In my previous article, I developed a simple dividend strategy with the goals of achieving a good dividend yield (4%) and reducing portfolio volatility relative to the S&P 500. I was amazed at the incredible response, as well as the quality of the comments left by the community. So first, thank you to everyone; I found the discussion very engaging and enriching! This inspired me to dig deeper and find research to support both choosing Dividend Aristocrats (DA) and Dividend Champions (DC), as well as the decision to weight stocks equally by dollar amount, instead of using market capitalization weightings. It’s easy to use common sense principles to justify these choices, but I wondered what research said about these ideas.
I found quite a bit of information, including lots of historical and statistical data. The good news is that it strongly supports both ideas, as well as a yield-weighting strategy, similar to those discussed in another SA article. To provide some focus, this article will concentrate on the research supporting the case for choosing DA and DC stocks and investing in dividend-payers. The next installment will discuss evidence supporting the weighting strategies. Also, I recommend checking out all of the references, to get even more details from the full source articles. For those who did not read my first article, the table below lists the 30 stocks that I have built a model portfolio out of, and will be tracking.
The Importance of Dividends
Take an MBA finance course and you will learn about the Modigliani–Miller Theorem, which basically says that in an efficient market, how a firm is capitalized is irrelevant to its valuation. Further, it asserts that whether a firm reinvests earnings or distributes them as dividends, the financial impact on investors is the same. Capital gains would equal dividends in a perfect market, so dividends are irrelevant. The theory requires some big assumptions though, such as no taxes, no transaction costs, and no asymmetric information. In our imperfect reality, ask an investor if s/he thinks dividends matter, and you are likely to get another response. Corporations seem to concur based on the number of firms paying and raising dividends. So aside from putting money in your pocket, why are dividends important, and how much impact do they have on an investor’s total return?
The Impact of Dividends on Firms
- Dividends monetize a portion of earnings and reduce excess cash available to management.
In other words, more money in your pocket is less in theirs, but is this a good thing? As usual, the answer is “it depends”. Smaller firms tend to reinvest earnings into the business to take advantage of growth opportunities with high rates of return. If a firm can deliver ROE greater than its cost of capital, value is added. As companies grow and mature, maintaining a high growth rate becomes more challenging, and can lead management to pursue riskier projects or to sit on excess cash. Here’s where value can be lost, so investors would prefer a dividend. With DA and DC firms, we are dealing with a mature group, so distributing a portion of earnings is reasonable, and as we will see, does not imply a lack of growth. Management just needs to make wiser decisions with the remaining cash.
- Dividends signal strength and confidence in the firm’s outlook.
Stability in dividend policy removes some uncertainty and helps the market to valuate a firm. A decrease in dividends often results in a negative market response[i], so management works to defend the dividend. Firms typically raise their dividend only when they are confident that it can be maintained at the new level, thus the increase signals strength and confidence in future prospects. Most firms follow a Smoothed Residual Dividend Policy, which minimizes dividend fluctuations. Investors prefer stable, but increasing, dividends per share, and the DA and DC firms have demonstrated that they can provide it.
- Dividends help to support the stock’s price.
The Dividend Discount Model calculates an intrinsic value for a stock based on its dividend per share, discount rate, and dividend growth rate. For those unfamiliar with the model, it is basically a variation of a discounted cash flow model; it calculates the present value of future dividends, assumed to continue in perpetuity. Assuming constant cost of capital and dividend growth, higher dividends leads to a higher stock price. With DA and DC stocks, we have the added benefits of larger, stable firms with established histories of dividend growth.
The Importance of Dividends to Investors
- Investors prefer dividends.
Most investors are risk-averse and prefer a predictable return (income stream) to uncertain capital gains.[ii] Investors also experience “regret aversion” more easily with dividends, since dividends are received without having to take any action. Selling some stock to obtain cash can lead to regret if the price proceeds to move higher.
- Dividends are a growing source of personal income.
