The Case for Dividends

Dividends, historically a primary source of U.S. equity returns, are poised to return as the most important contributor to returns in the decade ahead. We believe investors will focus on and pay a premium for companies with proven and sustainable levels of dividend growth. At 1.9%, the dividend yield on the S&P 500 is well below its 130 year average of 4.3% and not far from the all time low of 1.1% reached in 2000. Part of the reason is that payout ratios are under 30%, close to all time low levels, and well below their 130 year average of 62%. During the decade which ended in 2010, boards directed cash flow to repurchasing shares and away from dividends. But despite over $2.7 trillion of share repurchases during the decade, comprising over a quarter of its starting market capitalization, the S&P 500 delivered a total return of negative 4.7%. Companies have a terrible record of timing their share repurchases, with peak buybacks occurring at the market peak in 2007 and consuming 80% of earnings. As the market bottomed in 2009, repurchases declined 77%.

The trend toward dividends is just starting and has a long way to go. After declining 21% in 2009, dividends increased 16% in 2011 as 320 S&P 500 companies increased their dividends. Over 20 companies initiated dividends in 2010 and 2011 and Apple recently initiated a dividend. Companies that initiate meaningful dividends or offer sustainable dividend growth often see a significant benefit to their share price, as was the case with Time Warner Cable, whose share price has risen 86% (outpacing the S&P 500 by 55%) since initiating a generous 3.9% dividend in January 2010. There are 394 companies in the S&P 500 that pay dividends, down from 469 in 1980 and 438 in 1990. The average yield among dividend payers is 2.6%. There is substantial room for improvement, especially as corporate balance sheets swell with cash. Increasingly managements are recognizing that there is an expanding base of potential shareholders seeking safe and growing levels of income in an environment where reliable income is scarce.

There is a significant amount of research which supports the importance of dividends as a central component of total return for equities. From 1900 through 2000, a portfolio of U.S. dividend paying stocks with reinvested dividends returned 85 times the returns attained through capital gains[sup]i[/sup]. In an even longer study spanning the 200 years ending in 2002, Robert Arnott concluded that dividends were the primary source of returns for U.S. equities, accounting for 5.0% of the 7.9% annual return[sup]ii[/sup]. A 36-year study conducted in by Lehman Brothers in 2005 showed that high yield stocks also exhibit less volatility than low yield stocks[sup]iii[/sup] .

S&P 500 companies have spent trillions of dollars buying back stock since 2000 and yet in many cases investors have nothing to show for it; at least it is hard to measure the benefit of all of this activity. Sound security analysis must account for the dilution that occurs when management teams are generously rewarded with stock options. The repurchases that are required to offset this dilution are a transfer of wealth from the owners of the company (the shareholders) to the management team. When companies favor a dividend over share repurchases, they send a clear message that they are serious about rewarding shareholders. They are also signaling their confidence in the business and its ability to maintain dividend payouts. A meaningful, regular and growing stream of dividends is a superior use of free cash flow that directly benefits shareholders. And companies that initiate or significantly grow their dividends often see an immediate benefit to their share price and valuation. It is easy to overlook the importance of dividends when the dividend yield of the S&P 500 is under 2%, and the market is volatile, however, it is vital to remember the central role that dividends have played and will continue to play as a component of total return.