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Dividends: A Corporate Wellness Barometer

“Bull or bear a man may be, and still be an investor rather than a speculator, so long as he looks to dividends rather than to price changes to justify the cost of his stock.” 1     

John Burr Williams

After a very difficult end to 2018, stocks bounced back sharply in the first quarter of 2019 with the three major indices posting strong gains (DJIA +11.2%; S&P +13.1%; NASDAQ +16.5%).  A more cautious Federal Reserve and hopes for the easing of trade tensions buoyed spirits, but with the rising tide lifting all boats and markets once again flirting with highs, a selective approach to investing is more important than ever.

When it comes to equity investing, the ability to discriminate winners from losers is critical.  And while valuation techniques come and go, one enduring principle is the proposition that share prices are linked to future dividend flows.  Unfortunately, a runaway 10-year bull market has a lot of investors shunning dividends.  But make no mistake, dividends offer an efficient, objective way to exploit equity returns while mollifying downside risk.  Ignoring them is foolhardy.

At root, the case for dividends is refreshingly straightforward. Companies with generous, ever-increasing dividend payouts tend to deliver superior stock market performances.  Let’s take a closer look using the Dow Jones Industrials.  True, all thirty of the Dow’s constituent companies paid dividends in 2018.  But remember, if hard-earned money is to be risked, the strength of a company’s dividend policy matters.  Here’s where statistical analysis comes into play.

While Boston Research and Management does not invest solely in dividend paying stocks (e.g. Google and Berkshire Hathaway do not currently pay dividends), analysis suggests how companies pay dividends over time is a strong indicator of both longer term performance and protection from downside risk.  One screening methodology we use starts by calculating the trailing 10-year dividend increase paid by each company and then handicapping the records using a formula that rewards companies that religiously boost their payouts while penalizing those with “iffy” records.2

Think about two companies that paid out $1 per share 10 years ago and then, over the ensuing decade, bumped up their annual dividend to $10 (a 900% increase).   Would investors be indifferent about their choice?  Not necessarily.  The strength of a company’s dividend record isn’t measured simply by the size of its dividend.   The ability to grow the payout in the face of ever-changing economic and geo-political stresses counts as well.  Reliability is important.

Imagine Company A raised its dividend every year through thick and thin while Company B suspended its payout for two years owing to the Great Recession.  Even though both companies sport the same overall change measured point-to-point, the investment decision could be very different, especially for investors counting on investment income to support their lifestyle.   

A simple exercise illustrates this.  In constructing Figure 1, we simply divvied up the Dow into two buckets.  The top dividend growers (like Company A) were organized into one portfolio while the laggards (i.e. Company B) formed the other.  At the end of each year, the exercise was repeated and the funds rebalanced to take account of any rank-order changes.  How did the strategy pan out?  Well.

For starters, the strongest growers suffered fewer negative years (3 vs. 6) with less volatility.  Across the entire interval, the top tier delivered superior annual performance averaging 8.7% versus 7.3% for the weakest companies.

As a result, there was a noticeable difference in cumulative performances.  As shown below, the value of every dollar invested in the strongest growers increased to $3.90 vs. $2.85 for the weakest -- a 37% difference.

Beyond income generation and turbo-charged appreciation, there are other advantages.   Since dividends are born of corporate policy, companies with the strongest profiles tend to maintain their favored position.  So turnover is modest.3  And remember, low turnover translates to reduced costs and tax liabilities -- major performance killers.

True, all sorts of factors enter the stock selection process.  But the big takeaway is that dividends are an easy-to-monitor indicator of corporate wellness.  On the buy side, dividend growth spells prosperity.  On the flip-side, when a dividend grower fails to raise its payout (or worse, cuts it), it’s a warning sign worth heeding.  

1  John Burr Williams, The Theory of Investment Value, Harvard University Press (1938), p.33.
For a detailed discussion, see Charles E. Babin & William J. Donovan, “Investing Secrets of the Masters,” McGraw-Hill (1999), p. 184.
Turnover is defined by the number of portfolio positions changed out at each annual rebalancing.