This is a guest contribution from Nick McCullum of Sure Dividend
Dividends are an important part of shareholder total returns. The following chart compares the long-term price returns (excluding dividends) to the long-term total returns (including dividends) of the S&P 500 (approximated using the ETF SPY).
The 10-year rolling total returns of the S&P 500 over the past 10 years have been, on average, 82% higher than the price returns of the same period.
Said another way, over rolling 10-year periods, about 45% of the S&P 500’s total returns have come from dividend payments. Clearly, there is something to be said for the importance of dividends.
So how do we find the best dividend stocks?
One of the most important factors used in identifying high-quality dividend stocks suitable for investment is dividend history. Companies with long periods of steadily rising dividends make fantastic long-term investments.
One great example is the Dividend Aristocrats, companies with 25+ years of consecutive dividend increases. This group of 51 dividend stocks has historically outperformed the S&P 500 while simultaneously generating less portfolio volatility.
Dividend history matters. This article will provide an in-depth explanation of why dividend history matters when investing in dividend stocks.
For most investors, the main goal of investing in dividend stocks is to maximize returns without assuming undue risk. Stocks with long dividend histories are great securities for achieving this goal.
Generally, we measure ‘risk’ using stock price volatility. While volatility is an imperfect measure of risk, it does give investors some the ability to anticipate changes in their portfolio value.
So how do we identify dividend stocks with high performance but low volatility? Modern portfolio theory suggests that these investments are impossible to find, since excess performance can only be generated by assuming additional risk.
This is not the case in reality.
Consider, once again, the Dividend Aristocrats. In the introduction of this analysis, I made the bold claim that this group of elite dividend stocks outperformed the broader stock market while simultaneously generating less portfolio volatility.
The performance of the Dividend Aristocrats is compared to the S&P 500 below.
Clearly, the Dividend Aristocrats have generated returns well in excess of the returns of the S&P 500 over the past decade.
But what about volatility?
Data on the volatility and risk-adjusted returns of the Dividend Aristocrats can be seen in the following table.
The Dividend Aristocrats have had less volatility (as measured by the standard deviation) than their benchmark (the S&P 500) over 3-year, 5-year, and 10-year periods. This low volatility combined with the higher nominal returns has resulted in fantastic risk-adjusted returns, as measured by the Sharpe Ratio.
Clearly, dividend history matters.
This knowledge can be used outside of elite dividend stocks such as the Dividend Aristocrats.
More generally, dividend growers and initiators have outperformed all other subclasses of dividend stocks over long periods of time. Conversely, dividend cutters and eliminators have dramatically underperformed all other categories of dividend stocks.
This can be seen below.
Source: Why Dividends Matter
So what causes the out performance of dividend increasing stocks?
Well, aside from the obvious reason (higher dividend yields over time), there are qualitative factors that cause the out performance of companies with steadily rising dividends.
A company must have an enduring and defensible competitive advantage to be capable of increasing its annual dividend for many years in a row. Companies like Dividend Aristocrats and Dividend Kings (stocks with 50+ years of dividend increases) have successfully navigated through many recessions, economic downturns, inflation, deflation, currency swings, and even wars.
Clearly, they are special businesses. They can use their competitive advantages to help expand operations, outsell their competition, and improve their earnings-per-share. This is a large factor in the out performance of stocks with steadily increasing dividends.
The bottom line is this: long histories of steadily increasing dividend payments can help investors identify dividend stocks with higher returns and lower volatility, resulting in exceptional risk-adjusted returns.
Another reason why streaks of consecutive dividend increases are important is because of their safety.
The following diagram shows the probability of stopping dividend increases (either through a dividend freeze or a dividend cut) for companies with 25+ years of dividend increases versus companies with 10 to 24 years of dividend increases.
Source: Sure Dividend
Companies with 25+ years of consecutive dividend increases have a much lower probability of stopping their dividend increases.
Intuitively, this makes sense. The Lindy Effect suggests that the lifespan of an observed phenomenon is most likely to be seen at its half-life.
Said another way, if a company has increased its dividend for 25 consecutive years, it is likely to continue increasing its dividend for another 25 years (on average). The Lindy Effect gives an average lifespan, and holds true for baskets of stocks on average. The Lindy Effect will not hold true for each individual business.
In the real world, many unexpected factors come into play that are unpredictable. Some businesses with 25+ years of dividend increases may cut their dividend next year, while others may continue their dividend streak for another 100+ years.
For retirees and other investors that seek to generate inflation-beating dividend income from their investment portfolio, the Lindy Effect combined with investing in the Dividend Aristocrats or Dividend Kings is very reassuring. It implies that your investments will continue to generate a rising passive income stream for the years to come.
When investors think of metrics that are important to dividend investing, there are many that come to mind:
- Dividend Yield
- Dividend Payout Ratio
- Price-to-Earnings Ratio
Dividend history is sometimes ignored by dividend growth investors. It can be tempting to invest in younger dividend growth stocks with high dividend growth rates but not track record of long-term dividend growth.
However, this article showed that there is a great deal of benefit to investing in stocks with long dividend histories. These companies have defensible competitive advantages that create safety, performance and low volatility for their shareholders.