Dividend income as a percentage of personal income has steadily increased over the last 20 years, making dividends an important source of income. In 2007, dividend income comprised 6.7% of per capita personal income in the United States, compared to 4.8% ten years prior and 2.8% twenty years prior. During the same period, the percentage of personal income from interest steadily shrunk from 15.03% in 1988 to 10.41% in 2007. [iii]
Collectively, the preceding five bullet points make a good case for investing in stable dividend-paying firms with a history of increasing payouts. Such firms have weathered numerous economic cycles, changes in government, and market crises, and continued to increase dividends to shareholders. For investors, these firms provide more security and a consistent and growing income stream, but what about total return? And does paying higher dividends hinder the firm’s earnings growth rate? To quote Rod Tidwell, "Show me the money!", and the evidence to back it up too.
Dividends and Total Return
Search the internet for “dividends and total return” and you will come up with a range of claims as to the percentage of total returns that come from dividends. Last December, the BlackRock investment firm claimed “90% of U.S. equity returns over the last century have been delivered by dividends and dividend growth.”[iv] This seems a bit high, and the catch is in what “delivered by” means. Another article claimed that the figure included capital gains to the extent that they matched the rate of dividend growth; that is, the calculation assumed that 5% dividend growth contributed to 5% capital gain.[v] I’ll let you decide what to believe on this. There were a couple other sources with more believable numbers and the relationship was consistent. Dividends contribute a significant portion to total return over time.
- In its 2008 paper on Dividend Aristocrats, S&P noted that “since 1926, dividends have contributed to approximately one-third of total return while capital appreciations have contributed two- thirds.”[vi]
- Based on research by J. Wilson and P. Jones (2002) and more recent data, Thornburg Investment Management calculated the total return for each decade starting with 1871-1880, as well as the parts attributable to price appreciation and dividends.[vii] On average, income delivered 53.5% (more than half) of the total return amount over time.[viii] In addition, the volatility of the income component, as measured by standard deviation, was much less than that of the capital appreciation (1.3% vs 5.3%). Note: The charts below are included with permission from Thornburg Investment Management.
Dividends and Earnings Growth
“Conventional wisdom” suggests that if a firm has a high payout ratio, then it probably isn’t growing quickly and its dividend may be at risk. This argument makes sense, as one would expect that a firm that has more funds to invest in new opportunities would grow faster and has more cushion to cover the dividend. However, three research articles cited and summarized by Thornburg Investment Management support a surprising conclusion: over time, higher dividends lead to higher earnings growth.[ix]
Arnott and Asness (20 analyzed historical data from 1946-1991 in rolling ten-year periods (see chart above, stocks divided into quartiles by payout ratio).[x] In every case, the highest dividend payers had the highest earnings growth. It is worth noting that they did not use a static portfolio; they replaced stocks in their index over time, much like the S&P does. Still, the result is counterintuitive. The authors offered some explanations, which match with the previous discussion on the importance of dividends (positive signal of future growth, less “empire-building”, and more effective use of resources). In addition, there is the possibility of mean reversion combined with the sticky dividend theory. Assuming consistently growing dividends, a high payout ratio could indicate the price is undervalued, thus it will increase more going forward to return to the firm’s average payout ratio. The authors also humbly acknowledged that perhaps something went wrong with their data or experiment design. However, there is additional supporting research from different sources.
The same type of study was replicated in other countries including: Canada, Australia, France, Germany, Japan, Netherlands, Switzerland, and the United Kingdom (Parker, K., 2005 and Gwilym, et al., 2006). The Canadian and Australian studies examined ten-year EPS growth, while the rest used five-year timeframes. In all of the studies, the top quartile of dividend-payers had the highest average earnings growth, and in all but two, the top quartile also had the highest dividend growth. See the Why Do Dividend Strategies Tend to Outperform? article for the full tables and source references. Lastly, the 1-, 3-, 5-, and 7-year annualized returns of the S&P’s Dividend Aristocrat Index (dividend stocks) have outperformed the corresponding returns of the S&P 500 Index (the market), and delivered this return at slightly lower risk levels (standard deviation).[xi]
I believe a very strong research-based case can be made for pursuing an investment strategy that focuses on dividend-paying stocks. Dividends provide both monetary and informational value to investors, and impose some limitations on management with respect to how they deploy the firm’s cash. Research suggests that higher dividend payouts do not necessarily hinder the firm’s earnings growth, and in fact, may lead to higher earnings growth compared to firm’s with lower payouts. Based on the cited studies, over time, a diversified portfolio of consistent, higher-yielding stocks should outperform those with lower payouts and the overall market, with dividends contributing around 33% to 50% over the total return.
