Do Companies That Pay Dividends Outperform?
By: Ned Piplovic,
Although companies that pay steady dividends tend to outperform overall market averages over extended periods, many investors still misconstrue dividend investing as something that only income-seeking investors should consider.
However, backtested data indicates that all investors should focus on investing in dividend-paying equities to maximize their portfolio’s growth for the long term. Furthermore, equities with long records of consecutive annual dividend hikes tend to deliver large long-term returns with minimal volatility.
The benefit of dividend-paying equities for investors that seek steady income payouts to cover their ongoing expenses is obvious. However, even investors who are only looking for capital gains can leverage dividend distributions to enhance their long-term asset appreciation.
Most investors have some knowledge of dividend distributions. However, investors must dedicate the necessary time to learn and understand the additional nuances of dividend investing in order to take full advantage of dividend income payouts. Understanding the different types of dividends and their tax treatments as well as the timing of dividend dates and other details can help investors maximize the magnitude of their dividend income, as well as minimize the volatility and tax implications that come along with dividend distributions.
This article does not aim to be the ultimate and complete resource on the topic of how dividends work. However, this article will provide a foundation for a few basic dividend investing concepts upon which income investors can start to build their knowledge base through the many additional resources that are available online and in print.
What Are Dividends?
Dividends are periodic payments that are distributed by equities that choose to transfer a portion of their earnings or assets to their stakeholders. While the terminology technically differs for different types of equities, the concept is the same. Technically, the dividends designation generally refers to earnings payouts by certain types of equities that use earnings as the source for dividend payouts — such as C Corporations.
Alternatively, different types of equities — such as partnerships, limited liability corporations (LLCs), S Corporations, estates, trusts, etc.– technically use distributions. The main distinction between the two terms is that dividends, which are paid from an equity’s earnings, generally do not figure into the original cost basis of buying the stock. On the other hand, as they are sourced from the transfer of equities, distributions generally figure into an investor’s cost basis for taxation purposes. Therefore, unless there is a specific need to make this distinction, the term dividend will represent both dividends and distributions going forward as most of the concepts and ideas generally apply to both payout types.
The most frequent and most common type of dividends is cash payouts. While easy to implement by the distributing equity and easy to account by the receiving investor, cash dividends have immediate tax implications in the year in which they are distributed. Another type of distributions are stock dividends where investors receive a value equal to the dividend amount in the form of the company’s stock. The main benefit of stock dividends is that the Internal Revenue Service (IRS) treats these dividends as stock splits. Therefore, the investors carry no tax liability for the tax year in which they receive the stock dividends. As with all stocks, taxes on stock dividends are due only on the capital gains after investors sell the shares.
Cash dividends are subject to taxation at ordinary income rates. Alternatively, proceeds of stock dividend appreciation incur taxation at capital gains rates, which are generally lower than ordinary income rates. However, cash payouts that meet specific IRS requirements are classified as qualified dividends and enjoy the same benefit of being taxed at capital gains rates as stock dividends.
Equities generally distribute their dividend payouts at regular schedules. Quarterly and monthly payouts are most common, especially for equities in North America that report their earnings on a quarterly basis. However, because they are required to report financial results less frequently, many equities from Europe and Japan distribute their dividends only once or twice per year. In addition to these regular payouts, companies sporadically distribute unplanned cash inflows, extraordinary earnings or assets as one-time special dividends. The funds for these special distributions vary and can come from sources such as business divestitures, liquidation of investments, lawsuit awards, etc.
Using Dividends to Outperform Market Averages
Some investors might wonder why a company would even distribute any of its earnings instead of reinvesting the funds into business expansion. These investors that subscribe to the Modigliani-Miller Theorem — developed by economists Franco Modigliani and Merton Miller in the 1950s — claim that dividend distributions have no effect on the level of long-term capital gains in perfect market conditions. According to this model companies can generally increase capital gains for their shareholders by funneling any excess funds into investment opportunities. Therefore, an equity should distribute dividends as the last resort and only if a company has no other viable investment opportunities.
