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Dividends for Growth and Income Generation

21 April 2020

Key Takeaways from this Article

  • Companies that issue dividends can provide inherent fidelity to the financial state of the company while unhealthy companies are generally not in a position to provide dividends to their shareholders.
  • Qualified dividends (the dividend paid by an institution to its ordinary shareholders after the deduction of tax) are taxed at rates lower than the ordinary income tax rate of 45%. In South Africa, dividends tax is 20%.
  • Even during periods of recession, dividend stocks have historically shown growth.
  • Over the past 93 years dividend stocks traded on the S&P 500 have provided investors with returns close to twice those of stocks without dividends.

Kiru Padayachee, Business Development Manager at Glacier by Sanlam, examines what makes dividend-paying companies appealing to investors.

There is a laundry list of reasons why dividends matter to investors. Consider that dividends:

  • substantially increase stock investing profits;
  • provide an extra metric for fundamental analysis;
  • reduce overall portfolio risk
  • offer tax advantages; and
  • help to preserve the purchasing power of your capital.

Let’s Take a Closer Look at the Advantages of Dividends

1. Growth and expansion of profits

One of the primary benefits of investing in dividend-paying companies is that dividends tend to grow steadily over time. Well-established companies that pay dividends typically increase their dividend payouts from year to year. There are a number of "dividend aristocrats,” or companies that have continuously increased their dividend payouts for more than 25 years consecutively. Since 1980, the dividend average compounded annual growth rate for S&P 500 companies that offer dividends, has been 3.2%.

One of the basics of stock market investing is market risk, or the inherent risk associated with any equity investment. Stocks may go up or down, and there is no guarantee that they will increase in value. While investing in dividend-paying companies is not guaranteed to be profitable, dividend stocks offer at least a partial return on investment that is virtually guaranteed. It is very rare for dividend-paying companies to ever stop paying dividends. In fact, most of these companies increase the amount of their dividends over time. Many investors fail to appreciate the huge impact dividends have on stock market profits.

Dividends have accounted for almost half of stock-investing profits in the companies that make up major indices around the world. This means the inclusion of dividend payments has roughly doubled what stock investors have realised in returns on investments, compared to what their returns would have been without dividend payments.

Additionally, in this low-interest-rate environment, the dividend yield offered by dividend-paying companies is substantially higher than rates available to investors in most fixed-income investments.

Dividend-paying stocks can also improve the overall stock price. Once a company declares a dividend, that stock becomes more attractive to investors. This increased interest in the company creates demand and increases the value of the stock.

2. Dividends are helpful in equity evaluation

Just as the impact of dividends on total return on investment (ROI), is often overlooked by investors, so too is the fact that dividends provide a helpful point of analysis in equity evaluation and stock selection. Evaluation of stocks using dividends is often a more reliable equity evaluation measure than many other more commonly used metric such as price-to-earnings, or P/E ratio.

The potential problem with evaluating stocks solely based on a company's financial statements is that companies can, and unfortunately sometimes do, manipulate their financial statements through misleading accounting practices to improve their appearance to investors.

Dividends, however, offer a solid indication of whether a company is performing well. A company has to have real cash flow to make a dividend payment.

Dividends provide continuous, year-on-year indications of a company's growth and profitability, outside of whatever up-and-down movements may occur in the company's stock price over the course of a year. A company consistently increasing its dividend payments over time is a clear indication of a company that is steadily generating profits and is less likely to have its basic financial health threatened by temporary market or economic downturns.

An additional benefit of using dividends in evaluating a company is that since dividends only change once a year, they provide a much more stable point of analysis than metrics that are subject to the day-to-day fluctuations in stock price.

3. They reduce risk and volatility

Dividends are a major factor in reducing overall portfolio risk and volatility. Studies have shown that dividend-paying stocks significantly outperform non-dividend-paying stocks during bear market periods. While an overall downmarket generally drags down stocks across the board, dividend-paying stocks usually suffer significantly less decline in value than non-dividend-paying stocks.

During the 2008 global financial crisis that precipitated a sharp fall in stock prices, dividend stocks held up noticeably better than non-dividend stocks. Owning stocks of dividend-paying companies also substantially reduces overall portfolio volatility. A 2000-2010 comparison of dividend-paying companies versus non-dividend-paying companies in the S&P 500 Index, shows a marked contrast in levels of volatility. The beta of dividend-paying stocks during this period was 0.98, whilst the beta in non-dividend-paying stocks was 1.48.

4. Dividends offer tax advantages

Dividends are a very tax-efficient means of obtaining income. Qualified dividends are taxed at substantially lower rates than ordinary income. Individuals whose ordinary income tax rate is 45%, are taxed at a 20% rate for qualified dividends.

Dividends also help in another area that investors sometimes fail to consider:

  • they preserve the purchasing power of capital;
  • they counter the effects of inflation on investment returns; and
  • for an investor to realise any net gain from an investment, the investment must first provide enough of a return.

If an investor owns a stock that increases 3% in price over the course of a year, but inflation is at 4%, then in terms of the purchasing power of the capital, the investor has suffered a 1% loss. However, if that same stock that increased 3% in price also offers a 3% dividend yield, the investment has successfully returned a profit that outpaces inflation and represents an actual gain in purchasing power for the investor. The good news for investors in dividend-paying companies is that many dividend yields outpace inflation.

The information provided in this article has been researched from the following sources:

  1. The Intelligent Investor by Benjamin Graham.
  2. Behavioural Finance and Wealth Management by Michael M Pompian.
Glacier Financial Solutions (Pty) Ltd and Sanlam Life Insurance Ltd are licensed financial services providers
Sanlam Life Insurance is a licensed financial service provider.
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