Regular readers of this column know that at our investment firm, we focus on stocks of companies that regularly grow their dividends. The only time most growth managers pay attention to dividends is when they disparage them. Here are some of the canards growth managers use in denigrating dividends:
• “Paying dividends is an admission by management that there are no good investment opportunities for their cash;”
• “Paying dividends means the company has reached the end of its growth cycle;” or
• “We don’t want our stocks to pay dividends because our clients will just have to pay taxes.”
Does the last one even make sense? Imagine you’re working at a menial job, making $10,000 a year, paying no income tax, and you’re offered a great job at a salary of $250,000. Do you say, “No thanks, I’d just be paying a lot more in taxes”? In a choice between getting great returns and paying some tax on them versus poor returns with no tax, I’ll take the former any day.
Although we consider a portfolio of dividend-paying stocks to be a “core” equities holding for our clients, in their report giving our firm a five-star rating, Morningstar categorizes us a growth manager. And comparing us to other growth managers, Morningstar ranks us in the top 1 percent of managers with a 10-year track record. How can this be, given that we focus on what most growth managers disdain?
Let’s look at the facts about dividend-paying stocks.
According to Rob Arnott and Cliff Asness, writing in the Financial Analyst’s Journal, (“Higher Dividends = Higher Earnings Growth,” Jan./Feb. 2003) the evidence dramatically shows that stock portfolios with higher dividend payout ratios are associated with higher future stock portfolio returns. This phenomenon also applies at the individual stock level, according to research conducted by academic writer Khaled Hussainey, reported in the British journal Applied Economics Letters (Hussainey, K. “Do dividends signal information about future earnings?” 16 (12): 1285-1288).
The Ned Davis Research organization in Venice, Florida, based on its analysis over the past four decades, notes that stocks in the S&P 500 Index that pay no dividends have generated average annual returns of just 1.7 percent, while stocks that paid dividends generated average annual returns of 7.4 percent, or more than 5 percent higher per year. Stocks that raised their dividends averaged a whopping 9.6 percent in annual returns.
But wait, there’s more! One must always ask whether he or she achieved higher returns simply by taking more risk. Maybe dividend-paying stocks produce juicier returns, but are they just riskier? And are dividend-growing stocks, with even better returns, riskier still?
Risk is much more difficult to evaluate statistically than returns. But it’s widely accepted in the world of professional investors that volatility of returns is as good a proxy for risk as we have.
Volatility is a statistical concept relating to how much variability there is around an average, usually expressed in annualized “standard deviation.” The higher the standard deviation, the greater the risk.
In Capital Market Perspectives (“The Power of Dividends in a Slow Growth Environment,” Nov. 19, 2010), published by Oppenheimer Funds, Neil McCarthy and Emanuele Bergagnini show that, using the Ned Davis Research data, those higher returns from dividend-paying stocks come with lower, not higher, volatility. Here’s how the categories stack up:
| Dividend Policy | Standard Deviation | |
| Dividend cutters | 25.7 | |
| No dividends | 26.6 | |
| Dividend payers | 20.7 | |
| Dividend growers | 17.6 |
As Professor Thomas Howard of the Reiman School, University of Denver, puts it, you can have your cake and eat it too—higher dividend yields mean increased returns and lower volatility. The volatility (risk) of dividend-growing stocks is only two-thirds that of stocks that don’t pay dividends.
According to Howard, the effect of dividend growth on stocks is inversely proportional to the size of companies. That’s another way of saying that dividends increase returns and lower risk more for stocks of smaller companies than for those of larger companies. The Ned Davis Research data is based on S&P 500 stocks. Investors in stocks with smaller capitalizations than those in the S&P 500 can expect to improve their results even more by focusing on dividends and dividend growth.
If you want to find stocks that will help grow your wealth, it helps to look in the right places.
