Dividends: A Key Component Of Total Return

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Includes: KO, MO, PEP
by: Chowder

Summary

Dividends make up a significant component of long-term total return.

Income volatility is significantly lower than price volatility.

The longer the time frame, the more significant dividends become over capital returns.

The information age has made it possible for investors to quickly and easily learn about their investments. In recent years, the press, television, the Internet, brokers, and mutual fund companies have flooded the public with information about business and investing.

Every day, you are told of some great idea of where to put your money. If you turn to CNBC, you are given dozens of ideas every day on where to put your money into or take your money out of. Investor's Business Daily, the Wall St. Journal, and even here on Seeking Alpha, you are provided with scores of investing ideas daily.

The barrage of information aimed at investors produces more confusion than illumination. The number of possibilities may be fantastic, but at the same time, it is disheartening. How can an investor ... someone who's typically not a professional but who has important funds that must be properly invested ... possibly keep up with the flow of news, the flow of ideas, the flow of advice that so often contradicts even the most recent piece of advice that had flowed past only days or hours ago?

The question comes up again and again and again; where do you put your money?

There is a way to invest that makes sense, that's easy to implement, and that has a high chance of succeeding in meeting your long-term goals at the end of the road.

There is, if you're a long-term investor, a person that can look out a minimum of 10 years and more. There is, if you are a saver and builder, for people who understand (or want to understand) that the forces of time, modest and reliable growth, and compounding are on their side. Investing means investing ... the methodical accumulation of capital through a sensible and disciplined plan that recognizes that "shares" represent a partnership in a real and going business. Your plan, very simply, must recognize that you will manage your investments by actually being an investor ... a passive partner in a real and going business.

There is a way to earn solid returns on your investments over the long term with the lowest possible risk. It's an approach that can get you off the hook of information addiction, free you from the need to constantly keep up with the latest developments, and the opinions of a million pundits. In effect, you can invest in stocks without "playing the market."

When implementing a strategy, one goal, in addition to seeing your capital grow, is to sleep well at night. To be sure, your portfolio will go up and down, this can never be avoided if you hope to have reasonably good long-term gains, but the downs won't bother you because you will understand why prices have declined, and you'll have a high confidence level and a clear vision that prices will rise over the long term.

No investor can hope to succeed without having the ability to stick to a plan. You can't let your convictions be shaken or you'll jump from pillar to post the moment times become difficult, and in the end, you'll have little to show for it. However, if you are comfortable with what you are doing, and you have confidence in what you own, you will stick with your plan. This level of confidence can be achieved because your strategy will be based on common sense.

Common sense in investing means employing a strategy that's inextricably linked to the actual corporations in which you're invested. Investing is about being a partial owner of a real business; this fact should never be forgotten.

Common sense means your strategy needs to be effective in virtually all market conditions (it may shine in some types of markets and be just okay in others, but it should never contain the seeds of a short-term catastrophe if you're to maintain a calm mind as a strong holder). Common sense means having reasonable, achievable goals. Common sense means never trying to hit a home run and never berating yourself with remorse for a situation that doesn't work out.

The system that makes the most sense is income investing and income investing to me means dividend investing. The portfolio is a real portfolio, and when the market corrected in January, and the S&P 500 was 15.1% off its peak back in the summer, this portfolio was just 6.4% off its all-time high.

In addition to this, although January was a down month for the market, the portfolio saw its dividends paid increase 10.5% over January 2015. A double-digit pay raise.

According to a recent study by Brandes Institute, over longer time frames, dividends were to be a significant component of total return ... not share price ... dividends. The time frame for the study was from 1926 to 2014.

One of the key components found, at least for long-term investors, the income component of equity returns reached equality with the capital appreciation component around the 10-year horizon, and then became increasingly dominant as the time horizons were extended further.

According to Brandes Institute, the debate over the relative importance of income versus capital price changes is a classic case of "tortoise vs. hare." In today's information-saturated world, investors tend to focus on financial items that tend to change rapidly (i.e., prices) rather than those that may be more stable, such as dividends. But their studies showed clearly that over the long term, income-dominated capital price movements as a source of returns, even for equities.

Brandes Institute has long held that paying excessive attention to short-term price movements is a behavioral error that can lead investors to make bad investment decisions. Its data, in its research reports, suggests that investors might do much better to focus on their portfolio's income stream as it develops over time. Its study shows that the volatility of that dividend income stream was a very small fraction (under one-twentieth) of the volatility of stock price movements.

To the extent that volatility causes investors to worry, switching attention from price volatility to dividend volatility might ease that worry substantially.

In the January 25, 2016, issue of Barron's, on page 9, an article titled The Dividend Dilemma by Ben Levisohn, says that it is to overstate how important dividends are to a market's total return. Since the end of 1969, the S&P 500, including reinvested dividends, has returned four times more than its price appreciation alone.

In the same article, Iman Brivanlou, managing director for income equities at asset manager TCW says it's sticking with its old standbys, such as consumer staples Coca-Cola (NYSE:KO), Altria Group (NYSE:MO) and PepsiCo (NYSE:PEP). He also states it's sticking with utilities and telecoms. What they all have in common is the ability to pay their dividends no matter what the economy does.

At the time this article was submitted, Morningstar says that KO is selling at fair value, MO is selling at a 3.3% premium, and PEP is selling at fair value.

For those who are able to focus on the long-term income potential of these three companies, buying at or near fair value is a reasonable approach to purchase entry positions, and depending on one's current holdings, worth adding to, especially since all three of them have generated more than double-digit income growth with dividends reinvested over the last five or six years.

Conclusion and Summary:

1. Income provided a substantial part of long-term returns.

2. For investors who focus primarily on their income stream, the volatility of the income from dividends was a small fraction of the volatility of stock prices.

3. The Brandes Institute study has shown the income components of equity returns reached equality with the capital appreciation component after 10 years and then became increasingly dominant as the time frame was extended.

The message is clear; the combination of the power of the income component to drive returns, along with the power of compounding, may provide potentially attractive opportunities for long-term investors who own a globally diversified portfolio of dividend-paying stocks.

Disclosure: I am/we are long KO MO PEP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Sources for article: The Single Best Investment by Lowell Miller. Brandes Institute. Barron's.