The Importance of Dividends

The current dividend yield on the S & P 500 index is about 2%. According to a recent article in Barrons’, dividends accounted for 43% of stock market returns over the past 83 years. The remaining return came from the change in stock prices. So far in 2009, dividends have accounted for only about 10% of the market’s total return.

We believe that dividends help put a floor under the value of a stock, because you are receiving an ongoing stream of cash flows from the time that you make your investment. Growth stocks, which pay lower or no dividends, must earn their total return exclusively from the change in price.

It is important to consider both the level and sustainability of dividends. The S & P 500 has a payout ratio of about 45%. This means that for every $1.00 in earnings, companies are paying an average of about $0.45 in dividends. Significant levels of debt or off-balance sheet obligations like under funded pension plans or post-retirement health care benefits may restrict a company’s ability to pay dividends in the future, since they have other needs for this cash. When evaluating individual stocks for inclusion in client portfolios, our Investment Policy Committee considers both the current dividend yield and the payout ratio. A high payout ratio of 75% or more may indicate that the dividend is at risk of being cut in the future. An unusually high dividend yield is also a sign that the dividend may not be sustainable. If something seems too good to be true, it usually is.

Why not buy all dividend paying stocks? Different clients with different investment objectives may have different levels of dividend paying stocks. A retiree who is spending from their portfolio, in addition to possibly having an allocation to fixed income (bonds), may have more dividend paying stocks than a younger client in the accumulation phase. Increasing portfolio income is one factor that we take into consideration as we review client portfolios for potential improvements. Also, a cornerstone to our investment philosophy is broad diversification including growth and value companies, small, medium and large companies and international companies. We never know for sure what is going to do better, so we want to have a mix of assets that will perform well under a variety of market conditions. If we focused exclusively on dividend-paying stocks, we would be forced to underweight sectors of the economy like technology that we believe have attractive future growth prospects. This year, large growth companies have returned over 32% versus 17% for large value companies. Small and mid-sized growth companies have also outperformed their value counterparts during this period. Therefore, including an allocation to growth companies that pay little or no dividends has helped portfolio returns this year.

Currently, dividends are taxed at the same rate as long-term capital gains. With the Bush tax cuts currently set to expire at the end of 2010, dividends are scheduled to be taxed at higher ordinary income rates for 2011 and beyond. The main implication of this from an investment perspective is asset location. If the tax on dividends does rise, we would lean towards putting higher-dividend stocks in a tax-deferred account such as an IRA where feasible.

Bill Hansen, CFA
November 25, 2009

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