The power of dividends

I think I’ve made it pretty clear that dividend investing is the basis of my investment strategy. Why is that? Well, to summarize; dividends provide higher returns (see this post), dividends enhance returns during bear markets (see this post), dividends account for most of world wide stock market returns (see this post), and of course for retirees they generate income to live on irrespective of market prices. Today I want to drive the point home again about the power of dividends and explore some reasons why they are so powerful.

I came across a recent study that looked at the performance of the S&P500 across different types of dividend stocks and non-dividend stocks. You can find the study here. Lets take a look at the results of the study before we start the discussion. The study looked at annual returns from 1973 through September of 2010 of equal-weighted portfolios of the S&P500 stocks broken out by non-dividend paying stocks, dividend stocks with growing dividends, dividend stocks with no change in dividends, and those stocks that cut their dividends. There chart below shows the data.

Dividend stocks with growing dividends outperform non payers by 7.45% per year! Even dividend stocks that don’t grow their dividends outperform non-payers by 3.9% per year. Also, note that this out performance is way more than enough to overcome the tax disadvantages of owning dividend stocks in taxable accounts. How about risk, as measured by annualized volatility?

Pretty impressive. Not only do you get better performance but that performance comes with lower volatility, the modern finance measure of risk. There you have it – more data that supports that dividend payers are superior investments. As to the reasons for this out performance the study suggests that investing in dividends stocks is contrarian in nature because most investors believe that;

• rising dividend yields mean lower portfolio returns
• that the paying of dividends is an indication by management that they have no good investment opportunities
• a belief that dividends signal an end to a company’s growth
• the negative tax treatment of dividends means lower returns

There is nothing better I like than taking advantage of incorrect conventional wisdom. What I really liked about this study was the break out by types of dividend stocks, and it shows that the highest returns are to stocks that are increasing their dividends. The author then points to yet another fact that goes against conventional wisdom, “The overall conclusion is that rising dividends signal improved company performance and, in turn, higher individual stock returns.” In other words, dividends and in particular rising dividends are a forward indicator of improving company performance! And that is nothing if not extremely powerful.

In closing, this study proves yet again that dividend investing is a superior way to invest. In particular it points to a focus on investing in dividend stocks with growing dividends as the best dividend strategy. And it shows that sometimes you can have your cake and it eat it too – higher returns with lower risk.

Postscript: I haven’t found an investment product, fund or ETF, that implements such a strategy. It would be a very easy strategy to run in an ETF. It would also be very cheap to run. Maybe if I ever decide I want to work again I’ll take this on.