Don't Discount Dividends

American Century Investments

April 6, 2010

The global financial meltdown from late 2007 to early 2009 (and the Great Recession that accompanied this crisis) reminded investors of an important fact about financial markets: They can be very volatile and unpredictable during certain periods. Those who are old enough to remember the 1930s as well as those who lived through the 1970s were reminded of this fact. And those too young to remember either of these decades were given a painful lesson on this subject in the first decade of the new century and millennium.

During long and sustained bull markets—such as we had during the 1980s and 1990s—some fundamental rules and lessons about long-term wealth creation get overlooked, ignored or (worst of all) dismissed. One of those lessons has to do with the importance of dividends in long-term wealth creation for equity investors. When share prices are increasing at 10 to 20% per year, why worry about a 1 to 2% dividend yield (dividend yield equals the dividend per share for a given period divided by the ending stock price)?

In their classic and seminal 1934 book regarding equity markets titled Security Pricing, Benjamin Graham and David Dodd emphasized the importance of dividends in the overall valuation process for equities. They considered the importance of company dividends from three perspectives:

• First, as a cash flow to investors that contributes to the overall return on a stock (again, the dividend yield).
• Second, as a measure of a company’s financial health both in terms of sustainable earnings generation and the strength of the underlying balance sheet.
• Third, as a measure of management discipline and focus on enhancing shareholder equity through their understanding that not all internal investment opportunities that could be funded by reinvested earnings are value-creating.

In this Weekly Market Update, we will use one popular index of the stock market, the Standard & Poor’s 500 Index (which consists of large capitalization U.S. companies, the majority of which pay dividends), to illustrate why dividends are important to the long-term total returns for investors. The analysis is based on pre-tax returns but still relevant given the importance and growth of tax deferred retirement accounts such as Individual Retirement Accounts (IRAs) and employer-sponsored 401(k) plans.

 

Earnings Are Much More Volatile Than Dividends

One of the most basic models for equity valuation states that a company’s share price should equal its forecast earnings per share times its Price/Earnings (P/E) multiple. An army of equity analysts on Wall Street dedicate themselves to forecasting these two factors on a quarterly basis. As the chart below illustrates, for the combined companies within the S&P 500 over a 33-year time frame (from 1977 to 2010), the earnings per share of even well-established large-cap companies have been volatile and, in several recent incidences, prone to major and sharp declines. However, despite the collective earnings volatility, the combined dividends per share paid out by S&P 500 companies has been remarkably consistent with a reliable growth trend through both good times (bull markets) and bad times (bear markets). That is especially remarkable during the past two years when many S&P 500 companies reported negative earnings and still maintained their dividend payout to investors.

Source: Standard & Poor’s Benchmarks, Research, Datasets and Analytics website.

Why the Consistency in Dividend Payouts?

As noted earlier, one aspect of the importance of dividends is as a communication tool between management and investors that a company’s financial health is sound—both in terms of sustainable earnings generation and the strength of the underlying balance sheet. This communications tool is especially important during bear markets when share prices as well as earnings are generally plummeting. In the chart below, we plot the number of companies in the S&P 500 that either increased or initiated dividend payments versus those that decreased or suspended dividend payments from the first quarter of 2003 to the first quarter of 2010. From 2003 through the start of the global financial crisis in late 2007, the overwhelming tendency among S&P 500 companies was to increase/initiate dividend payments. Yet even after 2007, while an increasing number of companies decreased or suspended dividend payments (up to approximately 45 companies in the first quarter of 2009), a greater number of companies (55) either increased or initiated dividend payments. And the balance of the S&P 500 companies maintained their dividend payments despite (as shown on the previous chart) a very volatile and negative short-term earnings trend.

Source: Standard & Poor’s Benchmarks, Research, Datasets and Analytics website.

 

The Impact of Dividends on Long-Term Wealth

Any analysis of long-term wealth creation in the equity markets is dependent on the start and end dates selected (e.g. the “lost decade for stocks” from 2000 to 2009 reflected the relatively high equity market valuations as 1999 ended relative to their relatively low valuations by late 2009 due to the global financial crisis). In the chart below, we arbitrarily have chosen a period from 1988 to 2009 to illustrate several points. The first is that even investing in a large-cap universe such as is represented by the S&P 500 can be quite a roller coaster ride. Second, reinvesting dividend payments over the long haul has a profound impact on eventual wealth, especially relative to investing in the very same stocks and not reinvesting the dividends. Finally, as the black line illustrates, the proportion of total wealth due to dividend reinvestment is not only substantial but makes the biggest difference when markets go through a down/bear cycle. Because of their consistency in both good times and bad, dividends and dividend reinvestment can help cushion the downsides as well as enhance ultimate wealth. Which is why we say, “Don’t discount dividends.”

Source: Standard & Poor’s Benchmarks, Research, Datasets and Analytics website.

 

American Century Investments® offers a wide variety of stock, bond, asset allocation and money market funds. 

Contact one of our Investment Consultants to learn more.

 

The S&P 500 Index is a market value-weighted index of the stocks of 500 publicly traded U.S. companies chosen for market size, liquidity, and industry group representation that are considered to be leading firms in dominant industries. Each stock's weight in the index is proportionate to its market value. Created by Standard & Poor's, it is considered to be a broad measure of U.S. stock market performance.

Investment return and principal value will fluctuate and it is possible to lose money by investing.

The opinions expressed are those of American Century Investments and are no guarantee of the future performance of any American Century portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.

You should consider a fund’s investment objectives, risks, and charges and expenses carefully before you invest. Click here for a prospectus, which contains this and other information about the fund, and should be read carefully before investing.

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