A key component of a diversified income-oriented portfolio is dividends. This is what I have noted in the past during my presentations, blogs and online musings. They are a key part of a solid retirement income strategy.
The total return from stocks is derived from two key components: price appreciation and the cash flow from dividends.
Most investors are certainly familiar with the concept of price appreciation (or depreciation as was evident during the financial crisis and Flash Crash for instance). This is what the media each night focuses on when they report on “The Market.”
But less noticed is the value of dividends to the longer-term success of an investor.
The Value of Dividends to An Investor
Below is a chart of various recent periods of stock market performance compiled by Thornburg Investment.
The “Dividend Aristocrats Index” refers to an index of companies that consistently lead the market in paying dividends and regularly increasing their dividends.
|Annualized Total Return Period||Dividend Aristocrats Index||S&P 500|
|2005 – 9/2009||2.32%||-0.08%|
|1990 – 9/2009||10.97%||8.41%|
Dividend-paying stocks have shown these positive attributes over this period:
- Historically higher yields than bonds
- Historically higher total returns compared to bonds because of the stock appreciation potential of the dividend-payers.
- Higher income, capital appreciation and total return compared to the S&P 500 Index in almost all of the periods noted above and a near 20-year annualized total return of nearly 11% versus 8.4.
Dividend-paying stocks are probably not as sexy as most aspects of the stock market. They are part of “value investing.” They are the stuff of “conservative” portfolios built for “widows and orphans.” They are the basic building blocks used by Benjamin Graham, the author of Intelligent Investing and the principles on which Warren Buffet built Berkshire-Hathaway.
But for an income-oriented investor (such as a retiree) looking at ways to manage income in retirement, they should not be overlooked. In fact, recent research reveals that those companies that pay out higher dividends also tend to have higher stock prices because they also have higher earnings growth. And earnings growth is another key component in valuing stocks. This research indicates this as a global tendency.
Searching for Yield
Unfortunately, seeking out high dividend-paying companies in the US is not so easy. Unlike managements of Euro-based companies where paying dividends is a sort of badge of honor, US companies tend to be much more stingy in paying back earnings to owners of the company (the stockholders).
And the trend in dividend yields is one that continues to decline. A research note by Vanguard (May 2011) shows this trend. From 1928 through 1945, the average dividend yield was around 5.6% and dividends represented about 67% of company earnings (aka dividend payout ratio). From 1945 to 1982 the average yields dropped to 4.2% and the payout ratio to 53%. In the more recent period from 1983 through 2010, the average dividend yield has dropped to 2.5% with a payout ratio of about 46%.
As you can see finding “Aristocrats” that pay out higher than these averages makes a big difference. And the higher payouts may also portend higher future earnings as well as stock price appreciation.
But even those companies which are “stingier” will still help out a portfolio.
Do Lower Dividends Mean Lower Stock Prices?
The question that investors may be asking themselves now is “will these lower dividend yields (historically and compared to Europe for instance) be an indicator of lower stock prices?” Because the market’s dividend yield is below its historical norm, is that an indicator of lower total returns in the future?
While the stock market is certainly not without bubbles and crashes, it is unlikely that this is a factor in possible future stock price levels. Lower dividend yields are not necessarily an indicator of lower total returns.
There are other reasons that are more likely the cause of this trend toward lower yield payouts. Part of this is based on US tax policy. Another is the culture of US corporate management that has opted toward share repurchases instead.
In the US, there is a bias in favor of long-term capital gains over receiving dividends and paying income taxes.
When dividends are paid out all stock holders receive the income and are subject to tax. When management opts for a “share repurchase” program, only those who tender their shares are paid out. So this may be more agreeable to investors who are trying to manage their tax bill from investing. For those who are longer-term stock holders, they may receive more favorable capital gains treatment by holding the stock and waiting simply for appreciation.
Admittedly, there may also be an incentive by management not to declare dividends so that they can hold onto the capital to “reinvest” in the business – which may or may not be a good thing. (The same argument can also be seen in political terms in Washington when both parties are arguing about whether or not to have tax cuts).
And management may also have an incentive to repurchase stock because such programs provide the company with flexibility to change the terms – something that is frowned upon if management were to lower or cancel a declared dividend.
How to Use Dividends in Your Portfolio
In any event, using dividend-paying stock is something that makes sense in retirement portfolios. To provide tax efficiency, it makes sense to include these in your qualified accounts (like IRAs). And to boost income, it makes sense to add global dividend-paying stocks which tend to have higher yields and payouts. Nothing in these current research notes indicates that the lower US yields and payouts are an indicator for lower future stock prices. There are enough other things going on in the economy locally and globally that can impact do that.
To Build a Better Mousetrap or Get More Information
For more ways to build a retirement income portfolio, please feel free to give me a call directly at 978-388-0020 and stay tuned to the company website for upcoming webinars that will cover this topic too.