Digging Into Dividends (OPINION)

This discussion is probably as old as the stock market itself: What role do dividends play in assessing an investment?

In an academic sense, dividend policy can be viewed as irrelevant since an investor has a claim on the undistributed cash, which should be reflected in the stock price. In the real world, investors often display a preference for dividends as a “real money” check on management’s accounting and an avenue to reinvest in opportunities outside management’s area of expertise.

Keep in mind that there are two components of total return when evaluating investments: dividends and capital appreciation. Perhaps because the media tend to focus mainly on price changes, the dividend component of total return is sometimes overlooked.

Certainly, there have been periods of high growth and steep losses when 2 percent in dividend yield felt like an afterthought. But there have also been periods where dividends composed the majority of returns. Indeed, according to Chicago-based financial advising and market-data research firm Ibbotson Associates, since 1925, dividends were responsible for nearly 40 percent of total return. As we move into 2016, there are good reasons to consider dividend-paying stocks for your portfolio.

First, there is a clear trend of companies raising dividends. This year over 300 companies within the S&P 500 increased their dividends. Looking back to 2008-2009, as the credit markets tightened in the financial crisis, many companies cut their dividends in an effort to conserve capital. With earnings now in recovery mode, cash-laden balance sheets, and access to low-interest debt, companies are becoming increasingly confident to raise dividend payouts.

Second, in taxable portfolios, dividends are taxed at a favorable rate. While it’s difficult to project where tax rates may be following the next election, currently qualified dividends will be taxed at a maximum rate of 15 percent for most investors. Before the 2003 tax cuts, dividends were taxed at ordinary income rates.

For income-oriented investors, dividend stocks can be a good alternative or complement to investing in bonds. Investing in companies that have a strong balance sheet, a lot of cash on hand and consistent, healthy cash flows could provide yields higher than a majority of the fixed income yields today. During times of unfavorable market conditions dividend paying stocks can also provide a cushion for the capital losses in an investor’s portfolio. Dividend paying stocks also offer greater growth potential in a strong market environment than fixed income securities, so investors tend to get the best of both worlds: capital appreciation and a dividend payout. Dividends payments are also taxed at a lower rate than interest payments from bonds.

Currently, fixed income securities offer historically low yields which, combined with the possibility of rising interest rates, may limit the upside of those investments (remember bond prices fall as rates rise). Dividend stocks offer an effective solution with attractive income yields today and the potential for appreciation as equities are historically a good inflation hedge.

When selecting dividend-paying stocks, there are a few key things to keep in mind:

• Research stable companies offering attractive yields.

• Research the dividend payment history and make sure there is a consistent track record and a steady history of raising the dividend over time.

• Research the company’s balance sheet, profits and earnings potential. Dividends that are well-covered by earnings and a balance sheet that is not over-leveraged provide confidence in a company’s ability to continue to pay the current dividend and leave room for dividend boosts as conditions warrant.

“Too-good-to-be-true” yields are often just that. Abnormally high yields can be a result of a cratering stock price or other financial distress and may precede dramatic dividend cuts.

Not every stock in a well-designed portfolio needs to pay a strong dividend. Younger, early business cycle companies often pay little or no dividends, preferring to reinvest all profits back into attractive opportunities. Well-diversified investors need exposure to those types of stocks as well. But we believe dividend stocks play an integral role in long-term investing and work every day to identify and monitor attractive candidates. 

James Bell is a vice president and financial advisor at Garrison Financial of Fayetteville, a locally owned, independent investment advisory firm. He can be reached at [email protected].