The wise investor demands his investments provide ongoing cash returns. For income real estate, this means a monthly stream of net rental income after payment of all expenses, including the mortgage. For bonds, this means regular interest payments that, considering the issuer’s credit quality, are competitive with the terms other borrowers are offering.
How does this doctrine apply to stocks? Until the middle of the 20th century, stock investors expected to receive cash dividends. And because stocks were considered riskier than bonds, dividend yields were typically higher than yields on high-quality bonds. In the 1950s, investor attitudes toward dividends began changing. They realized a well run, growing business would produce increasing profits and dividends, leading to increasing share prices. Share price appreciation is an attractive form of return because one needn’t recognize the gain for tax purposes until it’s “realized” when the investment is sold. Also, for much of the past 50 years, tax laws have treated realized appreciation more favorably than cash dividends.
As the economy grew and prospered following World War II, and as the grim memories of the 1929 stock market crash and the Great Depression faded, investors also began to view stock price appreciation as inevitable. This change in outlook resulted in share prices being bid up, which led to falling dividend yields. Average dividend yields have remained consistently below long-term Treasury bond yields since the 1950s. Today, the typical stock dividend yield is 2 percent compared to a 5 percent yield on 10-year Treasury notes. As share ownership became more widespread in the robust markets of the 1980s, the link between share prices and cash dividends became weak or nonexistent in the minds of many investors. In the 1990s, many stock investors disdained dividends as unwanted cash. Many thought management should plow profits back into growing the business to generate ever-greater profits and thus an ever-increasing share price.
This latter view has turned out poorly for many investors. To illustrate, let’s look at stock market results since the mid-1990s.
Past results
In a strong market from 1995 through 1997, non-dividend paying stocks modestly outperformed dividend-paying stocks. As the market roared in 1998 and 1999, while dividend-paying stocks gained a healthy 35 percent, they were easily outdistanced by the non-dividend payers. The latter more than doubled, up 113 percent for the final two years of the late 1990s bull market.
When the new millennium arrived, it was time to pay the piper. In the March 2000 to September 2002 bear market, dividend-paying stocks declined about 25 percent, but non-dividend payers declined almost 70 percent. At that point, the latter were worth about what they had been at the end of 1996. And their owners had received no income from their non-dividend paying stocks in the interim.
Investors prescient enough to get out of the market in early 2000 racked up huge profits on their holdings. But few got out. Most watched helplessly like deer in the headlights as the market eradicated their gains—and then some.
Gains and losses expressed in percentage terms don’t have equal impact on investors. For long-term success, it’s more important to avoid large losses than to achieve large gains. That 70 percent loss over the 30-month period starting in March 2000 would wipe out a 233 percent gain!
My research on large-cap stocks using “point-in-time” data (data available at the time an investment is made) going back to 1987 shows clear outperformance by dividend paying stocks over non-dividend payers. The source of this outperformance is not so much the greater gains by dividend payers but their lower volatility. For example, the rolling average annual gain for dividend payers over this period was 12.5 percent, compared to 12.1 percent for non-dividend payers. But the volatility of the latter was two-thirds greater than the former.
By avoiding higher volatility, someone who invested $100,000 in dividend paying stocks at the end of 1986 would have a portfolio worth $860,000 at the end of 2005, compared to $628,000 for a similar investment in non-dividend paying stocks. This works out to an annualized return difference of about 2 percent. Companies that share their profits with their shareholders provide their investors with a better bottom line.
Rewarding returns
Some argue that company share repurchases are a more tax-efficient way than cash dividends for a firm to return profits to its shareholders. These companies use cash that could otherwise pay dividends to purchase their own shares on the open market. The theory states that by reducing the number of outstanding shares while company earnings remain the same, the market will reward the company with a higher share price, benefiting all shareholders with higher market values that do not in themselves generate any taxable event.
In his most recent annual report to Berkshire Hathaway shareholders, Warren Buffett counters that in many cases, share repurchases simply enrich management at the expense of shareholders. The increased share price resulting from share repurchases lets executives holding options exercise them at a profit, increasing their compensation. But because share repurchases have no impact on a company’s actual business operations, generate no increase in profits and do not represent any investment for the future, profits used to repurchase shares simply pass to management through the incentive options program.
Cash dividends do matter for stock investors. And if a company regularly increases dividends as profits grow, they matter a lot. For our firm’s Model Portfolio, we strive to find companies we believe can increase dividends at least 10 percent annually. Think of owning such companies like owning an apartment building in which your tenants willingly increase their rents 10 percent a year while your expenses remain stable. For real estate investors, that would be nirvana. For stock investors, it’s a ticket to greater profits.
This column is not intended as investment advice. You should consult your own adviser in determining whether to incorporate any of the opinions expressed here in your investment decisions.
David Raub has 16 years’ experience as a registered investment adviser. He is co-owner of Raub Brock Capital Management in Larkspur.