These results and the needs of investors support the selection of Dividend Aristocrats and Dividend Champions for a model portfolio of dividend growth stocks. These firms demonstrate stability, pursue a Smoothed Residual Dividend Policy, and have a long, established history of annual dividend increases. Furthermore, dividend-paying stocks are not just for income-oriented investors. With longer-term total returns exceeding the S&P 500 at reduced volatility, growth investors should also consider these stocks for their portfolios.
The next installment will summarize a comprehensive research study from England that provides evidence in support of a yield-weighted or an equally weighted dividend-paying portfolio, as opposed to one based on market capitalization. Those of you like me, who like to see more data and historical testing, will be interested in this paper. Stay tuned, and please continue contributing to this discussion!
- I am long: KMB, MO, COP, AFL, CB, INTC, and T. I may initiate positions in some of the stocks mentioned in my Simple Dividend Strategy model portfolio (SDS-30) in the next 72 hours.
- I am not affiliated with Thornburg Investment Management. I just asked to use two of their charts to illustrate their results and they agreed, which saved me some time. I’m also not affiliated with any of the research authors or S&P. If any of them want to hire me, I’m available. :-)
- I found one article from 2008, Dividends: Myths and Realities, by a Charles Schwab VP, which argued that dividend stocks underperform the market. I didn’t agree with it, and another SA contributor already posted a rebuttal. I am certainly interested if anyone finds research that says dividend stocks underperform though!
[i] Kania, S. & Bacon, F. (2005). What Factors Motivate the Corporate Dividend Decision?. ASBBS E-Journal 1(1), 99. Retrieved from: http://www.asbbs.org/files/2005/PDF/Kania.pdf.
[ii] Ibid., p. 98.
[iii] Standard & Poor’s (December 2008). S&P 500 Dividend Aristocrats. The McGraw-Hill Companies. p. 2. Retrieved from: http://www2.standardandpoors.com/spf/pdf/index/SP500_Aristocrats_Paper_2008Dec.pdf.
[iv] Melloy, J. (December 6, 2010). At Stake: Dividends Make Up 90% of Total Return. CNBC.com. Retrieved from: http://www.cnbc.com/id/40532507/At_Stake_Dividends_Make_Up_90_of_Total_Return.
[v] Elfenbein, E. (June 13, 2011). Do Dividends Make Up 90% of Total Stock Returns?. Crossing Wall Street. Retrieved from: http://www.crossingwallstreet.com/archives/2011/06/do-dividends-make-up-90-of-total-stock-returns.html.
[vi] Standard & Poor’s (December 2008). S&P 500 Dividend Aristocrats. The McGraw-Hill Companies, p. 1. Retrieved from: http://www2.standardandpoors.com/spf/pdf/index/SP500_Aristocrats_Paper_2008Dec.pdf.
[vii] Wilson, J. and Jones, C. (2002). An Analysis of the S&P 500 Index and Cowles’s Extensions: Price Indexes and Stock Returns, 1870-1999. Journal of Business, vol 75, no 3. Retrieved from: http://www.jstor.org/stable/3663703.
[viii] Remily, C. (October 2010). Pre- or Post-Tax, Dividend Strategies Are Still About Total Return. Thornburg Investment Management. Retrieved from: http://www.thornburginvestments.com/research/articles/pdfs/TH2274_AfterTaxDividends.pdf.
[ix] Thornburg Investment Management (January 2010, updated July 2011). Why Do Dividend Strategies Tend to Outperform?. Thornburg Investment Management. Retrieved from: http://www.thornburginvestments.com/literature/fund_literature/TH2122_dividendsOutperform.pdf.
[x] Arnott, R. and Asness, C. (Jan/Feb 2003). Surprise! Higher Dividends = Higher Earnings Growth. Financial Analysts Journal. Retrieved from: https://www.rallc.com/ideas/pdf/FAJ_JanFeb_2003.pdf.
[xi] Standard & Poor’s. (2011). S&P 500 Dividend Aristocrats – Strategy Indices. The McGraw-Hill Companies. Retrieved from: http://www.standardandpoors.com/indices/articles/en/us/?articleType=PDF&assetID=1245186604073.