In case you haven’t noticed, the stock market has been a little choppy over the past few weeks. Business and consumer confidence are flagging a bit amid the growing concerns that a potential trade war could spark a recession that would eat into corporate profit growth, the mother’s milk of rising stock prices.
The recent market volatility has been especially acute in the names that have dominated returns over the past two years, primarily large, high-growth companies with rich valuations that depend upon economic momentum to justify their premium prices. Think Amazon, Tesla, Google and Nvidia to name a few, most of which are down by double-digit percentages this year. Meanwhile, another segment of the market that languished in comparison to these large cap growth companies has held up much better during the recent pullback, providing investors with a degree of shelter from the storm: dividend paying stocks.
A dividend is a partial payout of a company’s net income to its shareholders. It helps to recall that every nickel of profit generated by a company belongs to the owners of that company. Management has some discretion as to when and in what proportion those earnings are handed over to the shareholders or held in reserve by the firm for reinvestment in future growth. Dividend payers typically seek to maintain a stable, slightly increasing quarterly distribution policy by estimating their projected annual profits, retaining a portion for future capital needs and sending the rest to stockholders in cash. Many investors desiring a stable cash flow build a portfolio that includes consistent dividend paying stocks, while others may choose to reinvest the cash flows into more shares or into shares of other firms.
The term “dividend” comes from Latin for “something to be divided.” It was first applied to the earliest publicly traded stock, the Dutch East India Co. dating to 1602. The East India Co. operated cargo vessels chartered to import valuable spices. Shares of the profits from the voyages were distributed in the form of dividend payments to shareholders, typically around 12% of the initial investment. While the shares could be sold to another investor (potentially at a profit), the main attraction remained the income derived from the regular payouts.
For much of history since the first stock corporations, the investors’ primary return was from the collection of cash dividends. By the mid-20th century, maintenance of a stable dividend policy by American corporations was so typical that the infant field of security valuation grew up around the premise of a predictable and growing payout. Known as the Dividend Discount Model, it posited that most firms pay consistent dividends and that the fair value of a company today is essentially the present value of all future dividend payments, assumed to increase at a constant rate over time.
In the 1950s, a new theory of the case emerged that focused on companies poised for more rapid expansion. These companies required more capital to finance their growth plans and typically paid out little or nothing in dividends. A distinction was born between “growth” stocks and “value” stocks, with value often associated with payment of dividends. Think of the contrast between Facebook (META) with no dividend versus 150-year-old General Mills that sports a payout of 4%.
While hardly axiomatic, dividend paying stocks tend to be somewhat less volatile on average than growth stocks. Fast-growing firms need to retain and reinvest profits to fuel expansion, and investors in these companies are content to let it ride. Dividend payers tend to be more mature, slower growing concerns whose shareholders prefer incremental returns over time. Due to the relatively steady annual distributions from these “cash cows” and the absence of explosive growth expectations, they often tend to be less volatile and can help to mitigate the more pronounced swings in a portfolio from the investor’s allocation to growth stocks.
In selecting dividend payers, it is important to consider the fundamental financial health of the company and not simply to reach for the richest payout. Unlike most bonds, which have a stated maturity date, stocks are perpetual (at least in theory, in that they do not mature). Also, most bonds have a stated payout rate that does not deviate over their lives, while stock dividends can and do vary over time. In good times, companies attempt to incrementally increase their dividend payout as profits expand, but they can also reduce or eliminate a dividend during hard times, often triggering a sharp price decline in addition to the lost income. Very high payouts could indicate an unsustainable dividend policy that may spell trouble.
For most individual investors, the safest and most convenient approach to dividend investing is to buy a diversified exchange traded fund or mutual fund that does most of the work for you. Exchange traded funds very often carry lower fees and are generally more tax efficient, an important consideration for investors outside of retirement accounts. There are plenty to choose from.
Over the past 10 years, growth stocks have outperformed value or dividend-oriented stocks by nearly double, but at the cost of much greater variability and a steeper decline on the downside. During times of great uncertainty, and especially when growth is expensive, an allocation to dividend payers can help buffer some of the downside if the going gets rough.
Christopher A. Hopkins, CFA, is a co-founder of Apogee Wealth Partners in Chattanooga.