When I wrote my first Top 40 eBook in 2008, I included a chapter entitled, "Why Invest in Dividend Stocks?" I discussed the pros and cons of dividend growth investing. On the "pro" side, I had 9 reasons to invest in dividend growth stocks.
A couple of weeks ago, I published the 2013 edition. My number of reasons to like dividend growth stocks has grown to 19. Here they are.
1. Dividends bypass the market
Dividends and market prices have a common source, namely corporate earnings. But they have utterly different mechanisms for converting earnings into investor cash.
Mr. Market translates earnings into market prices. Unfortunately, Mr. Market sometimes goes haywire and takes stock prices through irrational swings that have little to do with long-term business performance.
But companies themselves determine dividends. Corporate dividend decisions tend to be much smoother than price performance. Corporate dividend policies rarely go haywire. Fluctuating market prices have almost no influence on the dividend stream from a well-constructed dividend growth portfolio.
2. Dividend investing can relieve obsession over market volatility
Because of dividends' independence from market prices, many dividend growth investors find that the dividend growth strategy lifts a great worry off their shoulders.
The investing industry-brokerages, commercials, mutual fund companies, media, punditry-is fixated on the market. Intense coverage encourages a short-term focus and feeling that you have to "do something." But in dividend growth investing, you look to profit from being the owner of a business that sends you some of its profits rather than by holding a trading slip or lottery ticket. If you focus on that notion of partnering with your businesses, you can take the market's ups and downs in stride.
To a dividend growth investor, the market is simply a store where you can buy, and occasionally sell, stocks. You do not have to win trading battles to be successful.
3. Dividends are real cash money
Every dividend is a positive return to shareholders. Cash is sent to them. Dividends are completely transparent and immune from accounting manipulation or trickery.
4. Dividends are always positive
There is no such thing as a negative dividend. Even if a company cuts its dividend, the reduced dividend is still distributed to you. Only if a company suspends its dividend does it drop to zero. It never drops below zero.
5. Dividend investing provides ongoing feedback about your investment
Because dividends are paid quarterly, they provide feedback about your companies directly from the companies themselves. If a company pays and increases its regular dividends according to an established schedule, that in itself is important information about how that company (as distinguished from its market price) is performing.
6. Dividend growth companies are usually outstanding businesses
Dividend growth companies typically have:
- Proven, time-tested business models
- Steady growth
- Sustainable competitive advantages (moats)
- Solid balance sheets
- The strength needed to survive recessions
- Defensible market share
- Reliable cash generation
- Low debt
It requires an outstanding business to increase dividends for many years in a row. Weak businesses simply cannot do it.
7. Dividend increases are usually a positive sign about the company
A dividend increase can normally be interpreted as a positive sign that management has confidence in the company's prospects. A company following an established dividend policy will look ahead a few years when considering each year's increase. So a healthy increase is usually a good sign. (Of course, sometimes companies get their outlook wrong, as many banks did in 2007-08. Fortunately, examples of this kind are rare.)
8. Dividend companies tend to use their cash wisely
A strong dividend program suggests that management is probably making smart decisions with the cash remaining after dividends are paid. As observed by Robert D. Arnott in the Financial Analysts Journal in 2003:
Empirical data suggest that too many companies squander their retained earnings when those retained earnings are more than is required for…future survival and competitiveness.
In the best dividend growth companies, dividends reduce the cash available for corporate projects, so management exercises more discipline and vets those projects more carefully. The result is a more efficient and focused business.
9. Dividend programs tend to persist
Even though each dividend payout is a separate event, once an overall dividend growth program becomes well established, it becomes in effect a corporate policy. The dividend program becomes woven into the culture of the company. A company with a long history of increasing dividends will rarely abandon that policy.
While any company can be wounded during bad economic times, the best dividend companies are able to increase their dividends even if only by a small amount. So a healthy dividend increase of 5, 7, or 10 percent can be seen as an indicator that management probably foresees good sailing for its business over the next few years. When hard times hit, the dividend growth rate may slow, but the company is still able to increase its dividend a little.
10. Dividends increases continue even when stock prices decline
Dividend payments are generally independent of the stock's price. Prices go up and down all the time, but the best dividend stocks increase their dividends every year. So even when a dividend stock's price is falling or range-bound, it still has a positive return component via the dividends.
