Fairly often I'll hear an argument along these lines: "dividends are fine, but they don't mean much when you lose a bunch of capital." On the surface this line of reasoning appears sensible enough. After all, if you owned a company with a $100 share price that drops down to $80, a $3 dividend payment isn't going to "save you" from a negative return that year. Yet I would contend that this is a very short-term view.
If you have a 12-month time horizon, then sure it's likely that you will be fixated on the price rather than the dividend payments. However, if you have a long-term outlook, your sentiment towards lower prices could very well be the opposite. There are at least four mitigating factors related to how an investor thinks about steady and increasing dividends in the face of falling share prices.
Just because the share price drops doesn't mean you have to sell. Take a company like Johnson & Johnson (NYSE:JNJ) as an example. At the end of 2008, shares of Johnson & Johnson were trading around $60 per share. Then, just a few months later, the price had dived below $50. At the time the company was paying out $1.84 on an annual basis. Thus the casual observer could have remarked: "well, gee that dividend sure didn't prevent a negative return, now did it?"
Yet that's thinking in terms of months rather than years or decades. Incidentally, had the share price remained at $50, today that investor would have now collected roughly $14 in dividend payments. Contrary to the short-term reaction, the dividend payments could literally provide positive returns given a long-term view.
We now know that the share price of Johnson & Johnson did not remain at $50 -- instead it sits around $107. Of course the investor of 2009 wouldn't know that, but the benefit remains. When you find a business with growing earnings and dividends, the share price tends to increase as well. Not linearly, mind you, but certainly eventually.
Had you bought at $60 and sold at $50, the dividend wouldn't have helped a whole lot -- that much is true. Yet consider what happens to the long-term investor. They bought shares of Johnson & Johnson at $60 per share in 2008 with the intention to hold indefinitely -- years (perhaps decades) not months. It's as if they treated as a 10-year CD or private rental property: not caring about the short-term price and instead focusing on the underlying earnings power and growing cash flow. Every 90 days they were reminded of the benefits of being a part owner. Moreover, these cash payments just kept on increasing regardless of what nervous direction the share price moved. While the logic is the same with a non-dividend paying company like Google (NASDAQ:GOOGL) (NASDAQ:GOOG), the tangible nature of a growing dividend could very well prevent you from selling low.
Better Reinvestment Opportunity
As a long-term investor, your preferred choice of action is to either buy more shares over time or at the very least hold on to your wonderful partnership stake. If you're looking to buy more in the future, you want a lower price. We make no such mistake about buying milk at the grocery store, but for some reason many complicate things in the investing world. Earnings and dividends held constant, a lower price allows your investing buck to go further: buying more shares at a lower valuation and higher dividend yield.
Notably, even if you don't plan on buying more shares, you would likely prefer a lower share price. By means of a share repurchase program the company is often buying back shares on your behalf. In doing so, you don't want the company to buy out your previous partners at a premium. Instead, you want those repurchasing funds to go as far as possible -- eliminating as many shares as possible such that your ownership claim continues to increase.
Only if you plan to sell do you want a higher price. In effect, the outcome that short-term traders fear -- a lower price -- is the precise thing in which you should be rooting for. Without the intention to sell, a lower price means more earnings and dividends for you.
Capital Appreciation Will Come
Of course you can cheer for lower prices all you like, but alas this is often a temporary phenomena. With growing profitability, and hence a growing dividend for a company like Johnson & Johnson, capital appreciation will come along anyway.
Consider that at the end of 2008, Johnson & Johnson was paying out $1.84 in dividends. Today the company pays out $2.80 -- a number that is overwhelmingly likely to increase in the future. Had the price remained around $50, this would have simultaneously required a "current" dividend yield of 5.6%. If the company is able to grow its dividend by say 6% per annum, in the next 10 years a $50 share price equates to a 10% yield; possible, sure, but not especially likely. (Show me JNJ with a 10% dividend yield and I'll show you a place to invest.) As the dividend (and earnings) grow, the likelihood of lower prices subsides dramatically.
To the short-term spectator, it may seem as though the dividend makes up a small portion of the overall return. Stock prices routinely swing up or down 1% or 2% in a day, while the dividend yield often just sits in 2% to 4% range. It's not readily observable and thus people say things like: "the dividend doesn't mean much." Yet long-term investors, especially those focused on income, know that these payments can indeed become meaningful over time. It's the tangible, value stabilizing nature and lasting impact that makes dividends so appealing.
Disclosure: The author is long JNJ.
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.