The Power of Dividends
If we look at the data over the past 90 years, dividends were responsible for over 40% of the total return of the S&P 500 index, according to a 2021 publication by Hartford Funds. And over the last 50 years, dividend paying stocks have produced average annual returns largely in line with the S&P 500 Index, but with a lower degree of volatility.
While dividend stocks may not receive the same popularity as growth stocks in the current environment, dividend paying stocks can meaningfully contribute to total return over time, with potentially lower price fluctuations. This is especially important in the continuing low interest rate that we’ve seen persist over the last couple of years.
In the past, investors focused on producing current income, such as retirees or individuals nearing retirement, have been able to do that through bond allocations, when yields were much higher. However, in today’s low interest rate environment, it’s become increasingly difficult to achieve that investment objective though fixed income alone.
There are many investment vehicles that can help you combat low interest rates. With the 10-year Treasury bond paying just over 1% and similar bonds in Europe and Japan paying 0% or slightly negative interest rates, but in our view, there are a number of high-quality dividend paying stocks out there that pay a 2%, 3%, or even 4% dividend yield.
Income from bonds, such as Treasury or corporate bonds are federally taxed at an investor’s full ordinary income rate, whereas dividend income may only be federally taxed at a qualified rate, which is often much lower than ordinary income tax rates. So, for taxable investors there may also be potential tax benefits from receiving stock dividends rather than bond income.
But not all dividend stocks are great contenders for your portfolio and evaluating which ones may work for you can be challenging.
The security and growth prospects of the dividend between companies can differ, and sometimes meaningfully. Our investment approach to dividend stock investing focuses on companies with relatively low debt outstanding and have a reasonable payout-ratio (which is the percentage of net profit a company pays out in the form of dividends). We believe those characteristics better position a company to not only sustain current dividend payments, but hopefully grow them in the future.
As dividend investors, the last thing we want to experience is a dividend cut or outright elimination, and the historical return data supports this.
Dividend cutters and eliminators underperformed the broad dividend paying index by nearly 3% per year, on a total return basis. So, we would suggest approaching some of those very high dividend yielding stocks – like 6%, 8%, 10% - with careful scrutiny.
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