3 Reasons Why Dividend Stocks Tend to Outperform Non-Dividend Stocks

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When you own a stock, you are entitled to a share of any profits that the company makes. If you hold 100 shares of a local restaurant that has 1,000 shares of stock outstanding, you are a 10% owner of not just the business, but its earnings.

The restaurant could decide to retain these profits to expand the business, or it may give all or some of those profits to you directly. When profits are sent to owners, they are called dividends

There is a large body of research showing a long-term historical trend of dividend stocks beating non-dividend stocks. While an extra percentage point here or there may not seem like much, consider that an investor saving $10,000 per year, who earned 7% on his money, would end up with $761,000 after 30 years. A similar investor earning 9% per year would end up with $1,326,000. That extra 2% each year means almost double the wealth!

There are three primary reasons that dividend stocks, as a whole, tend to do better than their counterparts. Let's look at each individually.

Dividend Stocks Have Higher Earnings Than Non-Dividend Stocks

There are a lot of estimates and assumptions in accounting, and it can be easy for management to make profits on the income statement appear higher or lower than they actually are. 

That is where dividends come to the rescue. One thing you cannot fake is liquid cash—greenbacks that you can shove into your pocket or deposit in the bank. When a dividend payment shows up in your brokerage account, that money is yours. You can spend it, give it to charity, reinvest it or add it to your savings. 

Thus, companies with a long established history of continually increasing dividend payouts while boasting conservatively financed balance sheets are making money.

Dividends Support a Stock During a Market Crash

During major meltdowns of the stock market, strong dividend stocks tend to hold up much better than their non-dividend paying brethren. The reason is due to something called "yield support".

Imagine that you have a portfolio with $100,000 in it. But you only own shares of two stocks, and each stock holding is worth $50,000.

The first stock, Berkshire Hathaway, is one of the financially strongest businesses in history. It owns nearly 100 major corporations engaged in everything from construction, furniture, and insurance to banking, soft drinks, and jewelry. It has newspapers and candy shops; farm equipment suppliers and a railroad. Yet, Berkshire Hathaway hasn't paid a dividend since the 1960s.

The second stock, Johnson & Johnson, is the same size as Berkshire Hathaway but focuses on three major industries: pharmaceuticals, medical devices, and health-related consumer products. As of June 2018, you own 413 shares of Johnson & Johnson at $121 per share, or $50,000 total. Each of those shares distributes a cash dividend of $3.60 per year. That is a 2.98% dividend yield on current market price. That means each year you receive cash of $1,490 before any taxes you might owe. (You can avoid the taxes entirely if you hold the shares in something like a Roth IRA).

Imagine the world falls apart. Investors panic. There is mass chaos. Overnight, the stock market collapses by 50%. 

Now, your entire portfolio is worth just $50,000. You have $50,000 in losses. Your Berkshire Hathaway shares are worth $25,000, and your Johnson & Johnson shares are worth $25,000.

However, your Johnson & Johnson stock is still sending you $3.60 per share each year. That means the dividend yield is now 6.6% on market. (Note: Companies can, in times of trouble, reduce dividend payouts. But the strongest companies make it a point of pride to maintain and even increase dividend payouts each year.)

If there are any investors out there with spare cash, the odds are good they are going to be attracted to that fat dividend yield and buy shares of Johnson & Johnson, helping to put a floor under the stock price and stabilize it.

Combine that with your own human nature. If you had to sell shares to come up with cash, which will you going to give up first: The Berkshire Hathaway or the Johnson & Johnson? The first isn't sending you cash. The second is sending you $1,490. If you sell those shares, those checks stop, as well.

Most people keep the things that send them dividends. Real money sent directly into an account is very attractive, especially when the world is falling apart around you. Those who managed to survive fine could even use that dividend income to fund other purchases of cheap stocks, increasing the overall ownership of businesses in their portfolio.

Management Is More Disciplined With Dividends vs. Non-Dividends

When a firm sends portions of the money it generates back to the owners, it imposes discipline. Suddenly, if two potential acquisitions cross the desk of the CEO, he has to choose the more lucrative option with the better promise of expanding profits. It is this psychological restraint that is responsible for the superior returns generated by dividend stocks over long periods of time.

To illustrate how powerful this is, go back to our hypothetical portfolio in the first point. Charlie Munger once commented that, following his and Warren Buffett's death, the quickest way to solve Berkshire Hathaway's capital reinvestment risk would be to pay out most of the earnings as a dividend. The management can't screw up what it doesn't control. It's a brilliantly simple truth. Dividends impose discipline.

Everyone is always looking for the next Starbucks IPO, and those can be great. But don't forget to keep your eye on the cash0generating giants that "pound out money" for the folks who have their names engraved on the stock certificates. It's a wonderful thing to be sitting at home and see cash come into your accounts. If you've selected your holdings wisely, that figure should grow significantly over the years.