Why Dividends Matter, Until They Don't
Dividend paying stocks have outperformed non-dividend paying stocks from 1928 through 2013. Dividend stock outperformance is not an isolated event that happens once a decade, it is a fairly consistent phenomenon that has recurred throughout the last 80 years. This doesn't mean dividend paying stocks outperform every year, but they are likely to outperform non-dividend paying stocks the longer your time horizon is.
Dividend paying stocks have not only outperformed, they have done so with less risk. Dividend paying stocks have historically fallen less in market corrections. Dividend paying stocks have more stable stock prices; they have a volatility of about two-thirds that of non-dividend paying stocks.
Dividends and Profitability
Dividend paying businesses are generally less speculative than non-dividend paying stocks. If a company pays a dividend, it must have (or at least very recently had) cash flows in order to pay the dividend. If a business has no cash, it does not have the option to pay a dividend. Dividend paying businesses are on average profitable and have fairly consistent cash flows. The longer a business has paid (or increased) its dividend, the more stable and predictable the company's cash flows.
As an example, Wal-Mart (NYSE:WMT) has raised its dividend payments for 41 consecutive years. It has clearly been able to grow its cash flows over this time period. Amazon (NASDAQ:AMZN), on the other hand, has not been able to consistently achieve positive earnings per share. All its money goes into investing in new projects and/or paying its bills. There is nothing left over for shareholders. Amazon has been able to grow its revenue very quickly, but for how long? There is more uncertainty with investing in a business that can't pay a dividend (again, on average) versus a business that has a long history of being able to pay dividends. It is the difference between investing in a proven business model and investing in something that might be great down the line.
Dividends and Capital Allocation
Companies that regularly pay a dividend are forced to be more selective with their capital allocation. If 50% of a company's earnings are paid out to shareholders, the money that remains must be reinvested into only the most profitable opportunities the company has available. An example of a business that has done a fantastic job of paying out the majority of its earnings while still investing in high growth opportunities is Philip Morris International (NYSE:PM). Philip Morris has managed to grow revenue per share by about 8% a year while paying out close to two-thirds of their profits each year to shareholders.
On average, paying a dividend helps a business focus their capital on its highest return investments. Some businesses that don't pay dividends have excellent capital allocation management. Berkshire Hathaway (NYSE:BRK.B) comes to mind. Warren Buffett can probably reinvest his profits better than you or I can, even if he is handicapped to only invest in very large businesses due to the size of his company. Unfortunately, for every Berkshire, there are several businesses that reinvest earnings into mediocre projects. In these cases, the dividend would be better paid out to shareholders so they can reinvest it themselves (or spend it).
Dividends and Investment Opportunities
If a business does not have an abundance of growth opportunities that it can reinvest its earnings into, then it should pay them out as dividends. The threshold for whether to return earnings to shareholders or invest them in new projects should be the long-term average return of the stock market. It is a very reasonable assumption that any investor could reinvest dividend payments back into the stock market. Therefore, publicly traded businesses should not invest in projects that are going to provide less than 9% or so in expected growth for shareholders. As an alternative to dividends, the management of a company can return money to shareholders through share repurchases, which will be more beneficial to shareholders than a dividend if the stock of a company is undervalued. Hopefully, the management of a company knows when a business is undervalued; if anyone has insider knowledge of a business, it is the C-level officers of the corporation.
When Dividends Don't Matter
Not every business should pay dividends. Companies that are experiencing rapid growth and can reinvest earnings into high return projects should not pay a dividend (This would be Google (NASDAQ:GOOG) (NASDAQ:GOOGL), for example). Alternatively, businesses that have a manager who is exceptionally adept at purchasing businesses is most likely better off reinvesting earnings than paying them out (This would be Berkshire Hathaway). The reason why dividend stocks have historically outperformed non-dividend paying stocks is because most businesses do not fall into these categories. The majority of businesses in the stock market only have a limited amount of high return opportunities to reinvest earnings into. Everything else should be returned to shareholders. The companies that understand this tend to outperform the ones that don't.
Why I Invest In High Quality Dividend Growth Stocks
I personally invest in high quality dividend growth stocks using the 8 Rules of Dividend Investing because I believe they offer solid total return potential with less overall risk than the market. The historical record shows that dividend growth stocks in general have done very well over long time periods. This does not mean that there are no good investment opportunities elsewhere, but an investor who focuses on high-quality dividend growth stocks is likely to generate solid total returns with below-average volatility and drawdowns.
Disclosure: The author is long WMT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.