It depends. You can’t tell for sure that a company that pays dividends is better or worse than another that does not pay dividends. But as a group, yes, historical data indicates that dividend-paying stocks outperform non-dividend-paying stocks.
How do stocks make money?
There are two ways how a stock makes money for you:
- increase in share price
The combination of these two factors drives the total return of a stock. In general, a shareholder should be indifferent to whether his gains come from price appreciation or dividends. But that’s in theory. In practice, dividend-paying stocks usually (not always) share characteristics that make them more attractive than non-dividend-paying stocks.
Three reasons to prefer dividend-paying stocks
The following are three of the main reasons why an investor might prefer to buy shares from companies that pay dividends.
1. Companies that pay dividends often are truly profitable
Companies can do accounting “engineering” to overstate or understate profits to manage their results throughout time. This creative accounting usually misrepresents the reality of the business. Many times, these techniques, although legal, make it hard to get a real sense of the performance of a business.
However, a company can’t fake cash. With cash, you either have or you don’t. Since dividends are paid in cash, whenever you are the recipient of a check you are getting tangible value. It can be fairly surmised that companies with a long history of regularly increasing dividend payouts are, in fact, making money.
2. Dividend stocks are less volatile during a bear market
In a bear market, the prices of fundamentally solid dividend stocks tend to decline less than the prices of non-dividend stocks. This is due to the yield support. Let’s see an example. Imagine two companies that are equally financially strong. Company A pays dividends, and company B doesn’t. The dividend yield of company A is 3.0%.
Then the market crashes and both stocks are down 50%. Company A keeps paying you dividends as planned, which means the dividend yield is now 6.0%. You don’t get a check from company B because it doesn’t pay dividends. If you had to sell shares, which one would you rather sell? You would probably choose to keep the shares of company A. And if investors want to invest in the market, chances are they would prefer to buy shares of company A rather than shares of company B, putting a floor under the stock.
Dividend-paying stocks have displayed lower volatility over time
Annualized volatility (1986 – 2020)
Source: RBC Capital Markets Quantitative Research. Annualized volatility is calculated on an equal weight basis, S&P/TSX Composite Total Return Index, December 1986 – December 2020.
Standard deviation/annualized volatility is a commonly used measure of risk and is applied to the annual rate of return of an investment to measure the investment’s volatility. The standard deviation shows how much the return on an investment is deviating from expected normal returns. A high standard deviation indicates a greater variability in investment performance.
3. Encourage management to optimize capital allocation
The pressure of recurrently paying a percentage of earnings to shareholders imposes discipline on management. This encourages them to be more mindful of the uses of cash, from being more selective on their investment projects and acquisitions, to be more efficient in managing the working capital and planning capital expenditure.
A reason to prefer non-dividend-paying stocks
Although as a group, dividend-paying stocks usually yield better results for investors, there are occasions in which non-dividend-paying stocks are a better investment. When? When the price appreciation of its stock grows rapidly and significantly. This is sometimes the case of high-growth companies (e.g., Amazon, Google, Shopify, etc.).
Remember, what matters is the total return of the investments you make. That return includes the price appreciation gains and the dividends. For companies that don’t pay a dividend, their total return is equal to the price appreciation.
For well-managed dominant companies that play in attractive markets, the growth opportunities can be significant. Establishing themselves as the market leader requires a massive amount of capital. On many occasions, it makes sense that such a company retains all the cash flow it generates to reinvested in the company. The trick is, how can you be sure you found such a company that is a good investment opportunity? Well, do your homework. Subscribers to Fivent have access to our investment watchlist in which we analyze stocks that could be attractive investment opportunities even if they don’t pay dividends.
What does the data tell us?
In bull markets, when stock prices grow rapidly, the dividend component weight on the total return earned diminishes. For example, over the last five years, dividends have contributed just over 10% of the total return of the S&P 500. However, over the long term, dividends have contributed to returns significantly more. Over rolling 20-year periods, dividends have contributed more than half of the total return of the stock market.
As shown in the chart below, as a group, dividend-paying stocks (light blue) have outperformed the stock market (green). Better than owning dividend-paying stocks has been to own stocks that increased their dividends (dark blue).
Dividend-paying stocks have outperformed over time
Compound annual total returns (1986 – 2020)
Source: RBC Capital Markets Quantitative Research, data is calculated on an equal weight basis, S&P/TSX Composite Total Return Index, December 1986 – December 2020. Growers, Cutters, Payers, and Non-Payers determined yearly.
Ten dividend-paying stocks to include in your portfolio
Are you planning to invest in dividend-paying stocks? If you are, consider the following ten stocks.
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In a nutshell
There are good reasons to invest in stocks, regardless of whether they pay dividends or not. However, historically, dividend-paying stocks have outperformed non-dividend-paying stocks. Also, they have had lower volatility. I believe that investing in dividend-paying stocks is an attractive proposition when is done under the right framework. Choose stocks with:
- Conservative but meaningful payout ratios and yields
- Strong track records
- Prospect of rising payouts
Under the current market conditions in which stocks are richly valued, interest rates are low, and corporate balance sheets are strong, dividend-paying stocks will probably continue attracting investors.
This newsletter was written for educational purposes and does not provide investment recommendations specific to individual investors. As such, the financial instruments showed may not be suitable for all investors and investors must make their own investment decisions based upon their specific investment objectives and financial situation utilizing their own financial advisors as they deem necessary. Past performance of the financial instruments listed in this newsletter should not be taken as an indication or guarantee of future results. The price, value of, and income from, any of the financial instruments showed in this newsletter can rise as well as fall and may be affected by changes in economic, financial, and political factors. If a financial instrument is denominated in a currency other than the investor’s home currency, a change in exchange rates may adversely affect the price of, value of, or income derived from the financial instrument described in this report.
 “The Key to Long-Term Success: The Income Component of Returns” Brandes Institute, October 2012