By Hans Oudshoorn
Summary: Dividends have great appeal for many investors because it is nice when an investment generates some cash flow. Indeed, those looking for extra income from their investments or long-term capital growth cannot ignore strong dividend stocks, research shows.
In the first half of 2022, stock market indices and especially technology stocks fell sharply. After the summer catch-up of financial markets, prices faltered due to high inflation and price turbulence. It makes investors - who regularly hover between hope and fear - look for beacons in the stock market. In this article, we dive further into the world of dividends and show how it has historically been a beacon for investors.
The importance of dividends
When a listed company makes a profit, it may choose to distribute a portion of that profit to shareholders in the form of dividend. The payment of dividend is generally done on a quarterly basis but some companies pay dividends on a semi-annual or annual basis. In the long run, the total return on equities (within a portfolio or an index) is largely determined by dividends. According to a Hartford Funds study, dividends contribution averaged 40% of total return for the S&P 500 Index on a decade-by-decade basis over the period 1930 to 2021.
The study further notes that wealth creation is enhanced when dividends are reinvested in the underlying stocks rather than distributed, as shown in the chart below.
According to the same Hartford Fund study, starting in 1960, 85% of the total return of the S&P 500 Index can be attributed to reinvested dividends. This clearly shows the power of 'dividend on dividend', also known as compound dividends. The important lesson is that investing is not just about share price gains.
What characterises strong dividend players?
Historically, the S&P 500 Index dividend yields have been nearly three per cent annually but within the index, there are companies that are invariably above this percentage – for example, ExxonMobil and Pfizer. In Europe, companies such as Shell and Unilever also have relatively high and stable dividends. Generally, those companies share a number of similar characteristics.
• They are financially sound and have strong balance sheets.
• They often have a robust business model with one or more competitive advantages. These include cost advantages (for example, Unilever and Procter & Gamble can negotiate substantial discounts on purchasing due to their size), the so-called 'network effect' (credit card companies benefit when more and more retailers accept their cards), intangible assets (having special patents or patents) or 'switching costs' (an example, once you are a customer of Medtronic, which specialises in making pacemakers, among other things, you will not switch so quickly).
• They control a large market share as result of competitive advantages combined with strong brands. This gives them the power to raise prices without affecting sales volume. This, in turn, leads to their solid performance in terms of profitability in good and bad economic times and their ability to continue paying dividends.
• Finally, the companies often have good governance, communicate clearly and openly to shareholders and pay an attractive, but not too high, dividend.
The levels of dividends
Investors tend to focus on dividend levels. At first glance, an investment with a high dividend (yield) looks interesting. However, companies that pay too much dividend cannot reinvest that money to grow. By doing so, they possibly inhibit the development of profits and the share price. The rule of thumb is it’s good if a company does not pay out more than 75% of net profit. That way, at least 25% of net profit is used for future plans that keep profits up... and thus ultimately the dividend.
So as an investor, it is smart to read up on a company's dividend policy, or how they handle profit distributions. In short, companies that have a good balance between profitable investments and profit distributions perform best. These so-called 'dividend aristocrats' yield around 3-5% dividend yield.
If the dividend is well above 5%, it makes sense to be vigilant as an investor. This is because it is questionable whether such a payout percentage is sustainable. Philips' dividend yield, for instance, is currently above 6.5%. After several profit warnings and an announced reorganisation, there are doubts about the company's future. This translates into a falling share price. Given the storm the company is in, the question is whether dividends will be paid at all in the (near) future.
Investing in high dividends can be done by picking individual stocks or by investing in a mutual fund or ETF which have the advantage of being more diversified.