- Recent articles have debated whether dividends matter during accumulation or retirement.
- Some articles state that dividends don't matter, while others state that they do.
- "Do dividends matter" is the wrong question. The correct question is "Do dividends matter to you?"
There has been a spate of recent articles debating the relevance of dividends.
Dale Roberts got things started with "Actually It Is All About Total Return Totally!" He followed that up with "Dividends Don't Matter in Retirement Either," and then with "How Dividends Don't Matter in Retirement A Few Examples." The author's point in all of the articles was essentially that since dividends do not drive earning power, they are immaterial. He stated that "all that matters is total return," and "whoever has the most money wins."
Because the author believes that total return is the only investing goal worth pursuing, he believes that whether a company pays a dividend or not is irrelevant.
The only "thing" that drives growth is earnings power. It does not matter if a company decides to return some of the earnings to the shareholders by way of dividends, or decides to reinvest the profits into their own business for future growth. The dividends are immaterial.
This reasoning is seen universally in Modern Portfolio Theory. In a nutshell, the logic is that the only meaningful investing goal is total return; stock prices are correlated with earnings and earnings growth; dividends are irrelevant to earnings growth; and therefore dividends are irrelevant to investing.
There have been at least two response articles to the Roberts' series. In "Dividends Do Matter - Especially in Retirement," Adam Aloisi noted that dividend growth is a concrete way to survive retirement, and that there is forward value to focusing on the dividend producing capability of a company. Adam also noted that just because a company pays a dividend does not mean that it has less earnings power than a non-paying peer.
Regarded Solutions then published "Retirement Strategy: The Absurdity of Believing that Dividends Don't Matter in Retirement." The author's title tells where he stands on the issue. He asks the key question: What are you investing for? More on this later.
Finally, on the dividend-irrelevancy side, David Merkel published "Ignore Yield." In that article, he stated:
Yield is not an inherent feature of an asset… Dividends can be cut. Bonds can default… Rather, focus on the things that drive the increase in value of an asset. You can create your own "dividends" by selling off pieces of investments that you own….Getting yield from stocks is an uncertain proposition.
Do Dividends Drive Earnings Power?
I consider the question of whether dividends contribute to earnings capacity to be almost a red herring in this discussion about whether dividends are relevant to investors.
It is easy to see why so many believe that dividends detract from earnings power. The line of thinking is that companies that pay dividends have less money to reinvest in the company's growth, therefore the company cannot grow as fast as it would if it retained those earnings. We see this sentiment expressed often as an unquestionable financial truth, not worthy of further discussion.
But a key academic study examined the exact issue and concluded the opposite. The conclusion was that companies' payments of dividends increase their earnings power. The study is titled, "Surprise! Higher Dividends = Higher Earnings Growth" (Arnott & Asness, Financial Analysts Journal, 2003).
The study stated:
The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low. This relationship is not subsumed by other factors, such as simple mean reversion in earnings. Our evidence thus contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is consistent with anecdotal tales about managers signaling their earnings expectations through dividends or engaging, at times, in inefficient empire building.
The researchers generated a history of the earnings per share of the S&P 500 Index, then analyzed this against the dividends actually paid by the companies. They found a positive correlation between payout ratio and subsequent 10-year earnings growth. Companies with higher payout ratios, as a group, had higher subsequent earnings growth.
When you think about it, this answer comes as no surprise. After all, if you are considering excellent, low-risk companies that have the wherewithal to increase their dividends every year, doesn't it stand to reason that over long periods of time, they will do well at increasing their earnings too?
Whatever. There are two reasons that I think this is a red herring issue. First, it lumps stocks together. As many investors believe, it is a market of stocks, and conclusions drawn from masses of companies, or from indexes, can be misleading. They do not represent the nuances of investing in individual stocks that are carefully selected for the characteristics that the investor wants.
Second, this issue does not get at the fundamental question, which is what each investor's goals are. It merely suggests that an investor paying attention to dividends will not hurt himself or herself in total return. That is consistent with non-academic studies of dividend payers and raisers, such as the long-standing (now into its 42nd year) Ned Davis Research examination of that issue. The following graph is reproduced from Regarded Solutions' article cited earlier, showing that dividend raisers and initiators have tended to outperform other stocks.
That has also matched my experience in my public Dividend Growth Portfolio [DGP]. With dividends reinvested, it has never trailed the SPY (an ETF that tracks the S&P 500) in total return, also with dividends reinvested, since inception. Obviously, this covers a much shorter time frame, and I offer it only as an interesting example, not as a statistically valid study.
[Graphic by the author, covering the period June 1, 2008 through August 1, 2014.]
Do Dividends Matter?
