Why I Love Dividends

Recently, I wrote an article for another investing site in defense of dividend investing. It was in response to several articles with titles like “Why I Hate Dividends” and “The Dumbness of Dividends.” I have modified my article for this site.

The Case Against Dividends: The anti-dividend articles, when combined, made the following case against dividends:

1. Retained earnings produce growth. Money sent out as dividends cannot contribute to growth.

2. Retained earnings, if not re-invested for growth, are better spent in share repurchases than in dividends.

3. Share repurchases and reinvestments in the business should fuel future price appreciation. Dividends do not. In fact, dividends reduce price appreciation.

4. Dividends reduce the value of the underlying shares by the amount of the dividend.

5. Studies do not find that dividend stocks “do better” than non-dividend-paying stocks.

6. It is more tax efficient to generate income from selling shares than from dividends.

7. Dividends’ appeal lies largely with uneducated shareholders. Companies use dividends to bribe shareholders and to exploit shareholder ignorance.

8. Would you want Warren Buffett to distribute dividends rather than keep doing what he’s been doing for decades (Berkshire Hathaway does not issue dividends)?

The Case for Dividends: Here, I am not trying to show that dividend stocks are always the best investment. But I am trying to show that dividend stocks can be the basis of a very intelligent and successful investment strategy. Dividend stocks are not just for retirees or clueless investors.

The Dual Nature of Dividend Stocks: Many investors think of stocks as assets that you trade with a focus on price: Buy low, sell high. If you mention income production, they think of bonds. But dividend-paying stocks are instruments with the power both to produce income and to rise in price. A good dividend stock is an equity security like all others, but with unique income characteristics.

What I call the Sensible Dividend Investor is not stupid or ignorant. But he or she often comes to see stocks differently from growth investors. Stocks become like cash machines that generate streams of income. Dividend investors do not lose all interest in the price of their shares, but price doesn’t matter as much. If prices fall, the dividends keep coming. Price declines often present attractive buying opportunities for those who are still in the wealth-accumulating stage of their lives.

The idea that dividends are the principal reason for owning a stock is not a new concept. In 1934, Benjamin Graham and David Dodd wrote in their classic Security Analysis, "The prime purpose of a business corporation is to pay dividends to its owners [emphasis added].” This statement is more than a quaint reflection of its time. It is a fundamental view of what owning shares in a company is all about, as valid today as 75 years ago.

Stock Prices Tell Only Half the Story: The total return from stocks is comprised of two elements: price appreciation and dividends. Studies show that dividends have accounted for half or more of the total return of the stock market over very long terms. Despite this, there is no widely publicized “dividend index” that gets the coverage given every day ro the Dow, S&P 500, and NASDAQ indexes, even though those reflect price changes only.

As to price appreciation: A company creates value by generating profits. It ingests investors’ capital and/or borrowed money to get started, and then it utilizes the skills of its people, research, development, manufacturing, marketing, and other functions to bring in more money than it spends. The net pileup of profits and assets, and the company’s ability to utilize those to bring in ever-larger earnings, increase the enterprise’s value over time.

In turn, the company’s stock price goes up if the market recognizes the increased value of the company. Historically, through a wisdom-of-crowds “price discovery” process, investors have tended to recognize and pay for increased earnings capabilities. They do this by placing an appropriate multiple on a company’s earnings per share. Over long periods of time, the multiple has averaged out around 15-16. That is, if a company makes $1 per share profit, its price will hang around $15 or $16. Sometimes, prices rise or fall because the market places a higher or lower multiple on the shares. The multiple thus reflects investor sentiment toward the stock, or toward the entire stock market.

The Dividend Half of the Story: First of all, note the obvious: Dividends are always positive—there is no such thing as a negative dividend. As to the long-term record of dividend stocks, I will focus on just two studies to save space.

• Wharton Professor Jeremy Siegel’s research attributes 97% of the stock market’s total return from 1871 to 2003 to re-invested dividends, and he also states that from 1926 to 2004, reinvestment of dividends accounted for 46% of all stock market return after inflation.

• In a February, 2009 article, “Follow the Juicy Dividends,” BusinessWeek cited Ned Davis research showing that stocks with at least five years of dividend growth outperformed the S&P 500 every year from 1972 to 2008. The study showed these annual total returns:
          o Dividend Cutters or Eliminators: 0.5%
          o Non-Dividend Payers: 0.7%
          o S&P 500: 6.2%
          o Dividend Payers with No Change in Dividends: 6.2%
          o Dividend Growers and Initiators: 8.7%

The Share-Buyback Red Herring: One of the most-cited reasons against dividends is that shareholders are better off if the company uses that money to buy back shares of itself. Share repurchase programs are not regular programs. They are not predictable as to size or frequency. Some share repurchases are not completed after their announcement. In hard times, most companies will suspend a share buyback program before they touch the dividend.

Often companies pay top dollar for their shares. They don’t “buy low.” Figures from S&P show that few companies repurchased their shares in 2002, the bottom of the post-internet-bubble bear market. But when stock prices were increasing from 2003 to 2007, buybacks became rampant, peaking in Q3 2007, simultaneously with the market’s peak. Then in 2008-2009, when the next bear market hit, buybacks slowed dramatically. This phenomenon appears in every market cycle. USA Today ran a recent article in which it reported that S&P analysts studied stock repurchases from Jan. 1, 2006, through June 2007. They found that a third of all companies took losses from their purchases; three-quarters of the companies that bought back shares lagged behind the S&P 500 for the period; and the most aggressive buyers of their own stock were some of the worst performers.

