Dividends do much more than help you pay the rent

We believe that it pays to buy dividend-paying stocks. Dividends can assist you in paying your bills, of course. Even better, dividends are likely to improve your returns from your stock portfolio. This is particularly true of ‘dividend aristocrats’. In Canada, that refers to companies that have raised their dividends for at least five years in a row.

As their dividends climb year after year, dividend aristocrats yield more and more—provided that their share prices stay the same. In fact, their share prices usually rise. That’s because their rising dividends attract income-seeking investors. These investors bid up their share prices. If you own these dividend aristocrats, you win from rising yields, a rising share price, or some combination of the two.

In the U.S., the term ‘dividend aristocrats’ refers to companies that have raised their dividends for at least 25 years in a row. If we applied that criterion to Canada, this country would have very few dividend aristocrats. Among our Key stocks, Fortis Inc. and Canadian Utilities would qualify.

The U.S. criterion is too strict for Canada

The U.S. criterion would also eliminate dividend aristocrats that have only traded publicly for at least 25 years. This would, for instance, remove Canadian National Railway from the list of dividend aristocrats, even though the company has raised its dividend each year after going public in 1995.

The benefit of dividends is confirmed by many studies. Consider a study by Professor Jeremy Siegel at the Wharton School of the University of Pennsylvania. In his book Stocks for the Long Run, he writes, “The historical analysis of the S&P 500 [Standard & Poor’s 500 stocks] Index, supports the case for using dividend yields to achieve higher stock returns.

 “On December 31 of each year from 1957 onward, I sorted the firms in the S&P 500 Index into five groups (or quintiles) ranked from the highest to lowest dividend yields and then calculated the total returns over the next calendar year.

“The portfolios with higher dividend yields offered investors higher total returns than the portfolios of stocks with lower dividend yields. If an investor put $1,000 in an S&P 500 Index fund at the end of December 1957, she would have accumulated $201,760 by the end of 2012, for an annual return of 10.13 percent. An identical investment in the 100 highest dividend yielders accumulated to over $678,000, with a return of 12.58 per cent.”

The higher the yield, the better the return

A dollar in the second quintile would’ve turned into $577 for a yearly return of 12.25 per cent. The mid and bottom two quintiles lagged the S&P 500 from December, 1957, through 2012. A dollar in the middle quintile would’ve become only $144 for a yearly return of 9.46 per cent. A dollar in the fourth-lowest quintile would’ve risen to $103, for a yearly return of 8.79 per cent. The one anomaly was that the bottom quintile slightly beat the fourth quintile. A dollar in the fifth quintile would have turned into $109, for a yearly return of 8.9 per cent. Even so, higher dividend yields usually lead to better returns.

Professor Siegel also notes that “The highest dividend yielders also had a beta below 1, indicating these stocks were more stable over market cycles. The lowest-dividend yielding stocks not only had the lowest return but also the highest beta [often used as a measure of risk]. The annual return of the 100 highest dividend yielders in the S&P 500 Index since the index was founded in 1957 was 3.42 percentage points per year above what would have been predicted by the efficient market model [better risk-adjusted returns], while the return of the 100 lowest dividend yielders would have had a return that was 2.58 percentage points per year lower.”

Go big or go home

Just remember that the S&P 500 includes the 500 U.S. stocks with the top ‘market caps’. (The market cap is the number of shares outstanding multiplied by the share price). These companies are generally more stable than small firms. So they’re more likely to maintain their dividends. Small firms may have no choice but to reduce or eliminate their dividends.

Provided that you’re buying big and solid companies, a higher-than-average dividend yield is a positive indicator. With small companies, by contrast, a higher-that-average dividend yield can indicate that there’s a higher risk of a dividend cut or omission.

 

 

The Investment Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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