SHOULD YOU INVEST FOR DIVIDENDS?

The lure of dividends

Dividends have been a lure for public investors ever since the 1600s when the Dutch East India Company distributed regular profits to shareholders in the form of guilders (Dutch currency). Investors who are looking to maximize returns often shun dividend-paying stocks, mischaracterizing them as low return investments. In fact, those investors are missing out when one takes a historical view of stock market returns. You may be surprised to learn that stocks that pay dividends have outperformed non-dividend-paying stocks over the long run.

To illustrate this point, the chart below comes from JPMorgan using Ned Davis Research and data from January 31st, 1972 to December 31st, 2012. There is a link at the bottom of this post to the full study.

Most investors rightly assume that dividend-paying stocks tend to carry less risk, but history supports they have better returns as well. Why might this be? Companies that pay a dividend are generally profitable and produce enough cash flow to return to investors as a realization of years of internal investment. True, non-dividend paying stocks may have better growth since they are likely reinvesting all of their profits (unless they are buying back shares or paying down debt), however, those projects are not guaranteed to pan out. The company could be squandering cash flow that could be paid out to investors. Another possibility is that the company does not generate sufficient cash flow to pay out to investors. Those companies may be on fragile financial footing. Dividend investing does not always work, but in the long run the numbers do support dividend investing as a viable investment strategy.

Dividends (and the expectation for future dividends), in fact, are the underlying force that drives valuation for a stock. Let me explain. In theory, the value of any company is the present value of its cash flows. Current cash flows are worth more than future cash flows because you would always rather have something today than a promise for tomorrow. Benjamin Graham, the father of value investing, was arguing this point all the way back to 1934. But what if those cash flows are squandered by poor investment? Once a dividend is paid, the investor decides what to do with it. They can reinvest it in the same company’s shares, reallocate it to another investment or maybe buy a new iPhone. I believe that optionality to investors is worth something.

Many investors value a company based on its stream of dividends using what is called the dividend discount model (also sometimes referred to as the Gordon Growth Model). They look at dividends because there is a tangible nature to it in that it is money actually paid out to investors. It serves as a force in the market allowing investors to realize a return without selling. Think about this. If the stock price gets cheaper, an investor can buy a stock that yields a higher dividend (assuming the company can continue paying it) which attracts new investors to the stock.

It is common for investors to use bonds for income and while income from bonds is usually safer, there are some drawbacks. Dividends are not typically stagnant. Investors usually prefer companies that increase their dividends over time. This allows an investor’s income to potentially grow which is helpful because most people have expenses that rise over time due to inflation. That makes dividend income a nice complement to an investor’s bond portfolio.

But…

What’s the catch? Historically, a successful investor in dividend-paying stocks must look beyond the surface because certain characteristics have worked better than others. From January 1st, 1990 to March 31st, 2013, the best performing stocks were those which paid a high dividend yield but yet had a low payout ratio. This means that the investor received a sizable dividend relative to the price of the stock while the company was only paying out a small portion of earnings. This has been a successful strategy because this scenario typically signifies that the company can easily afford this dividend while still investing for the future. In contrast, the worst performing groups had high payout ratios. If a company is paying out most of its profits in a dividend, they don’t have much left over to invest for growth.

Sometimes investors become enthralled by a big dividend and forget to look under the hood. Companies know that investors are attracted to a generous dividend but their reluctance to change dividend policy can lead to some poor capital allocation decisions. This creates a trap for company management and can yield poor results for investors.

Scenario 1, a dividend as a barrier to investment: ABC company pays out 80% of profits in the form of dividends and many investors own the stock for the dividend. The company files a patent for the hottest pepper in the world presenting an opportunity to corner the hot pepper market. However, the company is reluctant to invest the necessary capital to build out manufacturing capacity, distribution, and marketing because it sees the dividend as a required claim on cash flow. This decision allows their competitors to catch up and create their own peppers and a fragmented market. The company’s profit growth suffers and investors are left worse off when compared to an alternate universe where the company strikes while the iron is hot.

Scenario 2, a dividend as a burden: There is also a possibility that a company could continue paying a dividend they can’t afford just to avoid disappointing investors. The company may start to borrow money just so they do not have to cut the dividend which can add further risk to the company’s stock. History is littered with examples of companies that viewed their dividend as a requirement to the detriment of the future. A recent example was GE, who slashed their dividend to a penny in 2018 as they faced up to liabilities stemming from long term care insurance contracts they’d written decades before.

So what’s the solution?

It’s important to perform proper due diligence before investing in a company’s stock. This includes an examination of a company’s balance sheet and cash flows. Can they afford to pay this dividend? Do they still have enough cash flow left over to invest for the future? Is company management making wise decisions with their capital? These are but a few important questions to ask prior to investing in dividend stocks. At Aurora, we peer “under the hood” with the goal of maximizing your chances of having a positive experience as a dividend investor.

Invest Curiously,

Austin Crites, CFA

Sources: https://am.jpmorgan.com/blobcontent/1383169208768/83456/11_695.pdf

Austin Crites is the Chief Investment Officer of Aurora Financial Strategies, a financial advisory firm based out of Kokomo, IN. He can be reached via email at austin@auroramgt.com. Investment Advisory Services are offered through BCGM Wealth Management, LLC, a SEC registered investment adviser. This blog does not constitute advice. This is not an offer to buy or sell securities. Advisor is not licensed in all states.