribution to total return. First of all, note the obvious: Dividends are always positive. As to the long-term record of dividend stocks, I will focus on just three studies to save space.
- Ned Davis Research determined that from 1972 to 2006, non-dividend-paying stocks produced an annual average return of 4.1% vs. dividend-paying stocks’ 10.1%. This is an enormous difference, covering 35 years and a motley assortment of economic and market conditions.
- Wharton Professor Jeremy Siegel’s research attributes 97% of the stock market’s total return from 1871 to 2003 to re-invested dividends, and he also states that from 1926 to 2004, reinvestment of dividends accounted for 46% of all stock market return after inflation.
- In a February, 2009 article, “Follow the Juicy Dividends,” BusinessWeek cited Ned Davis research showing that stocks with at least five years of dividend growth outperformed the S&P 500 every year from 1972 to 2008. A later update of that study that extended it to April, 2009 (and can be seen here. The study showed these returns:
- Dividend Cutters or Eliminators: 0.5%
- Non-Dividend Payers: 0.7%
- S&P 500: 6.2%
- Dividend Payers with No Change in Dividends: 6.2%
- Dividend Growers and Initiators: 8.7%
The Share-Buyback Red Herring: One of the most-cited reasons for inferiority of dividends is that shareholders are better off if the company uses that money to buy back shares of itself. Share repurchase programs are not regular programs. They are not predictable as to size or frequency. Some share repurchases are not completed after their announcement. In hard times, most companies will suspend a share buyback program before they touch the dividend. And failures to complete, or interruptions in, share repurchase programs are inconsistently reported.
Often companies pay top dollar for their shares. They don’t “buy low.” Figures from S&P show that few companies repurchased their shares in 2002, the bottom of the bear market. But when stock prices were increasing from 2003 to 2007, buybacks became rampant, peaking in Q3 2007, simultaneously with the market’s peak. Then in 2008-2009, when the next bear market hit, buybacks slowed dramatically. This phenomenon appears in every market cycle. USA Today ran an article about it just the other day (“Stock Buybacks Lose Some Luster,” January 29, 2009). S&P analysts studied stock repurchases from Jan. 1, 2006, through June 2007. They found that a third of all companies took losses from their purchases; three-quarters of the companies that bought back shares lagged behind the S&P 500 for the period; and the most aggressive buyers of their own stock were some of the worst performers.
Share repurchases can be a catastrophic use of company assets. Recent examples include Lehman Brothers’ (LEHMQ.PK) 2008 fiasco of spending $761 Million buying its own stock a few months before it collapsed, and Merrill Lynch’s disastrous $5.27 Billion repurchase program about a year before it averted collapse only through a shotgun marriage with Bank of America (BAC).
Diversification: Traditionally, certain industries—like utilities—are associated with dividends. But strong dividend stocks can be found in almost every sector: It depends on the company’s business model. In my new e-book, the Top 40 Dividend Stocks appear in 10 sectors—certainly enough to build a well-rounded portfolio.
The Taxation Issue: You must pay taxes on dividends. However, the Federal dividend tax rate of 15 percent makes it one of the least-taxed forms of income available. (Note: The 15 percent tax rate on dividends is due to expire at the end of 2010. Note also that dividends from REITs and certain other special corporate forms are taxed at your marginal tax rate, because their profits are not taxed at the corporate level.) Of course, if you hold your dividend stocks in a tax-deferred account, the normal tax benefits of such accounts apply to the dividends.
It is true that share repurchases are not taxed. But if you want to get the money from share price growth, you must sell some of the shares to get it. Your gain will be taxed at either the long-term or short-term capital gains rate. The Federal long-term rate is 15 percent, the same as with dividends.
Sometimes, investors become too focused on tax considerations. The primary appeal of dividends has never been based on a tax break; that is of recent origin anyway. The chief appeal of dividends is the opportunity to receive cash returns from stocks that are always positive, keep increasing, and are independent of price fluctuations.
Characteristics of the Best Dividend Companies: The best dividend companies have a strong culture of increasing the dividend annually if at all possible. Many have been increasing their dividends for decades. The top dividend-paying companies tend to have strong balance sheets and to handle cash conservatively. Most of them have rock-solid business models and are veritable cash machines. The best dividend-paying companies generate enough cash to fund both growth and dividends.
Dividends cannot be faked, unlike earnings. Dividend-paying stocks tend to increase in price more slowly than market-leading stocks during strong bull markets. They do not tend to “lead markets up.” But they don’t tend to lead them down, either.
