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Are Dividend Stocks Important?

Dividend stocks offer fixed-income investors a number of advantages over other stocks, including increased stability, real dollar payouts, more dependable returns, and greater protection against market fluctuations. We believe these stocks should play a major role in any portfolio where income is a priority. For this reason, we seek to hold higher quality* dividend stocks in our Pure Equity Dividend Model, which makes up the core of our Conservative and Moderate Allocations.

Renowned stock analyst and author David Van Knapp wrote a detailed analysis of the benefits of dividend growth stocks. His ideas mirror FAC's own philosophy. The following list is an excerpt from his article, "19 Things I Like About Dividends," which first appeared on Seekingalpha.com. (Click here to read the full article.) 

1. Dividends bypass the market

Dividends and market prices have a common source, namely corporate earnings. But they have utterly different mechanisms for converting earnings into investor cash.

[The market] translates earnings into market prices. Unfortunately, [it] sometimes goes haywire and takes stock prices through irrational swings that have little to do with long-term business performance.

But companies themselves determine dividends. Corporate dividend decisions tend to be much smoother than price performance. Corporate dividend policies rarely go haywire. Fluctuating market prices potentially have very little influence on the dividend stream from a well-constructed dividend growth portfolio.

2. Dividend investing can relieve obsession over market volatility

Because of dividends' independence from market prices, dividend growth investors sometimes find that the dividend growth strategy lifts a great worry off their shoulders.

The investing industry-brokerages, commercials, mutual fund companies, media, punditry-is fixated on the market. Intense coverage encourages a short-term focus and feeling that you have to "do something." But in dividend growth investing, you look to profit from being the owner of a business that potentially sends you some of its profits rather than by holding a trading slip. If you focus on that notion of partnering with your businesses, you may be able to take the market's ups and downs more in stride.

To a dividend growth investor, the market is simply a store where you can buy, and occasionally sell, stocks. You do not have to win trading battles to be successful.

3. Dividends are real

Every dividend is a positive return to shareholders. When distributed, dividends can be in the form of cash or stock.

4. Dividends are positive

There is no such thing as a negative dividend. Even if a company cuts its dividend, the reduced dividend is still distributed to you. Only if a company suspends its dividend does it drop to zero. It never drops below zero.

5. Dividend investing provides ongoing feedback about your investment

Because dividends are paid quarterly, they provide feedback about your companies directly from the companies themselves. If a company pays and increases its regular dividends according to an established schedule, that in itself is important information about how that company (as distinguished from its market price) is performing.

6. Dividend growth companies are usually better businesses

Dividend growth companies typically have:

  • Proven, time-tested business models
  • Steady growth
  • Sustainable competitive advantages (moats)
  • Solid balance sheets
  • The strength needed to survive recessions
  • Defensible market share
  • Reliable cash generation
  • Low debt

It requires an outstanding business to increase dividends for many years in a row. Weak businesses simply cannot do it.

7. Dividend increases are usually a positive sign about the company

A dividend increase can normally be interpreted as a positive sign that management has confidence in the company's prospects. A company following an established dividend policy will look ahead a few years when considering each year's increase. So a healthy increase is usually a good sign. (Of course, sometimes companies get their outlook wrong, as many banks did in 2007-08.)

8. Dividend companies tend to use their cash wisely

A strong dividend program suggests that management is probably making smart decisions with the cash remaining after dividends are paid. As observed by Robert D. Arnott in the Financial Analysts Journal in 2003:

Empirical data suggest that too many companies squander their retained earnings when those retained earnings are more than is required for…future survival and competitiveness.

In the best dividend growth companies, dividends reduce the cash available for corporate projects, so management exercises more discipline and vets those projects more carefully. The result is a more efficient and focused business.

9. Dividend programs tend to persist

Even though each dividend payout is a separate event, once an overall dividend growth program becomes well established, it becomes in effect a corporate policy. The dividend program becomes woven into the culture of the company. A company with a long history of increasing dividends will rarely abandon that policy.

