By Kenneth N. Green, CPA, MBA
Ever since the Great Recession of 2008-2009 and until this past year, the interest rates on high-quality fixed income securities have been paltry. The best way that retired investors have been able to obtain the income necessary to maintain their lifestyles has been through dividend-paying common stocks. Furthermore, the better interest rates that we have today may not last more than a couple of years if we do have the recession that many economists are predicting. Thus, making wise choices of dividend-paying securities will be ever more important in the years to come.
Thus commences the great debate as to whether it is better to invest in companies that pay a high initial yield or in those that have a lower yield and a higher dividend growth rate. There is no perfect answer here either. Rather, it is important to evaluate a company’s financial strength and stability as well as their history of dividend growth. Those companies that have grown their payouts for many years show the consistency and sustainability that their investors require.
Those companies that have extremely high yields typically have a very high payout ratio of their earnings. If their earnings should decline, a dividend cut or its elimination may be imminent.
Dividends play an important role in communicating the underlying financial strength of a company. Companies that have a long history of dividend payments are loathe to reduce their payouts to their investors and many are committed to annual increases in their payouts. A dividend increase indicates that a company expects future cash flows to increase and the dividend will be sustainable. On the other hand, a dividend cut is viewed as a negative development for the near-term financial health of the company. It is important to evaluate a company’s current yield in relation to its historical norms. A current yield that is higher than the company’s historical norm may indicate attractive valuation. Conversely, if the company’s current yield is below its historical norms, it would indicate that the company might be overvalued. The point is that analyzing a company’s dividend record can be an effective way to appraise its relative investment merit.
We present these arguments to conservative investors who are interested in maximizing the income from their portfolios while minimizing their levels of risk. Also, this applies to long-term oriented investors whose objective is to own a business for many years. In doing so, short-term price volatility becomes irrelevant. When an investor focuses on a growing income stream, it makes no sense to be concerned about the daily gyrations of stock price. Furthermore, dividend investing does not mean that an investor must accept lower long-term returns.
There exists a lot of empirical evidence that dividend growth companies outperform the market as a whole and their non-dividend paying peers long term. A recent article from Hartford Funds used data from Ned Davis Research to analyze companies that have paid a dividend in the past twelve months and those that have not. To summarize, companies were classified as “growers and initiators”, “cutters and eliminators”, and “no change”. The companies remained in their classification for twelve months or until a dividend change occurred.
The average annual return and volatility, measured by beta and standard deviation, were calculated for each category from 1973 to 2022. Based on the research, dividend grower and initiators had higher total returns and lower volatility than the equal-weighted S&P 500 index over the same period. Dividend growers and initiators outperformed dividend non-payers by an average annual rate of 10.84% since 1973. Companies that grew, initiated or continued to pay dividends have experienced the highest returns compared to other stocks, and with substantially less volatility.
Companies that have historically grown their dividends are often established, mature companies that have consistently generated cash flows sufficient to cover their payouts and still have funds available to reinvest in their businesses. These companies are able to operate effectively in periods of both economic growth and downturn, providing stability and income to investors, and potentially reducing the volatility of a portfolio. The combination of growing dividends and capital appreciation can contribute to a higher annualized return for investors in the long term.
An Imperfect Example
Chicago’s last locally owned major bank, the Northern Trust, serves as a less-than-perfect illustration of these aforementioned points. In 2007, the year prior to the Great Recession, Northern’s dividend was $1.03/share. Their dividend increased to $1.12 in 2008 where it remained through 2011, then increasing again in 2012, and again each year through 2020, and again held flat in 2021. Okay, there were a few years when the payout was not increased. However, there were no cuts either. Still, in the past five years the payout has increased at a 13% rate. Today the yield on the stock is 3.81%! This is the highest it has been in more than two decades. This is consistent with so many regional banks today as sentiment has soured following the nation’s recent bank failures. Further, Northern’s forward earnings multiple is 11X, lower than it has been in over two decades as well. Good buying opportunities arise when short-term performance is at its worst. This applies to dividends as well as it does to appreciation potential. As Warren Buffett reminds us, “Be greedy when others are fearful.”
Conservative, and especially retired investors should put maximum focus on dividends because they are more reliable and predictable than short-term stock prices and they are reflective of the fundamental financial health of a company. At this stage of economic and market cycles, we recommend that investors focus on dividend growth instead of dividend yield. Today, we favor companies that have boosted their dividend at high growth rates for several years consecutively.
Kenneth N. Green is the Senior Vice President and Director of Investments at Marc J Lane & Company, the investment affiliate of The Law Offices of Marc J. Lane, P.C.
If you would be interested in having the professionals at Marc J. Lane & Company confidentially evaluate your investment strategy, please feel free to reach out to Marc Lane at mlane@marcjlane.com or 312/800-372-1040.