There’s no better way to build wealth over the long term than with high-quality dividend-paying equities.

— Roger Conrad, Canadian Edge

I know what you’re thinking. Dividends are boring. Only widows and orphans that are ultra-conservative need them.  Why should I care that a stock pays a piddling 5% annual dividend when I can get a 400% return on a non-dividend paying stock like Oshkosh Corp. (NYSE: OSK), which the Personal Finance investment service recommended back in October 2008 at $9.66 and which this past April closed above $44. Wow! With gains like that, dividends aren’t important, right?

Wrong. Of course, if one could always buy stocks that go up 400% in less than two years, dividends wouldn’t matter. But nobody can.  Such stocks are typically high risk and, if you don’t time your purchase just right, you could end up hitching a ride downtown rather than uptown.  Sure, it’s nice when you catch one of these rockets, but most of us mere mortals rely on diversified portfolios that beat the market by a few percentage points annually to earn our keep. And over long timeframes, a few percentage points of annual outperformance can add up to monstrous retirement nest eggs. 

The Beauty of Compounding

Take for example, a 35-year old person with a $100,000 lump sum to invest (optimistic, I know) until retirement in 30 years. Let’s assume the long-term average real return of the S&P 500 is 7% annually and this person is able to earn 9% per year, two percentage point better than that. At age 65, an investment portfolio indexed to the S&P 500 would be worth $761,000. Pretty darn good. But an investment portfolio that was able to earn just two percentage points more per year would be worth $1,327,000, or 74% more! It’s amazing what compounding of returns over time can do. None other than Albert Einstein is rumored to have said: “The most powerful force in the universe is compound interest.” Whether Einstein said it or not, it’s true.

Dividends and Wealth Accumulation

With that backdrop, I now present to the mere mortals amongst us a modest yet powerful investing secret that can substantially increase one’s wealth: buy dividend-paying stocks and reinvest your dividends! In his investment classic, The Future For Investors, Wharton finance professor Jeremy Siegel notes that during the 132 years between 1871 and 2003:

97% of the total after-inflation accumulation from stocks comes from reinvesting dividends. Only 3% comes from capital gains.

That’s simply amazing. Another way of saying it is that reinvesting dividends provided 33 times more money than not reinvesting dividends.

Even if you look at dividends on a non-compounded basis, but simply as a percentage of average monthly return, the importance of dividends is impressive. According to Standard & Poor’s, from 1926 to December 2009, dividend income constituted 34% of the monthly total return of the S&P 500. In some decades – like the 1940s and 1970s when stocks struggled – dividends made up half or more of the total return.

Bring on the Bear Market!

In “The Future For Investors,” Siegel discusses how dividends are “bear market protectors” and “return accelerators.” He gives as an example the Great Depression of the 1930s. The Dow Jones Industrial Average reached its peak price on September 3, 1929 and didn’t hit that level again until November 24, 1954 – more than 25 years later. Zero price appreciation for 25 years. Stocks were the worst place to be during this period, right? No way. An investor who bought the stocks in the index at the peak in September 1929 and reinvested dividends actually made more than four times his money — a positive return of more than 6% per year during this 25-year period!  This is more than twice what an investor who sold stocks in 1929 and bought bonds made and four times what an owner of treasury bills made.

Not only did stock investors make good money during one of the worst periods in stock market history, but Siegel demonstrates that the bear market of the Great Depression actually accelerated an investor’s returns:

Although dividends declined a whopping 55 percent from their peak in 1929 to their trough in 1933, stock prices fell even more. As a result, the dividend yield on stocks, which is critical to an investor’s total return, actually rose. $1,000 invested at the market peak would have turned into only $2,720 in November 1954 if the Great Depression had never occurred. This is 60 percent less than what investors actually accumulated as a result of this economic catastrophe.

Dividend Stocks Are Superior

The power of dividends is not limited to index investing and reinvesting dividends, however. Study after study has shown that dividend-paying stocks as a group outperform non-dividend paying stocks.  For example, Al Frank Asset Management performed a study of large-cap stocks between 1990 and 2005 and found that dividend payers not only returned more, but did so with less volatility (i.e., Beta) – the best of both worlds:

	Dividend Payers	Non-Dividend Payers	Wilshire 5000
15-Year Return	11.7%	10.2%	8.6%
15-year Beta	0.88	1.63	1.00
10-Year Return	11.9%	9.2%	8.3%
10-year Beta	0.86	1.69	1.00
5-Year Return	1.7%	-12.4%	-2.7%
5-year Beta	0.82	1.80	1.00

Reasons for Dividend Stock Outperformance

The question remains why do dividend-paying stocks exhibit such superior investment qualities? There are a number of reasons:

1. Dividend-paying stocks have higher earnings growth.

To many, this is counterintuitive since business schools teach that earnings should be higher the more capital that is reinvested in the business. In reality, corporate executives often retain too much of company earnings because they want to build empires, even if those empires involve low-return investments that don’t cover the company’s cost of capital and are, therefore, value destroying. Forcing these executives to pay out cash to shareholders imposes discipline on them and results in them investing only in the highest-return projects. As Professor Siegel has written:

I am in favor of paying out dividends because of moral hazard and agency costs. Doing so should reduce management’s waste of shareholders’ profits.

2. Dividend-paying stocks have higher earnings quality.

Investors react very badly toward companies that cut dividends. Consequently, companies decide to pay dividends only if they are reasonably certain that they will not be forced to cut them later on. This fact leads to a natural selection process whereby only companies with strong and stable earnings streams decide to pay dividends.

3. Dividend-paying stocks are easier to value.

As Professor Siegel has written:

Dividends are crucial for pricing a firm, since finance theory states emphatically that the price of a stock is not the discounted value of future earnings, but the discounted value of future dividends and cash distributions.

This makes sense since you can’t eat earnings; you can only spend the cash that you actually receive. Cash in your pocket is worth more than cash you theoretically own but can’t access. So the value of a company based on free cash flow is overstated. Lastly, since dividends are rarely cut, a valuation based on them is more certain, whereas free cash flow can fluctuate wildly and is harder to estimate accurately. A bird in the hand is worth two in the bush, as they say.

Low Payout Ratio is Best

Not all dividend-paying stocks are created equal. A Credit Suisse study found that between 1990 and 2006 dividend-paying stocks with a combination of relatively high yields and relatively low payout ratios (i.e., percentage of earnings paid out in dividends) not only outperformed the overall market by 7.6% annually, but also outperformed other dividend-paying stocks on an annual return basis:

	High Payout Ratio	Medium Payout Ratio	Low Payout Ratio
Low Dividend Yield	8.6%	14.7%	16.9%
Medium Dividend Yield	11.2%	13.1%	17.6%
High Dividend Yield	11.0%	13.5%	19.2%

The importance of a low payout ratio makes sense since it means that a company has sufficient cash to reinvest in its business and also has room to increase its dividend over time.

Have I Changed Your Mind About Dividend Stocks?

To sum up, dividends are important generators of wealth. They are definitely not boring and many are actually growth stocks. Ignore them at your own risk.

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Want help assembling an investment portfolio based on dividends? KCI’s Roger Conrad specializes in dividends! Roger’s Canadian Edge service recommends the best in in low-risk, high-dividend Canadian income trusts. In fact, Canadian income trusts are the highest-yielding investments in the world. Try Canadian Edge risk-free today!