The Taxation Issue: You must pay taxes on dividends. However, the Federal dividend tax rate of 15 percent makes it one of the least-taxed forms of income available. (Note: The 15 percent tax rate on dividends is due to expire at the end of 2010. Note also that dividends from REITs and certain other special corporate forms are taxed at your marginal tax rate, because their profits are not taxed at the corporate level.) Of course, if you hold your dividend stocks in a tax-deferred account, the normal tax benefits of such accounts apply to the dividends.

It is true that share repurchases are not taxed. But if you want to get the money from share price growth, you must sell some of the shares to get it. Your gain will be taxed at either the long-term or short-term capital gains rate. The Federal long-term rate is 15 percent, the same as with dividends.

Sometimes, investors become too focused on tax considerations. The primary appeal of dividends has never been based on a tax break; that is of recent origin anyway. The chief appeal of dividends is the opportunity to receive cash returns from stocks that are always positive, keep increasing, and are independent of price fluctuations.

Characteristics of the Best Dividend Companies: The best dividend companies have a strong culture of increasing the dividend annually if at all possible. Many have been increasing their dividends for decades. The top dividend-paying companies tend to have strong balance sheets and to handle cash conservatively. Most of them have rock-solid business models and are veritable cash machines. The best dividend-paying companies generate enough cash to fund both growth and dividends.

Dividends cannot be faked, unlike earnings. Paying dividends takes cash out of the hands of management and forces management to handle the remaining cash more carefully. As noted in the November 24, 2008 edition of Fortune, “Companies that retain most or all of their earnings frequently squander those profits. CEOs waste those retained earnings on ‘empire building’ via overpriced acquisitions. Amazingly, companies that pay big dividends actually grow their earnings far faster than those that reinvest most or all of their profits. Paying dividends imposes discipline; it makes the top brass far more careful in deploying scarce cash.”

Dividend stocks tend to attract a different constituency from growth companies. Many shareholders prefer a steady return and a predictable, reliable dividend flow. Investors following a dividend-growth strategy are less likely to sell their shares in response to short-term difficulties. The dividend stream is generally independent of price changes in the stock itself. Shareholders are, in a sense, set free from constant concern about the stock’s price. Dividend investing is a strategy for the long haul. The major attraction is not to make money from price increases, although that is delightful. The major attraction is the dividend itself.

The Power of Rising Dividends: Well-chosen dividend stocks increase their dividends every year, and those can be re-invested to accelerate the process of building wealth. Even if not re-invested, rising dividends obviously deliver increasing income. In contrast to growth stocks, dividend stocks do not have to be traded to realize these benefits.

The best dividend stocks usually grow their dividends at a higher rate than inflation, unlike the fixed dividend payment from most bonds. If you own shares in a dividend-paying company that increases its dividends, your yield on cost (that is, the yield on your original investment) goes up. This happens even though the current yield stays the same. It’s simple math. No matter how the stock’s price changes over the coming years, your personal yield (= yield on cost) will always be based on what you paid originally.

Over time, your personal yield will surpass the 10%-11% long term total average return of the stock market itself, just from the dividends alone. This is the most powerful aspect of dividend stocks. The process can be accelerated, of course, by re-investing the dividends and letting them compound.

This contrasts sharply with bonds. Bonds are fixed income investments. We can easily see the ways that they are “fixed”: Their term is fixed; their “coupon,” or rate of return, is fixed; and their nominal worth at the end of the term is fixed. You get back what you originally paid—in dollars that have been eroded by inflation.

Take a look at this table of returns for a terrific dividend company, Automatic Data Processing (ADP):

Year                         2005     2006     2007     2008     2009
Price Return         +5%      +9%      +3%     -9%      +9%
Dividend            $0.65      0.79      0.98     1.20      1.33
Div. Increase                  +22%    +24%  +22%    +11%

Note how the price return varies each year, including going negative in 2008. Also note how the dividend just keeps marching up each year. ADP has been raising its dividend for 35 straight years now, yields about 3.5% to new purchasers (much more than that to investors who have owned it for years), and is one of only four US non-financial companies with an AAA credit rating. Another of the four AAA-rated companies is Johnson & Johnson (JNJ), also a top dividend stock.

Of course, there is risk to any company’s dividend. If a company suffers dramatic financial misfortune, and its profits fall or disappear, so can its dividends. Financial calamity will trump any company’s desire and ability to keep sending out dividends. Dividends are not guaranteed. But for well-selected dividend payers, that risk is usually small.

What About Buffett? Do I want Berkshire Hathaway to pay dividends? Personally, I could not care less. I believe that every company has an optimum level of dividend payout that the company discovers over time, as it matures. For new companies, the optimum rate is almost always zero. They need all the cash they can get to grow from corporate infancy through adolescence and into adulthood. For some mature companies, this level is still zero, because of its business model. Berkshire Hathaway certainly has enough cash to pay a dividend, and who knows, they may choose to do so some day, just as Microsoft did a few years ago. But Buffett does OK with a zero dividend, and that’s fine with me.

Summary: Simply stated, the case for dividend stocks goes like this:
• Dividends are always positive.
• The best dividend-paying companies raise their dividends regularly, usually at a pace that exceeds inflation. Their growth is not curtailed by the dividend payouts.
• Dividends are not just for current income. They can be re-invested to accelerate the wealth-building process. Over time, a very high yield on cost can be achieved.
• Dividend stocks offer the potential for price appreciation in addition to the dividends they pay.