Seemingly eons ago, my graduate finance class covered the newly hatched idea that dividends don’t matter to investors. It was authored by two Carnegie Mellon professors named Modigliani and Miller and the idea came to be known as the Miller-Modigliani Theorem or "M & M" to graduate students in finance. Both were economics professors who were called to teach a finance course in the business school and found the existing literature to be confusing. They proposed a contrary view of financial management that hypothesized that the capital structure of the firm (amount of debt or equity) did not matter, nor did the company policy of paying dividends (more or less). The eventual result of this and other research was their receipt of the Nobel Prize in Economics which they received while chaired at the University of Chicago, bastion of Nobel Prize winners.
Many investors today look at dividend paying companies differently than M & M. Companies that pay dividends generally have the following desirable characteristics:
- They are disciplined in their investment process – reducing the risk of large investments that turn bad. Legendary professor Ben Graham spoke for higher dividends in order to keep management focused on getting high rates of return. How many bad acquisitions have we seen in the past twenty years that destroyed shareholder value?
- Dividends offer a view of management’s confidence in the business through the eyeglass of the amount paid out. Boards will not declare or increase dividends if they have low confidence in the company’s prospects going forward, since the penalty for cutting is very high.
- The mere fact that the company has excess cash to pay out suggests a certain financial strength. There is a simple folk truth that "you can’t fake cash", although we would add "but you can borrow it".
Dividend Stocks Perform Better
There is a lot of empirical research that shows dividend stocks outperform non-dividend stocks and bonds. But within the dividend category, there is another sub-group that performs better – the dividend growers. Here is a summary of some of the research reports:
Goldman Sachs report: "Why Dividend Growth Matters"
GS presented some return figures for the S&P 500 Index from January 1972 to March 2012. $100 invested in 1972 would have increased to the following amounts:
S&P 500 | $1585
S&P 500 /dividend Payers | $3000
S&P 500 Dividend Growers and Iniators | $4031
The dividend growers increased to 2.5 times the simple index amount in those 40 years and compounded at 9.5% versus 6.5% for the index.
New York Times article by John Wasik "The Dividend as a Bulwark Against Global Economic Uncertainty" September 15, 2011:
Dividend paying stocks returned 8.9% since 1982 versus 1.8% for non-dividend paying companies since 1973 according to a study by Ned Davis Research.
Dividend Stocks are the Major Source of Returns
Another way to look at the importance of dividends is through the contribution made to total stock returns. Historically, the contribution of dividends has varied and in the 1980′s and 90′s, contributed a third or less of returns. In this period, economic growth was robust and decisions to pay out a dividend were viewed as a sign of weakness in growth opportunities for any company. Generally speaking, dividends are your friend given their contribution to returns as noted in two articles below:
1. Eagle Asset Management white paper entitled "Dividends Deliver", June 2012:
Eagle used a very long time horizon from 1871 to 2003 and concluded that 97% of total real returns came from dividends and only 3% came from capital gains.
2. John Bogle, legendary founder of Vanguard Funds, writing on the website IndexUniverse.com concluded:
"Over the past 81 years, then, reinvested dividend income accounted for approximately 95% of the compound long-term return earned by the companies in the S&P 500. In other words, the reinvestment of dividends accounted for almost all of stocks’ long-term total return."
Summary: Why Dividends Matter
- Dividends and dividend growth have historically been the major source of returns for stock investors.
- Dividend growth stocks tend to outperform the indexes over time.
- Dividend growth stocks help recover in significant downturns and reduce risk as a result.
Dividend growth stocks tend to have stronger business positions, more disciplined use of cash, and less likely to foolishly invest company assets-another way to reduce risk.