For example, here is a five-year chart of Aflac (NYSE:AFL). Notice how the dividend (blue line) has just continued upward to its current value of $0.35 per share (quarterly), while the stock's price (red line) has jumped all over the place.
As stated earlier, this independence of dividends from market prices means that the consistent positive return from dividends can provide a degree of insulation from turbulent markets. That, in turn, can provide peace of mind to the investor.
11. You do not have to sell the stock to get the dividend
Dividends are sent to shareholders directly by the company. If a stock pays no dividends, its total return comes solely from price changes, and you can only realize returns if you sell the stock. There is no other benefit from ownership.
In contrast, when you buy a share in a dividend stock, you receive an important right embedded in each share: The right to receive dividends from that company.
A problem with confining your benefits to stock prices is that they are determined by an irrational intermediary: Mr. Market. In my experience, a carefully selected portfolio of dividend growth stocks is pretty reliable about its dividend returns. That is not true of most stock prices, which vary widely in comparison to the relatively steady progress of dividends.
Critics of dividend investing sometimes state that "a dollar is a dollar," what difference does it make if you get a dollar from dividends or a dollar from selling a few shares? The difference is obvious. In order to get your hands on a dollar of capital gains, you must sell shares. After selling, you own fewer shares. The shares you sold can no longer do anything for you, since you no longer own them. So the difference between getting a dollar from dividends or from capital is that you still own the shares in the first instance and don't own them in the second.
12. Dividend payouts rise over time
Hundreds of dividend companies have a long history of increasing their dividend regularly. Companies such as McDonald's (NYSE:MCD), Coca-Cola (NYSE:KO), and Johnson & Johnson (NYSE:JNJ) have increased their dividends every year for decades. It is logical to expect that they will continue to do so if they possibly can.
This is the most powerful aspect of dividend growth stocks. It is why dividend growth investors are often content with stagnant stock prices. It is why retirees - seeking income that keeps up with inflation - become attracted to dividend growth stocks. It is why many income investors consider dividend growth stocks to be more attractive than bonds, whose yields are fixed.
13. Dividends have a low tax rate
For most taxpayers, the current maximum Federal tax rate on qualified dividends is 15 percent. That means that dividends are among the least-taxed forms of income you can get.
14. Dividend stocks tend to be less volatile
In September 2011, the New York Times, in an article titled "The Dividend as a Bulwark Against Global Economic Uncertainty," referenced an ongoing study of dividend stocks by Ned Davis Research (NDR). It reported that NDR's study showed that dividend growth stocks are less volatile than other stocks. They have clocked in at nine percentage points lower in standard deviation than companies not paying dividends.
The smoother price ride generally makes dividend growth stocks easier to hold during times of market volatility. Beyond that, the dividends themselves help cushion portfolio losses when equity prices are declining. Dividends have gentle trends that are fairly predictable. For that reason, dividend stocks tend to attract a constituency of owners who are less likely to sell shares in response to short-term price difficulties so long as the dividend is not damaged.
15. Your principal can increase over time
When you buy stock, you are purchasing a piece of the company. You own a fraction of everything about the company. You can sell that piece any time you want or keep it as long as you want. Until you sell, the company sends you dividends.
If and when you sell, you will receive whatever price Mr. Market has determined for the shares that day. Hopefully, that will be more than you paid for them. So the dividend stock investor potentially gets positive returns from both sources of total return: dividends and price appreciation.
Many researchers have noticed that, over long time periods, increases in dividends loosely track increases in the prices of the equities generating those dividends. That's why you do not see the yields of most dividend stocks climb to ridiculous levels as those companies raise their dividends year after year. It is because the prices are rising too, keeping the yields relatively stable.
Some dividend students believe that the dividend increases themselves pull the stock prices higher over time. I hesitate to attribute a causal relationship between dividend increases and stock price increases. But clearly they are correlated. It is accurate to say that both are the result of the company's earnings growth. That growth is recognized in the boardroom by increasing dividends. It is recognized in the market by rising share prices.
