Dividends are underappreciated and misunderstood by most investors. With average dividend yields at about 2.5 percent, too many see them as an insignificant part of potential total returns (total return = price change, plus income). They do not appreciate the impact dividends can have on improving performance while helping to control volatility. Most importantly, few understand that a company’s dividend policy conveys vital information from management about their discipline in allocating shareholder capital, as well as their confidence in the business and its future earnings power.
Conventional wisdom is that companies paying lower dividends, retaining a greater portion of profits for reinvestment, will experience faster earnings growth than companies that pay out more of their earnings in dividends. However, research has dispelled this notion. For example, in “Surprise! Higher Dividends = Higher Earnings Growth!” (Financial Analysts Journal, January/February 2003), Robert Arnott & Clifford Asness wrote: “The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low.” We hypothesize this relationship exists because the cash payment of a meaningful dividend to shareholders imposes an important discipline on management and their capital allocation strategies, resulting in higher returns on invested capital. Conversely, low payout ratios engender an environment of inefficient empire building.
A company’s policy toward dividend increases is also worth noting because it provides tangible evidence of management’s confidence in future earnings growth. Press releases, SEC filings and those glossy annual reports give investors a lot of valuable information, but dividends are where the rubber meets the road. As an unrecoverable cash payment to shareholders, it’s highly unlikely that any dividend rate would be increased if there was uncertainty as to the company’s ability to grow earnings. Also, consistent dividend increases confirm the success of a company’s capital allocation disciplines and reward shareholders with a rising stream of income.
A consistent dividend policy sends a message, as does a change in policy. Any change in policy, positive or negative, warrants further study with a very critical eye toward negative policy actions. (If you want to believe everything is OK after a dividend cut, perform your analysis again after considering what must have been said during the board meeting to cause the directors to reverse a long-standing policy.)
Dividends should not be discounted. Over the past 100 years, dividends have contributed approximately 45 percent to equities’ total return, including reinvestment. And, while this contribution to total return should be an important consideration for all investors, the information conveyed through a company’s dividend policy can be priceless.
