by Matt Malick
“Do
you know the only thing that gives me pleasure? It's to see my dividends
coming in.” - John D. Rockefeller
In the world of investments, everything is cyclical. Hot trends
inevitably cool off and passé ideas return to popularity. Today, stock
dividends have become the latest investment theme to regain favor.
As the last secular bull market was surging in the late 1990s, dividends became
a mere afterthought and many analysts even condemned them. Equities were
easily achieving double-digit total returns year after year, making dividends
seem relatively insignificant. Furthermore, many market professionals
suggested that corporations were better served using cash to fund acquisitions
and other growth opportunities, a sign of rampant optimism. The logic was
that companies had superior internal investment opportunities and to return
money to shareholders in the form of a cash dividend was actually a
waste. It was the era of the celebrity CEO who could make no bad
decisions.
The next twelve years, however, were an entirely different story.
Equities entered a “lost decade” of relatively flat returns with the S&P
500 at roughly the same level where it peaked in 2000. And instead of the
public considering CEOs to be celebrated allocators of capital, they have
gradually become bemoaned fat cats.
Ironically, since 2000, a point in time when dividends were largely ignored,
virtually the only return that buy-and-hold equity investors reaped were
from dividends. This “reversion to the mean” phenomenon is not unusual,
but always unexpected.
Today, dividends are experiencing renewed appeal throughout the investment
community. In aggregate, U.S. equity mutual funds suffered $103 billion
in redemptions in the 12 months ended January 31, 2012, according to
Morningstar. But, nervous investors did not shun dividend stocks.
Just last year, mutual funds that focus on dividends attracted $3 billion
in inflows and dividend-themed exchange traded funds took in another $14.3
billion. There is often an inverse relationship between mutual fund flows
and future performance – positive flows can predict underperformance, while
negative flows can suggest outperformance.
Investment companies have identified the opportunity to appeal to yield-starved
investors, launching 16 brand new dividend-oriented funds in 2011. Even
the Fidelity Equity Income Fund II, which appointed a new manager and increased
its exposure to dividend-paying stocks, changed its name to the Fidelity Equity
Dividend Income Fund.
Perhaps an interesting sign of the general hunger for dividends is the March
2012 cover of Investment
Advisor magazine with its headline, “Dividends, Dividends,
Dividends!”. The assumption among the punditry is that - given
below-trend economic growth and, at the same time, strong corporate balance
sheets - future returns favor companies that return cash to shareholders.
Despite general enthusiasm, sometimes a contradictory sign, there is actually
very sound logic behind dividend stocks. According to Morningstar, “Since
1927, high-dividend-paying stocks have returned 11% per year, beating the 8%
return from nonpayers and resulting in an ending wealth that is 8 times larger.
Better yet, they accomplished this feat while incurring less volatility.”
Furthermore, Ned Davis Research finds that between 1972 and 2005, S&P 500
stocks that had consistently grown their dividends outperformed the nonpayers
by 6%. And presently, the dividend payout ratio (the amount that a
corporation distributes in dividends relative to its earnings) is at a historic
low of 32 percent. In the past, the average payout ratio has been over 50
percent. This statistic implies that companies have plenty of room to
raise their dividends in the years ahead.
Moreover, the tax rate on qualified dividend income – currently 15% for most
taxpayers – is at an all-time low.
Finally, bond yields have become so paltry that dividends are an increasingly
important source of income. As of today, the yield on the ten-year
Treasury stands at 1.97% whereas the dividend yield on the S&P 500 is 1.93%
and offers the potential for price appreciation.
Yet, after turning in stellar performance relative to other equities in 2011,
dividend stocks have not fared as well through the first two months of
2012. According to Bespoke Investment Group, the stocks in the
S&P 500 that pay no dividend have outperformed the 50 stocks in the index
with the highest dividends by a whopping 12.03%.
In our opinion, dividend-paying stocks serve an important role in a diversified
portfolio. In fact, our managed equity portfolio has a considerably
higher average yield than the overall market. But dividends are not a
cure-all for apprehensive investors. The consensus seems to be that
dividend stocks are sure to hold their value, continue paying healthy yields
and offer potential capital gains.
We urge caution that dividend-payers are still equities and carry the risk of
loss. And stock dividends are not guaranteed – just ask shareholders in
most financial companies during the crisis years of 2007-2009.
Of equal importance, if the market performs well over the next several years,
which is our expectation, investors will eventually take notice and start
chasing returns. Dividend stocks could easily trail the overall market if
sentiment improves. This is an important reason to hold a mix of equities
in different businesses and with varying market capitalizations, geographic
footprints and dividend levels.
The bull market that began in March of 2009 is now the ninth longest bull market
since 1928, but the retail investor has still not returned. For now,
dividend paying stocks are the investor’s training wheels to get back into the
market. But if stocks have a big year of gains, greed can take over and
folks may think they are riding in the Tour de France and toss the training
wheels.