While any company can be wounded during bad economic times, the best dividend companies are able to increase their dividends even if only by a small amount. So a healthy dividend increase of 5, 7, or 10 percent can be seen as an indicator that management probably foresees good sailing for its business over the next few years. When hard times hit, the dividend growth rate may slow, but the company may still be able to increase its dividend a little.

10. Dividends increases can continue even when stock prices decline

Stock prices go up and down all the time, but the best dividend stocks increase their dividends every year. So even when a dividend stock's price is falling or range-bound, it still has a positive return component via the dividends.

As stated earlier, this independence of dividends from market prices means that the consistent positive return from dividends can provide a degree of insulation from turbulent markets. That, in turn, can provide peace of mind to the investor.

11. You do not have to sell the stock to get the dividend

Dividends are sent to shareholders directly by the company. If a stock pays no dividends, its total return comes solely from price changes, and you can only realize returns if you sell the stock. There is no other benefit from ownership.

In contrast, when you buy a share in a dividend stock, you receive an important right embedded in each share: The right to receive dividends from that company.

A problem with confining your benefits to stock prices is that they are determined by an irrational intermediary: [the market]. In my experience, a carefully selected portfolio of dividend growth stocks is pretty reliable about its dividend returns. That is not true of most stock prices, which vary widely in comparison to the relatively steady progress of dividends.

Critics of dividend investing sometimes state that "a dollar is a dollar," what difference does it make if you get a dollar from dividends or a dollar from selling a few shares? The difference is obvious. In order to get your hands on a dollar of capital gains, you must sell shares. After selling, you own fewer shares. The shares you sold can no longer do anything for you, since you no longer own them. So the difference between getting a dollar from dividends or from capital is that you still own the shares in the first instance and don't own them in the second.

12. Dividend pay outs may rise over time

Hundreds of dividend companies have a long history of increasing their dividend regularly. We believe it is logical to expect that they will continue to do so as long as their fundamentals stay consistent, these are things that FAC continually monitors.

This is the most powerful aspect of dividend growth stocks. It is why dividend growth investors are often content with stagnant stock prices. It is why retirees - seeking income that keeps up with inflation - become attracted to dividend growth stocks. It is why many income investors consider dividend growth stocks to be more attractive than bonds, whose yields are fixed.

13. Dividends have a low tax rate

For most taxpayers, the current maximum Federal tax rate on qualified dividends is 15 percent. That means that dividends are among the least-taxed forms of income you can get.

14. Dividend stocks tend to be less volatile

In September 2011, the New York Times, in an article titled "The Dividend as a Bulwark Against Global Economic Uncertainty," referenced an ongoing study of dividend stocks by Ned Davis Research (NDR). It reported that NDR's study showed that dividend growth stocks are less volatile than other stocks. They have clocked in at nine percentage points lower in standard deviation than companies not paying dividends.

The smoother price ride generally makes dividend growth stocks easier to hold during times of market volatility. Beyond that, the dividends themselves help cushion portfolio losses when equity prices are declining. Dividends have gentle trends that are fairly predictable. For that reason, dividend stocks tend to attract a constituency of owners who are less likely to sell shares in response to short-term price difficulties so long as the dividend is not damaged.

15. Your principal can increase over time

When you buy stock, you are purchasing a piece of the company. You own a fraction of everything about the company. You can sell that piece any time you want or keep it as long as you want.

If and when you sell, you will receive whatever price [the market] has determined for the shares that day. Hopefully, that will be more than you paid for them. So the dividend stock investor potentially gets positive returns from both sources of total return: dividends and price appreciation.

Some dividend students believe that the dividend increases themselves pull the stock prices higher over time. I hesitate to attribute a causal relationship between dividend increases and stock price increases. But we believe it is clear that they are correlated. It is accurate to say that both are the result of the company's earnings growth. That growth is recognized in the boardroom by increasing dividends. It is recognized in the market by rising share prices.

16. Historically, dividend growth stocks have outperformed the market in total returns

Not only might your principal rise over time, but historically dividend growth stocks have in fact outperformed the broad market in total returns. Numerous studies have shown this. They differ in methodology and time frames, but the similarity in their conclusions is overwhelming.

