Posted on October 31, 2006 by David Laidlaw
As one approaches retirement, investment goals often shift from growth to income and capital preservation. There are two reasons for this change. The first is that investment income is needed to make up for lost salary. The second is that the absence of a salary provides investors with less margin for error since the ability to bounce back from poor returns is lower. Significant market losses are less likely to be as severe with portfolios that provide higher levels of interest income and dividends.
Most investors increase the amount of bonds in their accounts and decrease their stock holdings over time. This tactic enhances income and decreases volatility since bond prices are more stable than stock prices. However, many investors neglect high dividend paying stocks. There are many benefits associated with buying such stocks.
The historical data suggest that domestic stocks have returned about 6.5% per year over the last century in real returns (real returns are net of inflation). The main components of the total return of stocks are dividends, growth in retained earnings and the expansion in the amount the market will pay for those dividends and earnings. Breaking returns down into these component parts produces very interesting results.
Surprisingly, the largest contributor to stock returns over the past century has been dividend yields. Throughout much of this period stocks paid dividend rates of 4-5% annually compared to today when the average stocks yields about 1.5%. The second largest contributor to total return involved the appreciation in the amount an investor will pay for a given unit of dividends, earnings and sales. Stock valuations are much cheaper now than they were during the technology bubble that peaked in early 2000, but it is unlikely that a great deal of future returns will come from expanding valuations. Therefore, the majority of future returns will be dictated by dividend yields plus the growth that results from companies putting their capital to productive uses.
Dividend paying stocks also provide a degree of protection against inflation. Most bonds pay a fixed coupon rate until they mature. On the other hand, stocks increase their dividends over time. For example, a small industrial company, Landauer, Inc (symbol: LDR), that we hold in our portfolios for dividend purposes has increased its dividend steadily over the years. In 1997, Landauer paid out $1.20 per share in dividends. This year, the stock will distribute $1.80. This change represents a 50% increase in payout over the last nine years and corresponds to an annual rate of 4.6%. These increases have significantly outpaced inflation which increased at a rate of approximately 2.5% per year during the same period.
High dividend paying stocks are also tax efficient investments. The tax act passed in 2003 reduced the maximum federal rate at which dividends are taxed to 15%. This rate is less than half the 35% rate that top bracket tax payers pay on their other income.
Finally, all other things being equal, companies that pay out a higher percentage of their income as dividends are less likely to be involved in corporate wrongdoing. Paying a dividend enforces a degree of discipline on companies. A dividend is an obligation that the market will react negatively to if not paid. Almost all of the major business scandals over the past few years have involved managements that have diverted corporate cash to themselves from shareholders. Most of these companies such as Enron (<1% dividend yield), WorldCom (no dividend) and Tyco paid little or no dividends. Therefore, owning a higher percentage of dividend paying stocks decreases the likelihood that your portfolio will include the next poster child for corporate malfeasance.
Given the importance of dividends in providing total return and the other benefits described above, we believe that high dividend paying stocks should play an important role in income-oriented portfolios.