3 Reasons Dividend Stocks Tend to Outperform Non- Dividend Stocks

Cash Generating Stocks Have a Long History of Superior Investment Returns

Businessman watering potted money tree, cropped
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When you own a stock, you are entitled to a share of any profits that the company made. In a simple scenario, if you held 100 shares of a local restaurant that had 1,000 shares of stock outstanding, you would receive 10% of the restaurant’s earnings. The board of directors, who is responsible for representing the stockholders’ interest and hiring management, may decide to retain these profits to expand the business, or it may decide to mail them out to you in the form of a check.

When profits are sent to owners, they are called dividends

There is a large body of academic research that shows 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 $4,065,289 after 50 years. A similar investor earning 9% per year would end up with $8,150,836.  That extra 2% per annum meant roughly 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.

1. Dividend Stocks Often Have Higher Quality Earnings -- You Can't Fake Cash

There are a lot of estimates and assumptions in accounting. How quickly do you depreciate a building? How large of a reserve do you establish for sales returns? In the short term, it can be easy for management to make profits on the income statement appear higher or lower than they actually are.

Both can be problems, including the "cookie jar" practice of lowering record earnings one period through the use of aggressive accounting methods, only to reverse those conservative estimates during a poor period to lead to overall smoother figures.

While there can be a long discussion about the causes of this behavior -- Main Street investors practically beg for companies to do it by demanding an unrealistic upward trend of the earnings line when that isn't how the world works most of the time.

Seeing through the ripples to the actual stones underneath the water can be difficult if you aren't aware of forensic accounting techniques needed to accomplish such a task.

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 company mails you a check for your cut of the profits, that money is yours. You can spend it, give it to charity, reinvest it, or add it to your savings. As most stocks are non-assumable these days, they can't take it back from you.

Thus, it can be accurately surmised that companies with a long established history of constantly increasing dividend payouts while boasting conservatively financed balance sheets are, in fact, making money.

2. Dividend Yields Can 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. You didn't manage it well and never paid attention to articles about diversification so you only have two stocks. 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 1960's.

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 such as mouthwash, baby powder, and Band-Aids.

As of today, you own 672 shares of Johnson & Johnson at $74.41 per share, or $50,000 total. Each of those shares distributes a cash dividend of $2.44 per annum. That is a 3.3% dividend yield on current market price. That means each year you receive cash of $1,639.68 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%. It's happened before, and it will certainly happen again. That's the nature of the world.

Now, your entire portfolio is worth $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 $2.44 in the mail each year. That means the dividend yield is now 6.6% on market.

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 mailing you any checks. The second is sending you $1,639.68. If you sell those shares, those checks stop, as well.

Most people keep the things that mail them dividends. Money coming in the mailbox or via direct deposit 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.

3. Pressure On Management to Be More Selective About Uses of Shareholder Capital

When a firm has to send 30% to 50% 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 cash generating 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.