Paying dividends takes cash out of the hands of management and forces management to handle the remaining cash more carefully. As noted in the November 24, 2008 edition of Fortune,
Companies that retain most or all of their earnings frequently squander those profits. CEOs waste those retained earnings on ‘empire building’ via overpriced acquisitions. Amazingly, companies that pay big dividends actually grow their earnings far faster than those that reinvest most or all of their profits. Paying dividends imposes discipline; it makes the top brass far more careful in deploying scarce cash.
Dividend stocks tend to attract a different constituency than growth companies. Many shareholders prefer a steady return and a predictable, reliable dividend flow. Investors following a dividend-growth strategy are less likely to sell their shares in response to short-term difficulties. The dividend stream is generally independent of price changes in the stock itself. Shareholders are, in a sense, set free from constant concern about the stock’s price. Dividend investing is a strategy for the long haul. The major attraction is not to make money from price increases, although that is delightful. The major attraction is the dividend itself.
The Power of Rising Dividends: Well-chosen dividend stocks increase their dividends every year, and those can be re-invested to accelerate the process of building wealth. Even if not re-invested, rising dividends obviously deliver increasing income. In contrast to growth stocks, dividend stocks do not have to be traded to realize these benefits. No matter what market conditions are, the relentless mathematics of dividend investing keeps rolling along.
The best dividend stocks usually grow their dividends at a higher rate than inflation, unlike the fixed dividend payment from most bonds. If you own shares in a dividend-paying company that increases its dividends, your yield on cost (that is, the yield on your original investment)goes up. This happens even though the current yield stays the same. It’s simple math. No matter how the stock’s price changes over the coming years, your personal yield (= yield on cost) will always be based on what you paid originally.
Over time, your personal yield will surpass the 10%-11% long term total average return of the stock market itself, just from the dividends alone. This is the most powerful aspect of dividend stocks. For a complete discussion of it, see my article, “10 by 10: A New Way to Look at Dividend Yield and Growth". The process can be accelerated, of course, by re-investing the dividends and letting them compound.
This contrasts sharply with bonds. Bonds are fixed income investments. We can easily see the ways that they are “fixed”: Their term is fixed; their “coupon,” or rate of return, is fixed; and their nominal worth at the end of the term is fixed. You get back what you originally paid—in dollars that have been eroded by inflation.
Take a look at this table of returns for a terrific dividend company, Automatic Data Processing (ADP):
Note how the price return varies each year, including going negative in 2008. Also note how the dividend just keeps marching up each year. ADP has been raising its dividend for 35 straight years now, yields about 3.5% to new purchasers (much more than that to investors who have owned it for years), and is one of only four US non-financial companies with an AAA credit rating. Another of the four AAA-rated companies is Johnson & Johnson (JNJ), also a top dividend stock, about which I wrote a couple of weeks ago.
Of course, there is risk to any company’s dividend. If a company suffers dramatic financial misfortune, and its profits fall or disappear, so can its dividends. Financial calamity will trump any company’s desire and ability to keep sending out dividends. Dividends are not guaranteed. But for well-selected dividend payers, that risk is usually small.
What About Buffett? Do I want Berkshire Hathaway (BRK.A) to pay dividends? Personally, I could not care less. I believe that every company has an optimum level of dividend payout that the company discovers over time, as it matures. For new companies, the optimum rate is almost always zero. They need all the cash they can get to grow from corporate infancy through adolescence and into adulthood. For some mature companies, this level is still zero, because of its business model. Berkshire Hathaway certainly has enough cash to pay a dividend, and who knows, they may choose to do so some day, just as Microsoft (MSFT) did a few years ago. But Buffett seems to be doing OK with a zero dividend, and that’s fine with me.
Summary: Simply stated, the case for dividend stocks goes like this:
- Dividends are always positive.
- The best dividend-paying companies raise their dividends regularly, usually at a pace that exceeds inflation. Their growth is not curtailed by the dividend payouts.
- Dividends are not just for current income. They can be re-invested to accelerate the wealth-building process. Over time, a very high yield on cost can be achieved.
- Dividend stocks offer the potential for price appreciation in addition to the dividends they pay.
In his new comment to his original article, David Jackson stands by his point that there's no reason to believe that you will do better with dividend-paying stocks than non-dividend paying stocks. However, he suggests that there is “a strong case for viewing dividend-paying stocks as a separate asset class, halfway between stocks and bonds.” Given my own view of dividend stocks as having characteristics of both stocks and bonds, I think that this is not a bad way to look at it. However, I simply look at the top dividend-paying stocks as a category of stock with certain unique characteristics, around which an intelligent long-term investing strategy can be built. I also believe that such a strategy, when executed with care, has a high probability of success.
Disclosure: Long JNJ