Reasons to Consider Investing in Dividend Stocks
If you've ever had occasion to look into the academic research comparing different types of returns from stocks that have different characteristics, as a class, dividend stocks tend to do better than the average stock over long periods of time.
There are a multitude of reasons as to why this occurs but it's a powerful enough force that many investors have done quite well for themselves over an investing lifetime by focusing on dividend stocks, specifically one of two strategies — dividend growth, which focuses on acquiring a diversified portfolio of companies that have raised their dividends at rates considerably above average and high dividend yield, which focuses on stocks that offer significantly above-average dividend yields as measured by the dividend rate compared to the stock market price.
Our hope is that by giving you a basic framework, you can understand some of the forces at play; how human nature, accounting, business management, and the stock market all come together in a way that can allow a prudent investor to enjoy streams of passive income from his or her holdings.
Cash Flow Restrictions Result in Lower Accruals
Though it may be a bit early in the article to hit you with this one, we want to start off by talking about it first because it is the one we consider particularly important. Usually, investors aren't exactly interested in learning about advanced accounting techniques or diving into an income statement or balance sheet. Nevertheless, it's the heart and soul of the investing process.
After all, a business is ultimately only worth the net present value of the discounted cash flows it can and will produce for its owners. In fact, when valuing a company or stock, most professional investors use a form of modified free cash flow rather than reported net income applicable to common. In most cases, the preferred metric is something known as owner earnings.
A company that pays dividends has to physically come up with cash that investors can receive; cash that is mailed to them in paper check form, directly deposited into their checking or savings account or sent to their broker for deposit in their brokerage account.
As the saying goes, "you can't fake cash". Either the dividend shows up or it doesn't. This has the effect of causing companies that devote money to dividends to have lower so-called accruals between free cash flow and net income.
In plain English, that means there are fewer meaningful adjustments in the accounting records of the corporation so the "quality of earnings" is higher in that the reported profits are almost in line with the conservatively calculated free cash flow. It is a well-established fact that, over longer periods of time, companies with lower accruals handily beat companies with higher accruals when measured by total return.
On-Going Cash Commitment Reduces Funds Available for Managerial Allocation
Executives and managers are only human. When cash begins to pile up in surplus, many men and women find themselves facing a constant pressure to spend it, even if spending it would be a mistake or lead to less optimal outcomes.
For those in Corporate America, when that spending is devoted to mergers and acquisitions, it can result in a much larger domain and all that comes with it, usually stock options, restricted stock, higher salary, bonuses, pension benefits, and, perhaps, even a golden parachute.
On the whole and in the aggregate, companies that pay dividends have a first-line of built-in inoculation in that the folks running the enterprise simply don't have as much money on hand as they otherwise would have had if there were no dividend in place.
This means that executives have to be far more selective when identifying potential merger and acquisition candidates than they otherwise would have had to be in a world of easy money. Each project needs to be compared and contrasted to others with only the best projects selected and merely "good" projects discarded.
"Yield Support" During Stock Market Crashes
Imagine that you are looking at a stock that trades at $100 per share. Now, imagine that stock pays a 3% dividend. The company itself is extraordinarily stable. Earnings cover the dividend sufficiently and those earnings are from diversified underlying sources so there's only a tiny probability of a dividend cut. Now, imagine that the stock market begins to crash. This company falls to $90 per share, $80 per share, $70 per share. It keeps going, down through $60 per share, $50 per share.
At some point, provided that dividend is safe and investors are convinced it is going to be maintained, the dividend yield on the stock itself is going to be so attractive that it brings in buyers from the sidelines, people who otherwise cannot stand to see the yield right there in front of them without doing something about it. Consider that the exact same $3 per share dividend would be a 6% dividend yield if the stock were trading at $50 per share instead. This explains why dividend stocks tend to fall less during bear markets.
The Return Accelerator Phenomenon
But that's not all. That yield support leads to another phenomenon that has been studied by respected Wharton professor Dr. Jeremy Siegel, which he calls the "Return Accelerator" or bear market protector. In essence, investors who reinvest their dividends accumulate more shares during stock market collapses as the dividend yield expanding allows them to gobble up more equity with each dividend check they shove back into their account or dividend reinvestment plan. As we discussed in my in-depth article on investing in the oil majors, that is one of the reasons the oil companies, as a class, did much better than the average component of the original S&P 500 stock market index back when it was introduced in 1957.
In fact, Dr. Siegel demonstrated that the worse the volatility, the better the long-term investor did! The reason has to do with the mathematics. The lower the cost basis of each subsequent purchase, the faster the average weighted cost basis of the entire position is drug down and the more shares the investor accumulates which, themselves, pay dividends. This means it takes a much smaller increase — certainly far less than the previous breakeven point - to get the position into profitable territory.
Dividend Stocks Provide a Huge Psychological Advantage to Certain Types of People
As the father of value investing, Benjamin Graham, once wrote, “The real money in investing will have to be made — as most of it has been in the past — not out of buying and selling, but out of owning and holding securities, receiving interest and dividends, and benefiting from their long-term increase in value.”
When you own a company that distributes some of its profits in the form of a cash dividend, it becomes a lot easier to focus on things that matter like "look-through earnings"; to make the connection between the success of the enterprise and you actually getting your hands on some of the cash that flowed through the corporate treasury.
It can make you more patient, focusing on whether or not your dividend checks are getting larger with time, mostly ignoring the quoted stock market value. This, in turn, can lead you to buy and hold investments, reducing frictional expenses, increasing your odds of taking advantage of things such as deferred tax liabilities, and, ultimately, the stepped-up basis loophole.
It may not sound like a major advantage but, in the real world, it can mean the difference between failure and success. One of the things most secret stock market millionaires have in common is they aren't particularly keen on hyperactivity.
Whether it's retiree Anne Scheiber amassing $22 million from her New York apartment or a minimum-wage janitor like Ronald Reed accumulating $8 million in equities through paper certificates and DRIPs, they tend to find exceptional companies, diversify so as to avoid wipe-out risk, and then hold on as if their life depended upon it.