The perception of dividend investing is that its for old folks getting ready for retirement who are looking to pick up a steady income stream in large companies with limited growth. While well established companies are certainly good candidates for paying dividends, one of the best kept secrets of dividend investing is that it can create an sustained increase in your net wealth as well.
The fact that dividends provide a steady income stream is well known to most people. Either quarterly or semi annually, I get a cheque or direct deposit into my bank account that represents my entitlement to the cash flow that a company has paid out. For people looking for dependable cash flow streams, if you have a large well established company paying out dividends, there is a high degree of surety in collecting that dividend payment on a regular basis and therefore generating an income.
What’s a little less obvious is the wealth effect that also accrues to you each year that companies pay dividends, specifically as these dividends increase. The Single Best Investment by Lowell Miller makes a compelling case for why this is so. Let’s explore this a little further.
Much of the attractiveness of an asset class (say a stock, bond or property or anything else) is determined by the relative return that it delivers you, as well as the relative risk that you have to take in earning that return. I view return as being comprised of 2 components. There is the capital return that you get from an investment as well as the income return.
Certain segments of investors, are happy enough relying on the prospect of a capital return only to make up the bulk of their investment return. For stocks, a capital return comes from the consistent performance a business as it earns greater profits. An investor’s share entitlement then comes to represent a larger and larger profit. This eventually has the effect of pushing up the stock price. On the other hand, there are large groups of investors that are looking for steady, reliable cashflows, whether from bonds or property to provide them their return..
The other important factor that needs to be considered in deriving return is asset risk. Investors want to maximize their returns while taking the least risk possible. Thus while an assets potential return may be very high, if the cash flow or capital return to investors is perceived as being high risk or uncertain, such as asset or cash flow may be shunned in favor of something that is less risky, yet pays a slightly lower return. Its why you only see a small pool of investors typically invest in junk bonds. While the potential returns from these bonds are significant, you may lose your shirt in trying to chase this return.
A company that rewards investors with a steady income return with modest risk is likely to be something thats valued by investors. But then where does dividend growth fit in?. The beauty of companies that pay dividends is that with increases in profitability, they are able to increase the amount of the dividend that they pay out to investors. What this then means is that to the extent the risk profile of the company is unchanged, investors will “bid up” the stock price to the extent of the increase in the dividend to keep the effective risk / return profile of the company the same.
Lets look at an example. Johnson and Johnson investors may view a “fair” cash return for Johnson and Johnson stock of 4% for the risk that J&J represents. Thus if Johnson and Johnson pays out $2.00 in earnings, its stock will be priced at $50. Now suppose J&J decides to increase the dividend it pays buy 10%. All else being equal (ie with no changes in risk or increase in payout ratio), investors will continue to price J&J’s risk return profile at 4%. At $2.20 in dividends per share, this would equate to a share price for J&J at $55.
You can see over time how improvements in performance in the J&J business combined with increases in dividends that are ultimately passed through to its investors will lead to steady, consistent improvements in the value of J&J stock. The fact is that markets are not efficient in the short term, and temporary concerns about the economy, or geopolitical issues can be market noise that affects stock prices. Changes in tax treatment for company profits or dividends can also have an impact too. But in the long run? With the right business that steadily increases its dividends, you are almost assured of a steadily increasing stock price and slow and steady wealth creation.
Where’s the proof?
Need proof? In 1987, J&J stock was about $3.00 and the stock paid out about $0.10 in dividends ~3.3% yield. Fast forward to 2012 and J&j pays out about $2.45 in dividends. Its stock price? $70.00. Its approximate yield ~$3.5%. Not only have J&J investors been handsomely rewarded in terms of consistent income being paid out to them over time, they have got much greater net worth to boot.
Need even more convincing? Lowell Miller’s The Single Best Investment lays all this out very convincingly.