It’s a smart move to invest in dividend-paying stocks

Advisors


We know that equity exposure is important for long-term growth, but how should investors be positioned for an equity environment that in all likelihood will be more volatile than in the recent past?

One approach in uncertain times is to insist on payment up front — in other words, to invest in stocks that provide sustainable and growing dividends. Stocks that pay dividends have, over long periods, outperformed stocks that do not. Returns from stocks that grow dividends tend to be better still. And in our experience, these stocks have substantially less volatility than the broader market, helping to protect capital during market downturns.

Why are dividend-paying stocks less volatile?

To begin with the obvious, the dividend portion of their total return is paid to you in cash. Regardless of how a stock’s price fluctuates from there, you are starting out with the cushion of a positive return. Furthermore, a growing dividend usually reflects growing free cash flow from the underlying business. Companies that pay and grow dividends tend to be mature and well established, with the ability to withstand economic downturns and steadily grow their business across business cycles.

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If a company is growing dividends but not growing cash flows, it is liquidating. And we do mean cash and not earnings. Cash is what matters. Companies are run on cash. Earnings, on the other hand, are shaped by the vagaries of accounting. A host of issues, from the treatment of inventories to the rate at which capital assets are depreciated, can lead to positive earnings while cash flow is negative, or negative earnings while cash flow is positive.

Another reason dividend-paying stocks are often less volatile is that they have less “duration,” or interest-rate sensitivity, than stocks that pay no dividend. We know that as rates rise, the prices of longer-duration instruments fall faster than the prices of shorter-duration instruments (assuming all else being equal). While the concept of duration is thought to be primarily applicable to fixed-income assets, equities also have this characteristic. Just like bonds, the more cash paid sooner, the lower the duration. A stock that provides a healthy dividend is essentially a “shorter-duration” equity than a “growth stock” that has a very low or no dividend payout.

Another important concept is that, in our view, investors should think more broadly about the ways companies can return cash to their owners. Cash dividends, which we have discussed, are the most obvious means. And a long track record of regular, growing dividends speaks volumes about a company’s stability and the priorities and shareholder orientation of its management. But buying back shares and paying down debt are also legitimate ways to return cash, as both provide shareholders with a larger claim on future cash flows. Collectively, dividends, share buybacks and debt pay-downs are known as shareholder yield.



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