In English, the phrase "paying dividends" has a universally positive connotation. In investing, many think the same of dividend-paying stocks. Dividends' attraction has deep and varied roots: some view them as an additive to total performance, or "being paid to hold stock," others as cash flow creation, and still others claim stocks paying dividends offer a measure of safety versus those that don't. All these can be true—sometimes, and to varying degrees—but a dynamic market means they aren't absolute truisms. And over-reliance on a metric like dividend yield in portfolio construction can be problematic.
To Pay or Not to Pay?
Of the S&P 500's companies, 368 paid dividends as of May 2010—thus, broad market exposure almost ensures owning some dividend payers. Sometimes stocks paying dividends outperform non-payers (though this is likely contingent on other factors), but the reverse can also be true. Standard & Poor's reported the mean total return of non-dividend paying members of the S&P 500 was +77.4% from May 2009 through May 2010, while dividend-paying members returned +56.0%.[i] One could easily find other periods when average dividend-paying stocks outperformed. But selecting high–dividend paying stocks doesn't automatically improve performance.
When companies have profitable expansion opportunities, they can often generate greater shareholder value by reinvesting in the business than paying dividends. When opportunities seem more limited, the opposite may be true—more shareholder value could be derived via dividend payment.
This naturally changes as firms evolve. Early on, it's all about building the company and funding expansion (growth stocks), thus it makes sense to pay few, if any, dividends. As the company matures (value stocks), there are fewer reinvestment opportunities (note: this doesn't mean the company is any less successful), and management sends profits to shareholders. (Often, the defining line between "growth" and "value" is hazy. Perhaps the terms should be "growthier" and "valueish"?)
Clearly, a company sharing earnings with investors isn't necessarily a bad thing. Dividends are an important component of the equity markets' long-term return. With cash yields today at roughly 0% and government bond yields extremely low, in many cases, dividend yield outweighs other asset classes' yields. But high dividend yields aren't necessarily a good thing either.
A Dividend in the Hand Isn't Worth Two in the Market
It's important to note how dividends work from a shareholder's point of view. When a firm pays a dividend, the share price falls by about the amount of the dividend, all else equal. After all, the firm's giving away a valuable asset—cash! This impact can be difficult to distinguish from normal market volatility, but the bigger the dividend, the easier it is to see.
For example, after dividend taxes were lowered in 2003, Microsoft issued a special, one-time dividend in 2004 of about $3 per share—over 10% of the share price at the time.[ii] The share price dropped huge once the dividend was locked in—not because the firm's prospects deteriorated or the market took a dive, but because the firm gave away so much cash. That took Microsoft's share price from nicely positive before the dividend payment to negative for the year.
It's Reinvesting That Matters
While dividends might seem like a big plus, what investors do with them next is more significant. By themselves, dividends don't add much to portfolio returns. It's reinvesting dividends back into stocks that adds real value. Over the last 70 years, the S&P 500 has an average annualized price return (i.e., ignoring dividends altogether) of 6.6%. If you add in dividends but earned no return on them, the average annualized return increases only slightly to 7.2%. But dividends provide a big boost if reinvested—increasing average annualized total return to 10.6%.[iii] Almost a $10.5 million difference on $10,000 invested in 1939 just from reinvesting!
Dividends for Cash Flow, Yes or No?
Some investors favor dividends to help meet cash flow needs. And it's true—dividend income is one avenue to create cash flow from a portfolio.
But dividends aren't set in stone. Companies historically paying dividends aren't required to do so ad infinitum. Unexpected events, poor management, recession—virtually anything materially impacting a company's bottom line can impact dividend payouts. British oil giant BP recently suspended its dividend as a result of the Gulf of Mexico oil spill. Beleaguered banks and automakers cut dividends massively (if not entirely) during the financial panic and recession. Remember, dividend yields are simply reflections of history that aren't certain to persist.
For many investors there's a better way to generate cash flow: Sell stocks! Selling stocks has some advantages over purely relying on dividends or other income-producing investments, like bonds. Stocks are likely sold at either gains or losses. In taxable accounts, selling stocks at a loss raises needed cash with no tax due—and realized losses can offset gains later. Even if stocks are sold at gains exceeding losses, tax rates on long-term gains will likely be lower than dividends (assuming the 2003 tax cuts sunset as scheduled).
Not Always There When You Need Them
Often, dividends are seen as indicative of safety and vitality—the company must be swimming in cash to afford such generous profit sharing! Again, this is sometimes true. But dividends reflect the past—they're not always predictive of a company's future health. For instance, Lehman Brothers paid a dividend in August 2008—just weeks before collapsing. PG&E, a utility with a long history of paying dividends, stopped for four years while their stock fell from the low $30s to around $5 between 2001 and 2002. PG&E also shows how dividend yields alone can delude investors. Dividend yield is a function of past payments and current stock prices, so PG&E's declining share price pushed up its dividend yield after the last dividend payment before suspension. These are just two of many examples of how dividends can mislead.
Focusing primarily on dividend yield can also create a portfolio too concentrated by sector—chasing high-yielding automakers and financials (including REITs) in 2006 would've resulted in vastly below market returns in 2007-2008.
Dividend yield is one factor to consider when investing, but it isn't necessarily more or less important than many other factors. Investors must research far more to maximize the likelihood of success. More often than not, a portfolio's dividend yield should be the result of other active decisions made along the way.
[iii] Bloomberg, S&P 500 returns from 12/31/1939-12/31/2009