How Dividends Matter Even More During Periods of Inflation

by: David I. Templeton, CFA

As noted in a number of earlier posts, we use the dividend paying actions of companies as one way to evaluate a company's future growth expectations. In some ways, the dividend actions by companies provide investors with insight into management and the board's expectations of a company's future earnings prospects. This valuation methodology is what led to using the "dividend discount model" as a way to value companies. Importantly, the DDM can further be used to relate the value of a stock to a company's fundamentals.

Generally, companies do not want to reduce or slow their dividend growth rates as investors in these types of companies have come to expect a certain level of dividend growth or income growth. If the growth rate slows or other financial ratios begin to trend in the wrong direction due to a company's desire to maintain a certain dividend growth rate, this provides investors with important insight into the future return potential for a stock.

Additionally, as noted in a recent research report by Fidelity's Market Analysis, Research & Education group, dividends are a critical component of a stock's overall return. The opening paragraph of the report notes,

Companies that regularly return some of their profits to shareholders in the form of stock dividend payments are predominantly mature businesses that have steady cash flows, relatively stable profit outlooks, and lower operational risk on average than non-dividend-paying companies. These characteristics generally have led to less share price volatility for dividend-paying companies compared to the broader market. Typically, a company does not start paying stock dividends unless it is confident it can continue to generate enough earnings to distribute dividends on a regular basis going forward. The primary reason: cutting a dividend may be interpreted by investors as a negative statement about the company’s profit outlook, which may result in a decline in the company’s stock price.

One aspect of the current actions by the Federal Reserve, specifically, round two of quantitative easing (QE2), concerns us at HORAN in that it is likely to fuel inflation at some point in the not too distant future. In an inflationary environment though, stocks actually perform okay when looking at the entire inflation cycle. Our post titled Where To Invest In An Inflationary Environment addresses this point.

The Fidelity report also notes during the period 1974 - 1980, the rate of inflation was 9.3%. During this time period the return on the S&P 500 Index averaged an annual rate of return of 9.9%. The dividend component of this return (4.9 percentage points) accounted for nearly one half of the overall return as can be seen in the below chart.

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From The Blog of HORAN Capital Advisors

In conclusion, certainly, the level of dividends paid by companies have declined in recent decades; however, this decline seems to be reversing at the moment. More importantly, dividends continue to represent a critical component of the total return on stocks. And when, not if, we see inflation increase, this inflationary impact will be more favorable for stocks than for fixed rate bonds.

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From The Blog of HORAN Capital Advisors

Source: Realizing the Impact of Stock Dividends (.pdf)
Fidelity Management &Research Company
November 12, 2010