Track record of rising dividends a good litmus test for investment
• When the US stock market fell from 1929 to 1932 on a real basis, real payouts fell only 11%
In his book, The Future for Investors , Wharton Business School finance professor Jeremy Siegel gives investors concrete guidance about where to put their money if they are worried about a market downturn. Instead of relying solely on index funds, he suggests switching to companies with high dividend yields.
He then recommends reinvesting those dividends. Not only does that improve a portfolio’s long-term returns by buying in the downturns, it also reduces risk. First, because investors are more willing to hold on to regular cash-payers in the downturns, and second, because “dividends don’t lie”.
Dividends are a vital element of return, says James Montier in a GMO Paper titled A Man from a Different Time. Looking at the US market since 1871 ... on a fiveyear time horizon, dividend yield and dividend growth account for almost 80% of the return. On average, over the very long term, dividends have accounted for about 90% of total return.
That comes with the warning, however, from Michael Mauboussin and Dan Callahan at Morgan Stanley, that almost noone earns that alleged return, “as it assumes dividends are reinvested with no friction”. In other words, you have an automatic dividend reinvestment plan with zero taxes. “Most people spend the dividends they receive, and most funds allow the sum simply to go to cash.”
Still, according to Siegel, dividend-paying stocks outperform nonpayers, and dividend reinvestment expands that level of outperformance exponentially. The main reason is that companies with the cash flows that enable dividend payments tend to be the ones that survive over the long term.
As Ben Carlson explains in A Wealth of Common Sense: “Though stock prices themselves are volatile, the cash flows companies collectively pay out to investors don’t really fluctuate as much as one would think. According to Robert Shiller, from September 1929 to June 1932 when the US stock market fell 81% on a real basis, real dividends fell only 11%.”
In other words, during one of the worst economic disasters companies cut dividends only a little more than 10%! Unfortunately, while it’s tempting to look at what’s worked in the past and assume it applies to today’s markets, that’s not always the case.
These days many of the fastest-growing and financially healthiest companies in the world, such as Facebook and Google, don’t pay dividends, while high dividend payouts have become the refuge of utility companies and struggling oil pipelines — the opposite of what worked in the past.
“All you need for a lifetime of successful investing is a few big winners,” said Peter Lynch. “Invest in businesses that have a history of solid growth. The more a business grows, the more profitable your investment will become.”
And rising dividends are a good litmus test for profit growth. Decades of dependable dividend increases are hard to fake, even in a world fraught with accounting sleight of hand, and often, downright chicanery. A track record of dividend increases is a good way to determine whether a company has true competitive advantages and a durable business model.
“But, my biggest lesson was in chasing yield,” says Kanwal Sarai, founder of Simply Investing. “It is nice to see a big dividend cheque on a regular basis, but is it safe? Will the company continue paying it and growing over the next five, 10, 20 years?”
Not all rising dividends are necessarily good news. While most are a genuine reflection of an improving business, there are at least two scenarios in which they should be viewed with scepticism.
The first is debt-funded dividend increases. Income investors may turn up their noses at companies that are unable to maintain dividend yields, but it’s worse when a company raises debt to maintain or boost its payout.
The other scenario is disinvestment-related dividend increases. It’s not uncommon for companies that are selling assets to share the proceeds with shareholders. However, increasing a dividend after a disinvestment is unlikely to be sustainable. And most asset sales are undertaken because at least one aspect of a business is underperforming.
Franco Modigliani and Merton Miller theorised that, with no taxes or bankruptcy costs, a company s dividend policy is irrelevant. He said dividends should have no effect on a company ’ s capital structure or stock price since an investor can always buy or sell the stock in a company to replicate its expected cash flow.
But that flies in the face of the “bird-in-the-hand ” theory that investors value dividends more than capital gains in making investment decisions, something more to do with uncertainty they face than financial theory. If a firm’s value depended solely on its earnings potential and the risk to its underlying assets, it would be hard to explain its constant price gyrations.
The more likely explanation is investor sentiment; and it is here, in the message it carries, that a company’s dividend policy may be of greatest importance. One of the simplest ways for a firm to communicate financial wellbeing is to say, “the cheque is in the mail”.
IT IS NICE TO SEE A BIG DIVIDEND CHEQUE ... WILL THE COMPANY CONTINUE PAYING IT AND GROWING?
INCREASING A DIVIDEND AFTER A DISINVESTMENT IS UNLIKELY TO BE SUSTAINABLE.