The Case for Dividend Investing
An approach geared towards selecting stable, high-quality companies with strong cash flow generating attributes. Avoid dividend traps and weed out troubled companies for best results.
Some investors only invest in stocks that pay dividends, including those with long-time horizons. Is this old school methodology still valid in today’s age of technological and social media innovation, when hot companies have a myriad of attractive projects that may boost shareholder value?
While clearly not a rule applicable to all companies, dividend investing does provide a good anchor point. The reason is intuitive yet not direct and no it isn’t because of the cash dividend for the sake of it. After all, if the extra yield on dividends is offset by a constant depreciating share price due to fundamental business decline, it is more poison than pancakes.
Dividend Investing forces discipline
Companies with suspect balance sheets and poor cash management typically do not pay dividends. During the heydays of the dot com bubble, internet companies were enjoying incredible valuations with little to no profits. By applying the dividend principle, such companies would have been passed on and the investor shielded from catastrophic declines in equity value.
A reasonable yield accompanied by solid business fundamentals, avoids the noise in everyday markets. Analysts and investors often look to stock prices in forming an assessment of value. In turn being anchored by them.
Investors love exceptional stories from management teams. It imbues a sense of optimism and hope akin to purchasing a big draw lottery ticket. As droves of investors catch on to the story, stock prices can climb sharply, and any semblance of reasonable valuation or margin of safety vanquished. This happens far too often for a market perceived by historical standards to be efficient, due to fundamental human psychologies of hope and greed. Dividend investing can put a check on, but not cure for this.
Companies which pay dividends are financially stronger and better poised for long-term growth
Dividend Aristocrats, companies which have increased dividends every year for at least 25 consecutive years, are often among the most stable and best performing companies. Consistent raising of dividends over long periods is indicative of strong earnings and cash-flow growth. Policies of sound financial management are institutionalized within these firms and endure management changes.
Chart 1: Dividend Aristocrats vs S&P 500
Returns of Dividend Aristocrats’ have outperformed the broader S&P 500 companies by 1.24% per year since January 2008. In fact, a longer time horizon going back to 1986 reveals an out-performance of close to 3% per year, with less volatility.
The psychology of investors during bear markets is another big plus for dividend investing. Many investors when faced with constant market decline, will unload their shares at fire sale prices and take huge losses in the process. It is after all, very difficult to fight the panic and stay rational during times of duress. Receiving constant and growing dividends may provide some comfort and prevent you from hitting the “I quit” button too soon. This I would argue, offers the greatest value for the average investor.
It helps us achieve real diversification
Investors have a strong familiarity bias. We are more likely to invest into household names such as Google, Facebook and Microsoft as we feel their presence through our daily engagements and news media. This leads to over-concentration in a select group of industries, most notably technology and consumer discretionary and reduces the effectiveness of a diversified strategy. Inter-sector correlations are among the strongest, so having 100 holdings in the technology sector may have little diversification effect.
Because high dividend yields are often found in the utilities, telecommunications, REITs and consumer staples sectors, by including dividend investing in our overall strategies, we are investing in less cyclical sectors with lower correlations and betas to the broader market. Hence, achieving broad portfolio diversification.
Chart 2: Sector Dividend Yields
Chart 3: Sector Betas
But beware dividend “traps”
Not all dividend stocks are the same. Beware those which yield a dividend much higher than their industry’s average. Often, the business has just suffered a major setback or is in structural decline, leading to a share price plunge and hence, a high dividend yield. If the business continues to perform poorly, a high dividend yield will not offset the fall in share price. And eventually, the dividend will be reduced or eliminated altogether. For example, General Electric, a dividend investors’ darling and whose stock yielded close to 5%, was eventually forced to cut its dividend by 50% due to cash flow problems and business decline. It’s stock price at the time was already in steady decline.
Another key metric to observe is the company’s debt-to-equity and payout ratios. A company with a very high debt-to-equity ratio relative to their sectors, may be more vulnerable to financial shocks and liquidity events. Companies with very high payout ratios may be unable to sustain the same rate of dividends, unless their earnings are inherently very stable or anticipate high growth rates. Conversely, companies with low debt-to-equity and payout ratios are better poised to increase dividends in the future.
Incorporate stable and growing companies with reasonable dividend yields in your income portfolio
Dividend investing can be rewarding, provided one isn’t too greedy. Be suspicious of very high yields and high debt levels, understand the sustainability of the business model and focus not only on current yields but potential future yields before moving in.
The dividend approach is ultimately about selecting good-quality, stable companies with strong cash flow generation, that provide regular and growing income streams to meet expenses, and comfort during market meltdowns. Only by weeding out the traps and pitfalls can the dividend investor’s goal be achieved.