The case for including dividend stocks in client portfolios remains strong. Many of the advantages were shared in a Fidelity Investments research report, “Equity Total Return: Lower Volatility in the Longer Term.”
Dividend-paying equities have been able to offer better inflation protection than bonds. Inflation hasn’t been a concern recently, but price increases are likely to accelerate at some point as the economy recovers. When that happens, fixed-payment bonds lose purchasing power.
In contrast, shareholders have more of a buffer, Fidelity notes: “Broad-based price increases throughout the economy may lead to higher corporate revenues, allowing profits—and potentially stock prices—to increase on a nominal basis and offset rising inflation rates.”
Dividend-paying equities have tended to be less volatile. All stocks are subject to market volatility, but companies that have a history of steady dividend payments tend to be mature businesses. Such firms typically have steady cash flows, reasonably stable profits and less operational risk than companies that don’t pay dividends.
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This combination benefits shareholders, according to the report: “These characteristics have generally led to less volatility in dividend growth rates relative to earnings growth rates and to lower share price volatility for dividend-paying companies compared to the broader market.”
Dividends have been a major component of equity returns. It’s easy to overlook dividends during exceptional bull markets like 2013. That’s shortsighted reasoning, though. Dividends historically have accounted for a significant part of the stock market’s total return, though the percentage varies over time.
The focus on the income component in total return is another factor in favor of dividends, says Fidelity: “Moreover, a portfolio tilted toward dividend-paying equities may expect to get a greater proportion of total return from income—which depends on less volatile dividend growth—than price appreciation—which we believe is primarily driven by more volatile earnings growth.”
Sticking with Quality
Foreign companies frequently adjust their dividends to reflect current profits; but most U.S. companies strive for payout consistency, because a dividend cut can cause a large drop in a stock’s price.
The Nasdaq OMX Dividend Achievers’ component companies have achieved that consistency for their shareholders. According to the Nasdaq OMX website, the Dividend Achievers’ history goes back to 1979, “when Moody’s Investor Service developed a proprietary model to identify best-of-breed dividend-paying companies.”
In 1998, Mergent Inc., acquired Moody’s Investor Service and rebranded its products and services with the Mergent name. Nasdaq OMX acquired that brand in late 2012 and added rules-based methodologies to make the indexes “more transparent for investors.”
Mergent continues to publish the quarterly “Handbook of Dividend Achievers,” which provides details on the qualifying U.S. and Canadian companies. According to the spring 2014 issue, a U.S. publicly traded company must trade on a major exchange and have increased its dividend for the last 10 or more consecutive years to qualify for inclusion. Canadian companies must meet a five-year hurdle.
Most companies don’t make the cut: Only 10% of the 3,300-plus North American-listed, dividend-paying common stocks get classified as Dividend Achievers.
Making the Grade
The Nasdaq OMX group licenses multiple indexes based on the Dividend Achiever methodology to ETF and mutual fund companies. The indexes have slightly different qualifications adapted for their component securities, although the central theme of consistent dividend growth applies to all the indexes.
Nasdaq OMX says that to be included in the U.S. Broad Dividend Achievers Index, a security must meet many conditions, including requirements that it have a minimum three-month average daily dollar trading volume of $1 million, have at least 10 consecutive years of increasing annual regular dividends and may not be issued by an issuer currently in bankruptcy proceedings.
Nasdaq OMX evaluates the index securities each March, based on the previous December’s values. Additions to and deletions from the index take effect after the close of trading on the third Friday in March. Included securities that fail to meet the requirements or cut their dividend by more than 50% can be dropped during the year.
Because the markets dislike dividend cuts, companies’ boards tend to move cautiously when setting their dividend policies. As a result, the decision to start paying or to increase a dividend makes a positive statement about management’s outlook, observes Joe Becker, equity income specialist at Invesco PowerShares in Downers Grove, Ill.
Dividends are one of the two main ways that companies can return capital to shareholders, he says. Companies that pay consistent or growing dividends are signaling a degree of confidence that the business is sufficiently profitable to maintain or increase the dividend. In contrast, management wouldn’t increase a dividend if it had a negative outlook.
Jim Morrow, portfolio manager of Fidelity Advisor Equity Income Fund in Boston, shares a similar opinion. Dividends signal that the company is producing sufficient cash flow to actually pay the dividend—companies that are losing money do not pay dividends. Also, companies that have very volatile cash flow streams tend not to pay dividends.
Dividends also provide insight into management’s thinking about a company’s relationship with its shareholders. Dividend-payers’ view of capital allocation includes sharing excess cash with shareholders, and that’s a “huge positive attribute over time,” says Morrow.
In his experience, companies’ return of capital to shareholders tends to be good for stocks over long periods of time for several reasons. “Number one, they tend not to make dumb acquisitions or make silly decisions with their capital because they’re disciplined about returning capital to shareholders,” he says.
“And, number two, the management team is sort of signaling to you that they have confidence themselves in their cash flow profile and that they’re willing to make a commitment to the marketplace through the form of a dividend,” Morrow explains.
Corporate managers recognize the signaling role that dividends play and can structure their business activities in a way that supports dividends. Each company, of course, has a unique outlook, strategy and method for supporting dividend growth.
Questar Corporation in Salt Lake City reorganized in 2010 by spinning off its exploration and production operations to create a more utility-centric company, according to Anthony Ivins, vice president, investor relations and corporate treasurer.
In doing so, the company sought to grow its dividend faster than earnings growth, to a level competitive with similar companies. Questar has since raised its dividend by nearly 50% since the reorganization, targeting a 60% payout ratio, which has now been achieved.
In the case of San Dimas, Calif.-based American States Water Company, growing utility and contracting- services business has allowed it grow its dividend, according to CEO Robert J. Sprowls.