16. Historically, dividend growth stocks have outperformed the market in total returns
Not only might your principal rise over time, but historically dividend growth stocks have in fact outperformed the broad market in total returns. Numerous studies have shown this. They differ in methodology and timeframes, but the similarity in their conclusions is overwhelming.
One such study was published by Robert Arnott and Clifford S. Asness, "Surprise! Higher Dividends = Higher Earnings Growth, (December, 2001). This study suggested that low payout ratios accompany inefficient empire building and the funding of second-rate projects and investments, leading to poor subsequent growth. In contrast, high payout ratios lead to more carefully chosen projects with better returns. The authors found that companies with higher payout ratios had higher real earnings growth over the 10-year periods following the interval studied.
Two relevant studies were published here on Seeking Alpha last year. In a pair of articles (links 1, 2) Chuck Carnevale provided a rationale for why dividend stocks outperform: Investors value (or "capitalize") stocks based on earnings and prospects for earnings growth, and they do this whether or not some of those earnings are paid out as dividends. Consequently, over the long haul share price is not diminished by dividends. (Note to readers: Exchanges themselves lower the price of shares to reflect upcoming dividends, but this is an artificial price change that soon gets buried under actual trading prices). And Tom Armistead (link) created a 10-year back-test with no survivorship bias:
Backtesting validates the effectiveness of DGI (Dividend Growth Investment) strategies. Over the past 10 years, an investor utilizing this approach enjoyed lower beta, higher Sharpe ratios, lower maximum drawdowns, and considerable Alpha. As a bonus, he beat the market."
17. You can reinvest dividends to accelerate the compounding effect
Shareholders can do three things with dividends: Reinvest them, keep them, or spend them.
If you reinvest the dividends (either in the same stock or elsewhere), the reinvestment brings into play a second layer of compounding. (The first layer is the rising dividends themselves.) As you purchase more shares with the dividends, the number of shares on which you receive dividends goes up. They then generate additional dividends, which can then be reinvested, creating a virtuous circle of dividends --> reinvestment --> more shares --> more dividends, etc. This builds wealth at an accelerating pace. Your share base grows faster and faster because of the reinvestments. The growing number of shares increases the dividends you receive.
18. Rising dividends protect against inflation
"Risk" has many meanings in investing. One traditional meaning is the risk to your nominal principal amount. If there is no risk of that sort, a $500,000 portfolio today will be worth no less than $500,000 ten years from now. Under that definition, investment-grade bonds are risk-free, because their nominal or par value does not change over time.
But that common definition of risk ignores inflation. Inflation erodes the purchasing power of money over time. For example, while your principal in bonds is risk-free in nominal dollars, it is defenseless against the corrosive effects of inflation. The same holds true for bond income: It is fixed in nominal terms but steadily loses value in inflation - adjusted purchasing power.
In contrast, the income from dividend growth stocks generally grows faster than inflation, thus protecting against inflation risk. While the principal in dividend growth stocks will have more variability than bonds (which have no variability in nominal dollars if you do not trade them), the variability can work in your favor as we have already seen-prices can rise, thus protecting your principal from inflation risk too.
Speaking personally, sometimes I think that the only benchmark I care about as an investor is inflation, meaning that is the only thing I care about "beating."
In my own study of 51 years of the S&P 500 (link), I found that dividend increases grew the initial dividend stream by a total of 75 percent more than inflation, and that the dividend stream grew to more than 13 times its original size compared to about eight times the original amount for inflation. To be sure, there were periods when inflation exceeded dividend growth.
19. You do not need any more invested to generate 4 percent income rather than 4 percent from sales
It requires no more money to acquire a portfolio of stocks that will pay a dividend stream of 4 percent than to acquire a portfolio of stocks that must be liquidated to generate the exact same 4 percent. I focus here on 4 percent, because that is the amount often recommended to be a "safe" withdrawal amount from a retirement portfolio. The point that 4 percent of organic income equals 4 percent of "synthetic" income from selling assets is obvious, yet it is missed by many, who for some reason believe that living off of income is only for the very wealthy.
And of course, to repeat a point made earlier, if you get your income organically from the assets themselves, you do not have to sell them to generate that cash. Conversely, if you sell shares to generate cash, they are gone and will provide no future returns.
Disclosure: I am long AFL, JNJ, MCD. 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.