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The dark side of the dividend boom
More companies are boosting payouts, supporting stock prices and delighting investors. One hitch: dividends leave less to reinvest, and growth takes reinvestment.
By Jim Jubak
Dividends made a comeback in 2005. And it looks like the trend is here for the long term. After bottoming at 1.12% in March 2000, the yield on the stocks in the Standard & Poor's 500 ($INX) has climbed to a recent 1.83%.
That's still far shy of the historical average yield of 3.92% for the period that began in 1925. But, according to recent projections by Boston money manager Eaton Vance (EV, news, msgs), the trend toward higher dividends will run at least through 2010. The payout ratio -- the percentage of earnings a company pays out in dividends -- will rise during that period to 50% from today's 32%. To put that in context, the dividend payout ratio since 1936 has averaged 54%.
This swing of the pendulum from historic lows to something like the long-term average will do more than just put more dollars into the quarterly dividend checks that companies mail out. It will change market volatility, shift the relative desirability of stock sectors and change the growth rate in the economy as a whole.
Let's take a look at the difference this dividend comeback will make over the next five years.
Lower stock market volatility
It's not a coincidence that the bursting of the stock market bubble and the low dividend yield for this market cycle both came in March 2000. Historically, dividends have acted to put a floor under stock prices and provide investors with a decent return even when stock prices are headed south.
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So, for example, in the 10 years from the beginning of 1966 to end of 1975, a truly dismal period for stock investors, the S&P 500 averaged a total return of just 3.3% a year, according to Ibbotson Associates' long term data on the stock and bond markets. (By the way, the total return in real dollars was even worse in that period, since inflation averaged 5.7% a year.)
But think how bad the total return on stocks would have been for that period without dividends. The dividend yield for those years, again according to Ibbotson, averaged 3.47%. Take away dividend payments (and the return investors got from reinvesting those dividends), and capital appreciation -- the increase or decrease in the price of stocks -- averaged just 1.42% a year.
When stocks pay out 5.37% in dividends, as they did in 1974 after and because of the market plunge that year (large company stocks fell 29.72%, Ibbotson says), some investors will decide to hold on rather than sell. And that dampens the market's fall.
This incentive wasn't in view in 2000 when such stocks as Intel (INTC, news, msgs), Microsoft (MSFT, news, msgs) and Cisco Systems (CSCO, news, msgs) paid a grand total of zero, zip, nada in dividends. Capital appreciation was close to the only game in town. When stocks stopped going up, investors didn't see any reason to own them. Certainly, they weren't worth buying for their dividends.
In fact, I suspect that the lack of significant dividend yields on the stocks that make up the Nasdaq Composite ($COMPX) is one reason that it has taken so long to recover the ground it lost in the bursting of the bubble. Paltry dividends kept many value investors from buying these stocks -- and value investors play a critical role in the recovery of any heavily damaged stock price.
(The Nasdaq 100 Index ($NDX.X), which includes the big-cap Nasdaq stocks, has fared even worse than the Composite index. It lost 83% of its value from its peak in March 2000 to its bottom in October 2002. Today, the index is at about 35% of its 2000 peak. The Composite's value is 44% of its 2000 high.)
The return of patient investors
A decent dividend yield is the underappreciated foundation of long-term, buy-and-hold investing. You've all heard some version of this advice: No investor who has held onto stocks for 15 years has ever showed a loss for the period. And only two 10-year periods -- 1929 to 1938 and 1930 to 1939 (the years of the Great Depression) show a loss, according to Ibbotson data. Even then, the loss is relatively small: An annual 0.89% for 1929-1938 and an annual 0.05% for 1930-1939.
But that rule is only true because of the historical dividend yield of 3.92% -- and the way dividend yields rise when stock prices decline. Take away the average dividend, and, suddenly, long-term investors in the 15-year periods that began in 1927, 1928, 1929, and 1930 lost money. And the 15-year period that began in 1960 comes close to showing a loss.
Looking at 10-year returns, investors don't have to go back to the Great Depression to see that without the historical average dividend yield of 3.92%, it is possible to lose money with a 10-year holding period. It happened in 1965-1974, in 1966-1975 and in 1969-1978. That's not ancient history.
A shift toward large-company stocks
Want a decent dividend these days? Pretty much forget about finding one among the common stocks of any sector besides utilities. And the pickings aren't that great among utility stocks anymore, either. Because utility stocks have run up so much -- the Dow Jones Utilities Index ($UTIL) is up nearly 22% so far in 2005 after climbing 25.4% in 2004 and 24% in 2003 -- the dividend yield on the index had fallen to 3.15% as of Dec. 16. As large companies raise their dividends to something closer to the historical average, the gap with utility yields will close and large-company stocks will become more attractive.
History suggests that large-company stocks rather than small-company stocks will benefit most from this dividend effect. I say "suggests" because it is difficult to construct a small-company index that accurately represents the characteristics of what most investors think of as small-cap stocks. But the data from the Russell indexes is a decent indicator of the difference in yield between big- and small-company stocks. The large-cap Russell 1000 Value Index ($RLV.X) shows a yield of 2.5% right now; the small-cap Russell 2000 Value Index ($RUU.X) shows a yield of 1.7%. And large companies are more likely to have free cash flow that they can use to more quickly raise future dividends than small companies, which are often in the capital-consuming early stages of their growth.
This dividend differential is important. As Baby Boomers retire, they will be looking for yield and more willing to trade higher-but-uncertain capital appreciation for lower-but-more-certain dividend income.
A bad omen for growth
Why dividend yields fell so low in the 1990s and why they're on a rebound now are open questions.
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