One such study was published by Robert Arnott and Clifford S. Asness, "Surprise! Higher Dividends = Higher Earnings Growth, (December, 2001). This study suggested that low payout ratios accompany inefficient empire building and the funding of second-rate projects and investments, leading to poor subsequent growth. In contrast, high payout ratios lead to more carefully chosen projects with better returns. The authors found that companies with higher payout ratios had higher real earnings growth over the 10-year periods following the interval studied.

17. You can reinvest dividends to potentially accelerate the compounding effect

Shareholders can do three things with dividends: Reinvest them, keep them, or spend them.

If you reinvest the dividends (either in the same stock or elsewhere), the reinvestment brings into play a second layer of compounding. (The first layer is the rising dividends themselves.) As you purchase more shares with the dividends, the number of shares on which you receive dividends goes up. They then generate additional dividends, which can then be reinvested, creating a virtuous circle of dividends --> reinvestment --> more shares --> more dividends, etc. This builds wealth at an accelerating pace. Your share base grows faster and faster because of the reinvestments. The growing number of shares increases the dividends you receive.

18. Rising dividends protect against inflation

"Risk" has many meanings in investing. One traditional meaning is the risk to your nominal principal amount. If there is no risk of that sort, a $500,000 portfolio today will be worth no less than $500,000 ten years from now. Under that definition, investment-grade bonds are risk-free, because their nominal or par value does not change over time.

But that common definition of risk ignores inflation. Inflation erodes the purchasing power of money over time. For example, while your principal in bonds is risk-free in nominal dollars, it is defenseless against the corrosive effects of inflation. The same holds true for bond income: It is fixed in nominal terms but steadily loses value in inflation - adjusted purchasing power.

In contrast, the income from dividend growth stocks generally grows faster than inflation, thus protecting against inflation risk. While the principal in dividend growth stocks will have more variability than bonds (which have no variability in nominal dollars if you do not trade them), the variability can work in your favor as we have already seen-prices can rise, thus protecting your principal from inflation risk too.

19. You do not need any more invested to generate 4 percent income rather than 4 percent from sales

Theoretically, it requires no more money to acquire a portfolio of stocks that will pay a dividend stream of 4 percent than to acquire a portfolio of stocks that will generate 4 percent upon liquidation. I focus here on 4 percent, because that is the amount often recommended to be a "safe" withdrawal amount from a retirement portfolio. The ideal is that with the same outlay of cash, one can purchase a position which allows for a 4 percent return without liquidating. The point that 4 percent of organic income equals 4 percent of "synthetic" income from selling assets is obvious, yet it is missed by many, who for some reason believe that living off of income is only for the very wealthy.

And of course, to repeat a point made earlier, if you get your income organically from the assets themselves, you do not have to sell them to generate that cash. Conversely, if you sell shares to generate cash, they are gone and will provide no future returns unless re-invested in additional dividend shares of similar quality."

Note: FAC’s unique platform allows investors to hold less than one share, up to five decimal points, including dividend reinvestment in fractional shares. This offers our clients the compounding effects of buying more shares when share prices are down and fewer shares when prices are up. All this is done with NO transaction-driven fees, ticket charges, or additional costs, so our investors truly benefit from the compounding effect of dividends. This unique aspect of FAC's platform offers a valuable alternative to advisors and their clients.

For more on FAC’s common sense methodologies, see How Much Is Too Much Diversification? 

*Determined by Morningstar ratings of four stars or better.

**It is important to note that each of these points relate to Mr. Van Knapp's referenced article and that these are his views. It must also be noted that, while the goal of dividend investing is often to generate income, this income is not guaranteed. In fact, while it is sometimes helpful to evaluate historical data, regardless of the past performance or rating of a particular security, future results can never be guaranteed. Dividends and other payments from stocks, in addition to gains realized when selling securities, can result in taxable consequences that must be considered.  Additionally, dividends may be suspended or discontinued by the issuing company at any time.  The issuing company's stock price will typically drop by the amount of the dividend declared on the "ex-dividend" date.