February 2010

Dividends: ignoring them would be a mistake

Given the recent financial crisis, many major companies have a surprise in store for their shareholders: they’re cutting their dividends! But that’s no reason to snub shares that provide this type of income.

The diagram below presents a revealing look at the behaviour of the Canadian stock market over the past 20 years:

Source: Datastream; Russell Investments

Now, that’s striking! If an investor had reinvested all the dividends his/her shares would have provided, he/she would have earned 208% more than the stock market return without the dividends reinvested.

But there’s one small glitch in the above diagram: it only runs until July 2007. What’s happened
since then? One of history’s worst financial crises. In response to falling market prices, the dividend yield of many stocks (that is, their dividend/price ratio) has skyrocketed, which has given rise to concerns that, sometimes, have actually come to pass: with their liquidity being squeezed, companies that generally provided generous dividends to their shareholders have had to lower them, and even cut them completely. So, what’s a dividend you can’t collect worth? Nothing – and that doesn’t include the catastrophic impact on the price of the underlying stocks, which have suddenly become much less attractive.

Fact remains …

A major part of the return

Fact remains that, historically, dividends have been an essential part of the stock market’s
return. The New York Times recently reported that, over the past few decades, dividends have accounted for at least 40% of the S&P 500’s total return. Obviously, their contribution to a portfolio’s return is not always the same. In the 1980s, dividends only contributed 28% to the index’s return, and, in the 1990s, thanks to the bull market we experienced, slightly over 16%... which is still nothing to sneeze at.

But here’s the best part: since the beginning of the 2000s, dividends have represented the totality of the S&P 500’s return. In fact, without dividends, a stock portfolio based on the S&P 500 has been losing money ever since the beginning of this turbulent decade. With dividends, it is showing a slight profit. Overall, in the past 20 years, a portfolio consisting of US stocks that pay dividends has provided its owner with a return of no less than 2% per year more than a portfolio that does not pay dividends. That’s huge.

Generally essential in a portfolio

These figures show why stocks that pay stable and substantial dividends are generally considered an important part of any sound investment portfolio. They are an additional source
of income, have a good potential to appreciate and provide a certain measure of protection during bear markets. As well, in Canada, dividends are taxed less than other sources of income, like interest, for example.

Dividends are often associated with preferred shares, but some common shares also pay dividends. Investment funds are a good way of availing yourself of this type of stock for a modest sum. Besides the so-called “dividend funds,” many equity funds include stocks that pay dividends. And “high-yield” equity funds may also include this type of investment. But be aware of the management fees! If they’re too high, they’ll eat up a major portion of your dividend yield.

The stock market aristocrats

A good way to better understand the impact of dividends on a portfolio’s potential return is to visit financial information web sites and study the behaviour of the exchanges’ sub-indexes that track them. In Canada, the main sub-index to follow is the S&P/TSX Preferred Shares sub-index, as well as an interesting sub-index created in 2007, that is, the “Canadian Dividend Aristocrats” index. For the purposes of this index, an aristocrat is a company that has consistently increased its dividends every year for at least the past five years.

It’s true that, given the recent financial debacle, certain stocks that were once considered
perfect “widow and orphan stocks” because of their stable dividends may no longer be suitable for the conservative investor. After all, stocks are stocks, and they always carry risks. Yet, with economic and financial conditions taking a turn for the better, it might be wise to take another look at this type of stock. Because, if your portfolio has been looking a little rosier these past few months, making good strategic decisions now could make it even healthier over the long term.