Financial Reference

Back in 1938, John Burr Williams codified the fundamental principle of value investing: the value of a stock is the present value of its future dividends. It seems obvious, but underlying this statement is some very powerful, yet often forgotten, advice.

We forget at our our own peril. “From 1871 to 2003, 97 percent of the total after-inflation accumulation from stock comes from reinvesting dividends. Only 3 percent comes from capital gains.” (The Future For Investors) (By the way, if you are looking for a great introduction to investing, read this book!)

Not only have dividends been the driving force behind the real returns of the market as a whole, but the returns of individual stocks are driven by their yield. Jeremy Siegel sorted the stocks comprising the S&P 500 every year by dividend yield. He found, “in strictly increasing order, the portfolios with higher dividend yields offered investors higher returns.” (Ibid.)

David Dremen found similar results looking at the 1500 largest companies from 1970-1996. (Contrarian Investment Strategies: The Next Generation) He found that higher yielding stocks produced higher returns.

In addition, both authors found that “high yielding stocks also provide you with the best protection in a bear market.” (Ibid.) So, stocks with high dividends return more and offer better downside-protection. (So much for “tinstaafl”.)

There is one small difference between the findings of the two studies, however. The Siegel study found that the highest yielding quintile produced the highest return while the Dremen study found the highest yielding quintile produced the second highest return (to the second highest yielding quintile). I’m guessing it’s just because there is still enough variance left in the data to get different results with slightly different methodologies and data sets.

Either way, I am going to continue buying stocks with large dividends. And I am not going to worry whether a dividend is too high — just whether the company can support it in the future. For a reasonable dividend strategy — I agree with most of what he has to say except that I don’t worry as much about a high payout ratio (dividends/earnings) — see this blog).

But there is one big question left unanswered: why do dividends predict higher returns? From a strictly mathematical viewpoint, they should reduce the value of the company because they increase the tax burden.

I can think of three reasons why dividends increase value: (1) Dividends encourage managers to make better investments with the cash they have — i.e. they don’t have cash to burn on bad investments; (2) management will only give out large dividend payments if they are very confident about the future; and (3) a company can not pay dividends if it does not have cash earnings (without diluting shareholders).

Interestingly enough, there are people who argue that an increased payout ratio (dividends/earnings) is an indicator of higher future growth. (See, e.g., this month’s SmartMoney, p. 56.) I’m not yet convinced this is true because there is a very strong mathematical reason for the opposite to occur: the growth rate is = (1-Payout Ratio)*ROE. The mathematical relationship between the payout ratio is the exact opposite as what they are claiming!

In any case, there is very little doubt that buying high dividend paying stocks is good for your financial health. And I personally invest in high dividend paying stocks — I own no REITs, trusts, or bonds but have a yield of nearly 4%. (Of course, I think the companies I own have other good attributes as well. I don’t invest solely based on one factor.) Even if the market goes sidewise for some time, I will still get close to a t-bond return. And, if history is any guide, I should outperform the market over the long-run.