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Written by: Denver Investments
Many investors want to participate in the wealth-building potential of the stock market, but seek a solution that will dampen downside volatility relative to the overall market. With historically low fixed income yields, expectations of prolonged below-trend growth in developed countries, and the continued threat of inflation on the horizon, today's investors often hunt for solutions that can not only provide a source of current income, but also a potential source of income that will grow over time. While most investors look at the historical dividend growth of a company as a predictor of the company's future dividend intentions, we take a forward-looking approach to identify future dividend growers.
Dividends as a Significant Part of Total Return
Dividends have played a significant role in the returns investors have received over the past seven decades. Dividends have accounted for 31% of the total return of the S&P 500 Index over this 75 year period. When reviewing the return composition by decade, dividends have been a consistent and positive source of return while providing a cushion during periods of weak equity market performance. Dividend income has been a source of return in flat markets while the reinvestment of dividends in markets where stock prices have been depressed can accelerate and magnify the recovery of investor portfolios when markets rise.
Beyond their contribution to total return, dividends also reflect a compnay's earnings and cash flow strength. Companies that can grow their dividend need to have a business capable of strong and growing free cash flow and a shareholder-friendly management team that is disciplined in its use of cash.
Lower Volatility and Better Return for Risk
Conventional finance theory states that the only way to earn a greater return is through accepting greater risk. However, a growing body of research suggests that greater returns have been achieved by investing in lower-volatility stocks. Dividend-growing stocks have significantly outperformed non-dividend-paying stocks over time and have done so with less volatility. In addition, dividend growers and initiators (those companies able to raise or begin to pay dividends) outperformed the broader group of dividend-paying stocks with less volatility, thus providing an even higher return per unit of risk (higher Sharpe ratio).
While various empirical studies conclude dividend growth investing leads to lower volatility as dividend growers typically exhibit sustainable earnings and strong balance sheets, we believe the causal link is reversed: history shows companies that generate consistently high levels of cash flow offer the potential for dividend growth, superior relative returns and less risk. Quality and consistency of a company's cash returns also correlate closely with the company's stock price volatility, a point that many dividned investors take for granted. We refer to this subset of stocks as "consistent cash flow (CF) generators."
While the Sharpe ratio uses standard deviation to represent risk, the Treynor ratio uses beta as a measure of market or systematic risk. The Treynor ratio is useful in determining how a particular investment contributes to an already diversified portfolio. The table below illustrates that the lower the beta, all else equal, the more beneficial a new asset will be to the risk/return prospects of one's total portfolio.
Furthermore, it shows consistent cash flow is the best addition to an existing stock protfolio.
Dividend Growers Can Provide an Inflation Hedge
High-quality, dividend-growing companies can provide a hedge against inflation as income received from dividends has historically grown in line or often at higher rates than inflation. Such companies often possess pricing power and may be able to pass cost inflation on to the end consumer by increasing prices, which allows the company to maintain or increase profitability and increase dividend payments even in periods of rising inflation.
As a result, dividend growers have been more of an inflation hedge than non-dividend-paying stocks. As seen in Exhibit 4, since 1972, dividend growers have outperformed non-dividend-paying stocks in all types of inflationary environments.
Dividend Income Has Outgrown Interest Income
While yields on bonds have tended to be higher than yields on equities at a specific point in time, inflation erodes the purchasing power of a fixed income investment over time, while dividends from stocks have the potential to outgrow inflation. We can see in Exhibit 5 that the dividend income from $100,000 investment in stocks in 1985 (as represented by the S&P 500 Index) grew to $21,370. Meanwhile, interest income from $100,000 invested in bonds (as represented by the Barclay U.S. Aggregate Bond Index) only grew to $2,591. The yield on initial investment (left scale) for the stock investment is also significantly higher at period end at 21% versus 2% for the bond investment.
Yield and Diversification Opportunities from Global Dividend Investing
While investors in the U.S. have become more comfortable investing overseas, others may be surprised by the number of high-quality foreign companies that benefit from globally diversified revenue streams. In many cases, the strongest company with the greatest potential to grow its dividend in a particular sector may be found outside of the U.S.
Investing globally offers the opportunity for yield and diversification. Foreign companies follow a tradition of returning more capital to shareholders, evidenced by the fact that dividend yields have consistently hovered approximately 100 basis points above those of their U.S. counterparts. This provides portfolio managers with greater flexibility when constructing a portfolio. There are also diversification benefits to investing globally. This can lead to more consistency and help protect a portfolio against secular slowdowns.
For more information please contact Denver Investments .