Dividend Investing: Tried and true, for a reason
Eric Glover, CFA
Investment Director Equities
Dividends can be an important component of total return over the long term. They are often a more stable component of return than stock price performance and can help buoy a portfolio in years when market returns are negative. When a company can consistently increase its dividend over a long period of time, this is often a signal that the business is able to generate strong free cash flows through a myriad of market environments. Historically, companies that pay a dividend and grow it over time have delivered better returns with less volatility.
Below, we expand on four reasons why dividends matter to investors:
1. Dividends can be a significant component of return
Over time, dividends can comprise an important part of total returns in a portfolio. Reinvestment of dividends can result in higher portfolio growth through the power of compounding.
The chart below shows that returns from reinvested dividends can make up a substantial portion of return over time. Over the last 40 years, a significant portion of returns in major world markets came from reinvested dividends.
2. Dividend-paying companies deliver better returns with lower volatility
Dividends are not subject to the same fluctuations that stock prices are. Companies are careful to select an appropriate payout ratio that can be maintained or grown over time. When a company cuts its dividend, they are often punished by investors who sell their shares, driving the price lower. As shown by the chart below, companies that initiate, pay and grow their dividend deliver a higher return and lower risk than companies that do not pay a dividend or those that cut their dividend.
A company's ability to continue to pay a consistent dividend through a myriad of market conditions, and especially those that can grow their dividend, can be a signal of a durable business model with strong free cash flows.
3. Dividends are a stable component of return
A company's dividend payout ratio (the percentage of earnings paid out as a dividend) is generally more stable than its share price. As shown by the chart below, the dividend payout ratio of the MSCI World Index (an aggregate of many global companies) has ranged from 34% to 45% over the last 20 years. During the same time period, the annual return of the MSCI World Index has ranged from -26% to 35% (CAD). Even during years when the market return was negative, the dividend payout ratio of the Index remained above 30%.
4. Dividends remain an attractive form of income
Since the US Federal Reserve announced its first increase in the overnight lending rate in December 2015, interest rates have been on an upward trend in both Canada and the US. Concerns have been raised about the viability of a dividend-paying strategy as long-term interest rates have trended upwards. Rates have a long way to go before the historical spread between bond yields and dividend yields normalize (see charts below), showing that dividend yields are still an attractive method of generating income.
For investors with a long-term investment horizon, reinvested dividends can contribute substantially to portfolio growth. Moreover, dividends are not subject to the same volatility as stock prices and can provide a steady source of income when market returns are negative. Dividend investing is still a viable strategy in light of rising interest rates, as rates would need to increase substantially before the spread between bond yields and dividend yields reaches its historical level.
- Dividends can contribute significantly to portfolio growth over time through the power of compounding.
- A company's ongoing ability to pay and grow its dividend can be indicative of the company's ability to generate strong free cash flows through a myriad of market environments.
- Dividends are generally a more stable component of return than stock price performance, and can provide a steady source of income in years when market returns are negative.