I think that "Do dividends matter?" is the wrong question. The right question is, "Do dividends matter to you?"
Many investors, especially retirees, depend on dividends for an important part of their cash flow for living expenses. Dividends are, for them, income replacement for the job that they once had. Dividends certainly matter to them.
For other investors, dividends are a key component of building wealth for retirement. Roberts states unequivocally:
Dividends don't matter in the accumulation phase; all that matters is total return… Those who use dividend growth as a method to "grow the dividends" and invest on a total income strategy are likely giving up the potential to beat the market… And make no mistake, whoever has the most money wins. Period.
Many investors do indeed believe that the goal of investing is to "win." They want to beat the market and amass the biggest fortune. That is a worthy goal, and I do not criticize it.
But it is not the only sensible goal of investing. Total return is not the central focus for many investors. There are other legitimate reasons to invest. One of those reasons can be to optimize an income stream for current or future use.
The reason I use optimize instead of maximize is because different investors have different views of the best dividend goal.
- Some have stated that they prefer to invest in a stock with a 2% yield and a potential 20% per year growth rate instead of a stock with a 3.5% yield and a 7% growth rate.
- Others have stated just the opposite, that they prefer a higher yield now and do not demand extreme growth so long as their income grows faster than inflation.
- Many dividend investors like to have a few really high-yielding stocks (9% +), and they tolerate occasional dividend cuts in them so long as the overall long-term trend is up. They use the high income flow from riskier stocks to fund the purchase of more dependable stocks that will become their core portfolio years down the road.
- Some dividend investors see income optimization as their only goal. Others see it as a goal that stands ahead of total return, but they also follow total return. Still others use dividend investing techniques to achieve "growth and income."
So you see, even within the dividend investing realm, there are many flavors. To suggest that everyone ought to have the same goal -- maximum total return -- strikes me as arrogant. It is dismissive of many individuals who have different legitimate goals. I do not understand why sweeping judgments about other peoples' goals are even made.
And, as we saw above, an investor focused on dividend optimization will still get total return, and there is a good chance that it will be better than that achieved by the investor focused on maximizing total return.
I have three examples of sensible goals that do not place total return at the top of the goal pyramid.
The first is the goal statement from my aforementioned Dividend Growth Portfolio:
The goal of my Dividend Growth Portfolio is to generate a steadily increasing stream of dividends paid by excellent, low-risk companies. The numerical target is for the portfolio to deliver 10 percent yield on cost within 10 years of inception. I am more interested in the ability of this portfolio to produce income than its sheer size.
So far, I am achieving my numerical goal, as you can see from the following table.
Increase from Prior Year
Yield on Cost
The second example comes from frequent commenter and Instablogger Chowder. His profile states his goals:
My primary objective is income replacement! The objective is to start earning an income stream now, to replace the income that will be earned throughout the working years. I want that income to be reliable, predictable and increasing. The income stream will need to continue to grow to stay ahead of inflation. The strategy is to focus on the safety of the dividend first, then to focus on the growth of the dividend, and then to focus on total return.
The final example comes from contributor Bob Wells' goal for the Wells Family Retirement Income Portfolio:
Generate a steadily increasing stream of income paid solely from the growing dividends generated by high quality, low-risk companies with a track record of five or more years of providing safe and growing dividends. Our target is an increase in income from dividends and dividend growth at least twice the rate of inflation, while continuing to grow portfolio capital.
If you are told that total return is the only single correct goal in investing, or that if you don't beat the market you won't win, or to ignore yield, please consider whether that makes sense for you.
Do you want winning and beating the market to be your investment goals? Or do you have other targets in mind?
The fact is that investors have all sorts of different goals, and they cannot be fenced into one single category. Investing for income, and/or income growth, at any stage of one's life may not only be a sensible goal, it may be the single best goal for certain individuals.
In a comment to Regarded Solutions' article, contributor Dividend Dynasty said this:
I worked most of my career in investor relations for two S&P Dividend Aristocrat companies. I met and spoke with thousands of individual investors. Let me tell you, the happiest retirees all told me they had built their own little fund of dividend paying companies and were living large in retirement. I took their advice and built my own little fund of dividend paying companies (many dividend aristocrats) and am also living large in retirement. I built my parents' a little fund of dividend paying companies and they too are living large in retirement at 80 years old in an expensive independent living facility with no pension and minimal social security. I showed them they can afford to live there as long as they want and don't have to worry about running out of money.
As self-directed investors, we have a cornucopia of choices as to how to invest. We take what business models and investment products we find and decide which ones best suit our needs. Our needs are defined by ourselves, and they are called our goals.
Dividends matter if they matter to you.