Between 1972 and 2010, S&P 500 has increased from 102.09 to 1257 points. If you add in the reinvested dividends received each year, the index should have been sitting at 2,752. Given this simple calculation, it is no wonder that investors, who focus on stocks paying a dividend, have an apparent edge in the markets. The edge consists of the fact that their stocks will increase in price over time, while also receiving another form of return in the form of dividends. The dividend return is not dependent on the stock market and is typically less volatile than the return on capital gains. The dividend return can never be negative.
Companies that pay dividends are typically mature enterprises, with a proven business model that generates enormous amounts of free cash flow. These companies do not need to reinvest all of their profits in order to maintain and grow their business.
In essence they “spend” less than what they earn, and share the excess with shareholders in the form of dividend payments. On aggregate, such companies are the proven winners in the constant battle to win their customer’s hard earned dollars. Shareholders of these companies can generate price returns when the stock prices increase, and dividend return when they receive their distributions.
Thus, during prolonged bear markets, investors will receive at least some return on their investment in the form of dividends, until the stock prices recover.
Companies that manage to grow while paying dividends are akin to individuals who spend less than what they earn. In comparison, most companies that invest all of their earnings back in the business all the time are typically riskier propositions.
Chances are that companies that invest everything back into the business are doing so because of unfavorable economics or simply because their products or services would be rendered obsolete in a short period of time.
While one could cherry pick successful non dividend paying companies like Berkshire Hathaway (NYSE:BRK.B), on aggregate, investors in non-dividend stocks are likely to earn miniscule total returns over time. Reinvesting all profits into the business is akin to an individual living paycheck to paycheck. After all, investors in such companies will only realize a return on investment if they dispose of their stock, only when someone else is willing to purchase the stock at a higher price.
According to research from Ned Davis Research, dividend paying stocks in the S&P 500 outperformed non-dividend paying stocks in the index. A $1000 investment in income stocks in 1972 resulted in $27,110 by January 2011, versus $1940 for non-dividend paying stocks. This equates to a 8.80% annual return for dividend stocks, which is significantly higher than the 1.70% annual return of non dividend stocks. In comparison, S&P 500 delivered a 7.30% annual return over the same period. In other words, a $1000 investment in the index in 1972 increased to $16,100 by early 2011.
Past Performance is not a guarantee for future results. On the other hand, the significant outperformance of dividend paying stocks, and especially dividend growth stocks is hard to ignore.
In a world where stocks are being held for seconds, buy and hold investing seems obsolete. The long term wealth potential for patient dividend investors who reinvest their distributions year in and year out is out there.
In order to capitalize on their dividend edge, investors should focus on companies which can afford to consistently increase dividends, have sustainable dividend payouts, are attractively valued and have strong competitive advantages.
In addition, investors should also try to maintain a diversified dividend portfolio, consisting of at least 30 individual stocks, spread out across as many sectors as possible.