Pretty much all finance students are confronted early in their educational career with the question of whether or not dividend policy matters to the value of a stock. Specifically, a paper written by Professors Merton Miller and Franco Modigliani argues that it does not matter. Without boring anybody with the gory details, it’s worth exploring what that means for investors.
Many in the investing world view dividend stocks as the province of “widows and orphans”. At least some of the time, it is an accusation. Fair enough. It’s hard to argue that these equities don’t serve as a source of stability in bad markets. After conducting a study of his own, Wharton professor Jeremy Siegel finds dividend stocks to be effective “bear market protectors”.
What’s particularly powerful is that not only do dividends provide a measure of protection in the form of a consistent payout, they act as a “return accelerator” when they are reinvested in down markets. That is because the stocks are priced lower than they would be in a bull market, so the reinvested dividend is buying shares at a relatively low price. Those additional shares in turn accelerate the investor’s performance when strong markets return.
By way of example, Siegel cites the fact that it was not until 1954 that the S&P 500 returned to the level of values it held prior to the Stock Market Crash of 1929. However, those who reinvested their dividends through that period were 60% better off in 1954 than they would have been had the crash never happened. That’s a powerful accelerant.
Great, you say, but what about bull markets? Well, one school of thought would be that preserving capital during bad markets in exchange for slower growth during good ones is a reasonable tradeoff. I would agree with that. Take, for instance, the investor who lost 60% in 2008, but gained 103% in 2009. (That is the precise performance of a small-cap fund I reviewed for a 401k plan this morning). If an investor had $10,000 on January 1, 2008, he would have had $4,000 on December 31, 2008. After the spectacular run up in this particular fund in 2009, the investor would have ended the year at…$8,120.
In reality, though, over long periods of time, in good markets and in bad, dividend stocks outperform the overall market. In Jeremy Siegel’s study, he was surprised to learn that the highest yielding stocks, or those paying the highest dividends, generated between 2.5% and 4.5% higher returns than did the overall market. If that difference seems paltry, I invite you to review an earlier post outlining the dramatic difference that small increases in return can produce.
In a 2003 article in the Financial Analysts Journal title Dividends and the Three Dwarfs, Robert D. Arnott demonstrates the importance of dividends to the long-term benefit of owning stock. Arnott points to numbers that detail stock returns from the 1802-2002. How’s that for a long-term test? The average annual return for stocks over the 200-year period was 7.9%, of which dividends accounted for 5%. That’s 64% of the return! Other studies cover other periods of time but still reach the same conclusion: high-yielding stocks perform better than the overall market.
Do dividends matter? In a word, yes.