However, perfect market conditions seldom occur. Furthermore, many analyses of historical data has generally indicated that dividend-paying equities usually outperform their non-dividend counterparts in terms of total returns over extended periods of time. Equities with steadily rising dividends over long periods tend to perform even better in expanding markets and offer better capital protection during market downturns and recessionary periods.
The results of a study that was conducted by Hartford Funds supports the idea that dividend distributions correlate to higher long-term total returns. While not necessarily the driver behind these outsized returns, steadily rising dividend distributions indicate growth stability and operational efficiency, as well as financial competency. All of these attributes are necessary to support long-term capital gains.
Based solely on share price appreciation, the S&P 500 Index grew more than 43-fold between 1960 and 2018. While still impressive, that feat pales in comparison to the total return of those same equities including reinvested dividends. Reinvesting all dividends immediately after distribution resulted in a 246-fold total return over the same time period. Therefore, for every dollar of pure asset appreciation, reinvested dividends generated $5.70 in total returns for the exact same equities. The graph from the Hartford Funds study below indicates the difference between the two investment strategies.
Additionally, Ned Davis Research has classified all S&P 500 equities into five groups based on their dividend status and compared their total returns since 1972 to the returns of the equal-weighted S&P 500 Index. Again, equities that paid no dividends tripled in value but achieved less than 12% of the overall S&P 500 Index’s gains. Furthermore, equities that cut or eliminated their dividend payouts entirely advanced only 70%, which is less than 2.5% of the 27-fold gain for the overall index.
However, dividend-paying equities delivered 52-fold gains, which was 90% better than the overall index. Finally, equities that initiated dividend distributions or maintained rising dividend payouts rewarded their stakeholders with a 75-fold return over the same period, or 174% more than the index and 2,360% better than equities that did not pay any dividends.
In addition to delivering more robust long-term gains, dividend-paying equities — especially equities with rising dividends — also offer better downside protection during market declines and recessions. In a research study called “Do Stocks with Dividends Outperform the Market during Recessions,” Albert Williams and Mitchell Miller provide a comparison of returns from Dividend Aristocrats and the overall S&P 500 Index during the 2001 market correction in the aftermath of the dot-com bubble and during the 2008 financial crisis.
While the overall index declined 0.78% from April 2001 to November 2001, the Dividend aristocrats gained nearly 29%. However, the S&P 500 Index is not heavily represented by equities from the Technology sector. Therefore, the decline of technology stocks had a larger impact on the overall markets than the S&P 500 Index.
The 2008 recession was longer and had a larger impact on the overall market. Therefore, even Dividend Aristocrats delivered an average annualized loss of 12.2% between January 2008 and June 2009. However, the 29% annualized decline of the overall S&P 500 Index over the same period was more than twice the Aristocrats’ losses.
Subsequently, the overall index gained 38% on an annualized basis during the recovery phase between July 2009 and December 2010. While that represents a lofty gain, Dividend Aristocrats advanced at an annualized rate of more than 52% of the same time frame.
Individual equities with no dividend payouts can, and often do, outperform dividend-paying equities in the long term. However, identifying these high-performing equities requires extended market-analysis expertise, significant resources and time commitment. Additionally, while they may above-average performers over short periods of time, these equities with high appreciation tend to be very volatile and require frequent trading to capture the gains and avoid the losses.
Also, both of the studies that were cited above looked at total returns over several decades. While day-traders and professional investors might focus on much shorter terms, average individual investors generally work with long-term targets. Therefore, most individual investors can benefit more by investing at least a portion of their portfolio in equities with rising dividend distributions. This is especially the case for risk-averse investors, as well as investors that have other sources of income and can invest with a long-term horizon outlook for their retirement. However, no investment strategy is successful on its own. Therefore, individual investors must complete their own analysis and build a portfolio that uses several strategies to maximize their gains and limit their risk over the portfolio’s targeted time frame.
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Ned Piplovic is the assistant editor of website content at Eagle Financial Publications. He graduated from Columbia University with a Bachelor’s degree in Economics and Philosophy. Prior to joining Eagle, Ned spent 15 years in corporate operations and financial management. Ned writes for www.DividendInvestor.com and www.StockInvestor.com.