The Shareholders’ Cut

Markets & Investing

What dividends communicate to the most important people in the conversation.

Investors are needy. Insatiable, really.

But it makes sense: If an investor buys a share of a company, they’re going to want some benefit from it. And under the Friedman doctrine – the most influential model for business ethics since the 1970s – a company’s leaders are seen to have a moral responsibility to address that insatiable need, to provide “shareholder value.”

They do this in one of two ways: Grow the price of the stock or pay dividends to shareholders.

Growth gets all the good headlines, being about imagination, the future and newness.

Dividends, on the other hand, don’t have that flair. Dividends are more about sustainable profitability – about what is and what has been. Even the index exclusive to large US companies that have reliably increased dividends for at least 25 years has a stodgy name: the S&P Dividend Aristocrats.

But growth stories sometimes falter and dividend checks (almost) always cash. So as investors with needs, maybe it’s time we refamiliarize ourselves with our steady friend, the dividend.

Under the dividend umbrella

In a sense, every company seeks growth and most pay dividends.

Within the realm of companies comprising the Russell 3000 index, a majority have paid dividends in the past year, including more than 80% of the 500 largest American companies included in the S&P 500.* Of the ten companies at the top – all growth-oriented businesses – eight have a history of paying dividends.

But as investors sifting through a universe of stocks, we look for shorthand in understanding companies’ approaches to shareholder value, even if the border between a growth alignment and a dividend alignment is fuzzy. So, when we talk about “dividend stocks,” we mostly mean companies that pay meaningful portions of their income to investors. Investors are very interested in yield: the amount the company has paid compared to the price of the stock. And as long-term investors, we find information in the company’s balance sheet, price-to-earnings ratio and dividend payout ratio, which is the percentage of a company’s net income paid out as dividends.

We also classify dividend-paying companies by whether payments have decreased or increased over time, or if they’ve stayed the same. Among S&P 500 stocks, 69 have grown their dividend payments consistently over the past 25 years* – the Dividend Aristocrats. Whether growing, sustaining or decreasing dividends is good or bad news depends on your goals as an investor.

Back to your needs

Where dividend stocks fit into your portfolio depends on your goals, but they are often used to help produce income, reduce portfolio volatility or appreciate in value.

Income

The income case is simple. As a long-term investor with a healthy portfolio, you know that selling stock to provide day-to-day income has certain risks. Circumstances may demand you sell stock even if the market is down. You are also selling off pieces of your productive portfolio, limiting future growth potential. Comparatively, when you get a dividend payment, you keep the stock that paid it, and your wealth continues to benefit from any future increases in the stock price.

For income, dividend stocks are mutually responsive with the bond market. Bonds, a pillar of income investing, pay a set income over a set period. High-quality bonds are generally considered lower risk than stocks, since companies have no explicit obligation to continue paying dividends, but stocks have some attractive advantages. When interest rates are low, high-quality bond yields will also be low, so stock dividends may have stronger yields. Stock trading is also more intuitive than bond trading, which is largely conducted in direct transactions between institutional traders. Sticking to the stock market can appeal to investors who like to feel more connected to their portfolios.

Asset appreciation

Paying healthy dividends not only provides shareholder value; it also demonstrates a company’s strength. Dividends increase the value of holding the stock, which in turn is expected to increase the price that investors are willing to pay for it. Further, you can reinvest your dividends to buy more stock through a dividend reinvestment plan, called a DRIP. You’ll still pay taxes on the dividend (either as regular income or as capital gains, depending on circumstances), but if you don’t need the income, DRIPs can help you grow your portfolio.

These compounding gains are powerful. Looking at the S&P 500 from 1960 to today, 85% of the cumulative total returns are attributed to dividend reinvestment.

Lower volatility

Dividend stocks historically tend to outperform growth stocks in a down market, as their value is inherent to their sustainability as the business. Growth demands optimism. When optimism is hard to come by, investors may retreat to companies who plug along rain or shine. In the holistic fabric of the market, everything is connected, so prices of dividend stocks can increase during these periods – but a shift back toward a bull market can reverse fortunes.

Dividend inertia

You may wonder what keeps a company from issuing a dividend when it needs a quick boost to the stock price and then not issuing a dividend the next quarter. That may be more of a sociological question, but investors attribute a lot of meaning to dividend policy in a way they don’t for, say, stock buybacks. When a company changes dividend policy, the future-looking market makes a lot of assumptions as to why.

As a result, there are incentives for companies whose value is closely tied to its dividend policy to be transparent and consistent about it. And depending on what you’re looking for as an investor, that could be exactly what you need. It is all about you, after all.

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Past performance may not be indicative of future results. Investing involves risks including the potential loss of principal. Dividends are not guaranteed and will fluctuate. The S&P 500® Dividend Aristocrats® Index measures the performance of S&P 500 companies that have increased dividends every year for the last 25 consecutive years. The Russell 3000 Index is a capitalization-weighted stock market index that seeks to be a benchmark of the entire U.S. stock market. It measures the performance of the 3,000 largest publicly held companies incorporated in the United States. The S&P 500 is an index of 500 widely held U.S. stocks. These indexes are unmanaged and cannot be invested in directly.

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