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Dividend stock investing: more dividends, less appreciation?

Posted by admin on March 2, 2009 in Dividends

Robert Siegel recently noted that from 1981-2007 dividend stock returns has bucked historical trends. From 1871-1981,  dividends stocks paid 64.7% of its earnings in dividends (i.e. 64.7 cents of every $1 of profit was paid as a dividend) while experiencing relatively modest earnings per share (EPS) growth of 1.56%. However, from 1981-2007, one sees the opposite result. Dividend payout ratios drop to 46.6% and EPS growth increased to 4.5%.

A higher EPS and a lower dividend payout ratio does not necessarily imply that a dividend investor was better off in the last 25 years. After all, a total return on dividend stocks is the sum of dividend yields plus appreciation; as Siegel points out, “a dollar of retained earnings will yield investors  a return that compensates the investor for lost dividend income.” Therefore, there is an inverse correlation between dividend payout ratios and earnings per growth. The higher the payout ratio, the lower EPS growth.

This is a pretty logical conclusion. A company can divide a dollar of profit under two large categories: (i) return to shareholder via dividend or share repurchase or (ii) reinvest in the business by buying new equipment, paying down debt, buying a competitor etc. An increase in one category, means a decrease in other.

The starting date of this pattern is not accidental. 1981 is around the same period of time when the reforms of Reaganomics and Thatcherism began, marking a shift towards liberalizing markets and capital. Economic thought dictates that if an economic system makes the movement and availability of capital easier, the markets tend to rise accordingly. In such economic environments, it may be economically rationale for businesses to shift their $1 of profit towards economic expansive activities then returning money to shareholders.

If one subscribes to the theory that eventually the markets will eventually correct back to historical norms, then could we be looking at a return of stock return depending more on dividend payments than pure stock appreciation?

If one assumes that the period of 1981-2007 marks an extreme of high EPS growth and lower dividend payouts even if the markets moderate towards an average of  1981-2007 era and  1871-1981 era EPS growth and dividend payout ratio, the conclusions are still the same:

1. Excluding dividend payouts/dividend yields in calculating ROI on any stock overlooks the fundamental fact dividends compromise an essential element of return; and
2. Lowering the dividend payments, as many companies are doing now, may, over the long term, prove to be a tonic for negative or minuscule EPS growth. Business is about survival and, as a shareholder who holds several stocks subject to dividend reductions, it is better to get less over longer periods of time than none at all.