| Free Article |
Why I Love Dividends
by David Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
March, 2010
In this article, I am not trying to show that dividend stocks are always the best
investment. But I do wish to demonstrate that dividend stocks can be the basis
of a very intelligent and successful long-term investment strategy.
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 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. In
fact, 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, and it is 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 lavished every day on the Dow, S&P
500, and NASDAQ indexes, even though those reflect price changes only.
Price appreciation is certainly important. 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. Second, the
following two studies show the power of dividend stocks.
• 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. There are several reasons why this is not always--or
even not often--true.
First, 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.
Second, companies often 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? Another argument sometimes made against dividends is
that the "best" companies often do not pay them. Warren Buffett's Berkshire
Hathaway (BRK.A, BRK.B) is often cited as an excellent company that does
not pay dividends. Personally, I could not care less whether any particular
company pays dividends or not. 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's strength is in allocating capital, and
paying a dividend would just deprive him of some of the ammunition he uses to
do what he does best. Berkshire's returns come to investors totally in the form
of capital appreciation, and that’s fine with me. There are plenty of great
dividend-paying companies to choose from.
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.
by David Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
March, 2010
In this article, I am not trying to show that dividend stocks are always the best
investment. But I do wish to demonstrate that dividend stocks can be the basis
of a very intelligent and successful long-term investment strategy.
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 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. In
fact, 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, and it is 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 lavished every day on the Dow, S&P
500, and NASDAQ indexes, even though those reflect price changes only.
Price appreciation is certainly important. 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. Second, the
following two studies show the power of dividend stocks.
• 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. There are several reasons why this is not always--or
even not often--true.
First, 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.
Second, companies often 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? Another argument sometimes made against dividends is
that the "best" companies often do not pay them. Warren Buffett's Berkshire
Hathaway (BRK.A, BRK.B) is often cited as an excellent company that does
not pay dividends. Personally, I could not care less whether any particular
company pays dividends or not. 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's strength is in allocating capital, and
paying a dividend would just deprive him of some of the ammunition he uses to
do what he does best. Berkshire's returns come to investors totally in the form
of capital appreciation, and that’s fine with me. There are plenty of great
dividend-paying companies to choose from.
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.
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