“One common trap that dividend investors can fall into is chasing stocks with high yields when they should be buying dividend growth stocks that can promise years of steady income raises.” ~ Dan Burrows, Senior Investing Writer, Kiplinger.com

Over the last few years when non-dividend paying growth stocks were delivering significant double-digit gains in the span of months, it was easy to ignore the benefits of equity income, writes Stephen Dover, CFA, Chief Market Strategist, Franklin Templeton Institute. Today, given rising interest rates, slowing growth and heightened volatility, the role of dividends is changing amid a more challenging environment for multiple expansion.

Over the long-term, dividends have proven to be a significant driver of total return. Over the last 31 years, spanning January 1990 through December 2021, the receipt and reinvestment of dividends accounted for about 50% of the cumulative total return of the S&P 500 Index, according to Franklin Templeton. In addition, dividend growers, proxied by the S&P 500 Quality High Dividend Index, have outperformed their value and growth counterparts over the more than two decades since 1995.

Dividend payouts can act as a useful quality barometer. A solid track record of growing dividends consistently and sustainably over an extended period of time is typically seen as a signal of healthy company fundamentals, astute and efficient capital allocation and a firm commitment to shareholder value.

Dividend payouts are often cut during periods of grave economic stress, particularly in the most vulnerable companies.

• Dividends offer evidence of financial strength. Historically companies that initiated or increased their dividend have significantly outperformed those that cut or don’t pay a dividend.
• Often, stocks with the highest dividend yields come from companies whose market prices have fallen, indicating stress.

In the U.S., 242 companies cut or suspended dividends, according to Capital Group. This number of dividend cuts and suspension nearly match the total for the previous 11 years combined.

After historic cuts, some U.S. companies are restoring dividends

Source: Wolfe Research, LLC. Copyright © Wolfe Research, LLC 2021. All rights reserved. Only companies with market cap of at least $250 million included. Reinstated dividends statistic is through 5/31/21.

But the picture is improving. With the rollout of COVID-19 vaccines and the reopening of economies, many U.S. companies have begun to resume payments.

Many investors, when they search for dividend paying stocks, tend to start with companies that pay the highest dividend yields. These companies can be sound investments, but the high yield can also be a warning sign. “Companies that have very high dividends to start may not be able to sustain them,” Joyce Gordon, Capital Group equity portfolio manager, notes. “The high yield may indicate a company is a melting ice cube, and their business is in decline and they’re not reinvesting.”

Gordon says that dividend growing stocks represent a compelling value for investors. “I look for companies that are yielding around 2.5% to 3.0%, and that are growing their dividends and earnings around 10% or 12% a year. Today I am finding a number of companies that meet that criteria across a wide range of sectors and global markets.”

The best dividend stocks – companies that raise their payouts like clockwork decade after decade – can produce superior total returns (price plus dividends) over the long run, even if they sport apparently ho-hum yields to begin with.

Dividend growers are strong companies that are likely to be even stronger in five or 10 years. “I look for a company that can demonstrate the capacity and commitment to raise its dividends over time,” Gordon says. “I look for dividend growth that matches the underlying earnings growth of the company.”

Dividend growers historically have tended to generate greater returns than other dividend strategies, while also keeping up relatively well with the broader market. People assume that growth companies far outpaced dividend paying stocks over the past decade, and that’s true when you look at the highest yielding stocks. But dividend growers did nearly as well as the overall market.

By providing a growing stream of income, dividend growth can be a sign of company executive management’s more rigorous capital allocation process. “Because they are committed to setting aside some proportion of their earnings for investors, they tend to have better discipline and may be less likely to make some ill-advised acquisition,” Gordon says.

Because it is reflective of growing earnings, dividend growth can also offer a measure of resilience against interest rate hikes, Gordon adds.

Reinvested dividends. The power of reinvested dividends

One company that has consistently grown its dividends is McDonald’s. To get a sense of how regularly reinvesting dividend payments can compound over time, consider a hypothetical $100,000 investment in the company for the 20 years from December 31, 2000, through December 31, 2020, with all dividends reinvested.

Sources: Capital Group, FactSet. Growth rate calculations for value of shares from reinvested dividends and dividends paid use the first year’s dividends payment ($676) as a starting value.

Reinvested dividends tend to provide a downside cushion for total returns during periods of modest capital gains. The 2000s—the “lost decade” for stocks—is a crucial case-in-point. While the S&P 500 delivered annualized total returns of -0.95% in the 10 years from January 2000 through December 2009, the figure would have been worse had dividends been removed from the calculation. Annualized price return for the index in the 2000s averaged -2.72% versus dividends, which provided 1.77% annualized return over the 10-year period.

Using the power of the compounding of re-invested dividends is a good way to build real wealth, simply. Albert Einstein has called compound interest the “Eighth Wonder of the World,” since the power of compounding can be a wonder to behold. The magic of compounding, as Ben Franklin famously said, “Money makes money. And the money that money makes, makes money.”

“Compound interest is the Eighth Wonder of the World. He who understands it, earns it. He who doesn’t pays it” ~ Albert Einstein

Compound interest or “interest on interest” is effectively what compound interest is for investors. “Interest on Interest” or “dividends on dividends” is why the compounding effect on dividend reinvestment creates wealth. The longer you reinvest the dividends, the more dividends you receive because you own more shares. And the cycle continues as long as the investor stay invested in the market and reinvests his/her dividends.

S&P 500 Dividend Aristocrats.

The objective is to find companies that are growing their dividends faster than the market average over time. The Dividend Aristocrats are companies in the S&P 500 Index that have raised their payouts for at least 25 consecutive years. This list of the S&P 500’s best dividend stocks is a mix of household names and more obscure firms, but they all play key roles in the American economy. And although they’re scattered across pretty much every sector of the market, they do all share one thing in common: a commitment to reliable and long-term dividend growth.

References:

1. https://www.capitalgroup.com/advisor/insights/articles/dividend-growth-special-sauce-long-term-investing.html
2. https://www.franklintempleton.com/articles/strategist-views/the-case-for-dividends
3. https://www.kiplinger.com/investing/stocks/dividend-stocks/604131/best-dividend-stocks-you-can-count-on-in-2022
4. https://www.wealthplicity.com/investing-strategy/stocks-and-equities/the-power-of-compounding-dividend/

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested.