Cash is King: The Long Term Value in Dividend Stocks

From the 17th century to the early 19th century, dividends were the main reason that most people got involved in the stock market. Although speculation was quite common among early stock market participants, it was traditionally regarded as a form of gambling, not unlike betting on horse races or gambling one's paycheck on a game of blackjack. Legendary investor Benjamin Graham, writing in the early 20th century, famously counselled investors against speculating on stock prices, advising them to instead view stockholdings as claims on an income generating business. One of Graham's seven criteria for a desirable common stock was "continued dividends for at least the past 20 years."

Nowadays, this view might appear outdated. When Ben Graham was writing The Intelligent Investor, the average dividend yield on the Dow Jones Industrial Average was around 4%, almost twice what the yield on the DJIA is today. In the days when 4% dividend yields were standard, a stockholder would only need to get 3% a year in capital gains to get a satisfying annual return of 7%. Today, price increases are seen as contributing much more value than dividends do. In a market where dividend yields on S&P 500 stocks rarely exceed 2%, it can be tempting to view dividend investment as anachronistic. This has been the dominant view in financial press, where you're more likely to hear about how the state of the union address could affect the market, than how dividends can contribute to the returns on your portfolio.

However, at least in some circles, dividends seem to be making a comeback. Many popular investing websites, such as motleyfool.com and CBS MoneyWatch, have started publishing articles extolling the virtues of dividend stocks as bulwark against the vagaries of the unstable modern investing climate. Motley Fool has an entire section devoted to dividend and income investing, and many mutual fund companies have funds dedicated to dividend and income investing. The reasons for the renewed interest in dividends are fairly obvious. People want a portfolio with a stable income stream as well as the potential for capital gains, and dividend stocks provide a greater chance for this than any other investment instrument. The real question is, with average yields being so low, how can the investor pick dividend stocks that have a shot at beating the market over the long term?

The first thing to keep in mind is that even today, there are stocks out there that throw off impressive dividends. Although the average yield on the s&p 500 is quite low, there are many “diamonds in the rough” available for investors who are willing to shop around. At the time of this writing, Verizon Communications (NYSE: VZ), a component of the Dow Jones Industrial Average, pays a dividend of 42 cents a share, for a yield of 5.32%. Pfizer (NYSE: PFE), another DJIA component, pays a dividend of 20 cents per share, for a yield of 4.17%. Other DJIA companies with yields over 3% include Johnson and Johnson (NYSE: JNJ), AT&T (NYSE: T), and Merck (NYSE: MRK). As of Feb 21, 2011, the average dividend yield on the Dow Jones Industrial Average was 2.69.

The big picture here is that while dividend yields have declined over time, they have hardly disappeared. However, this is not the end of the story.

There is a source of value hidden in dividends that most investors consistently miss: the capacity for companies to raise dividends over time. It is quite common for managements to increase their company’s dividends after a period of growth or the sale of assets. These increases are not always permanent, but companies with a long term (i.e. 20 year plus) record of raising their dividend year in and year out rarely break the trend. Why is this important? There are two reasons. One, companies with a long term track record of dividend increases can prove that their dividend increases are commensurate with earnings growth, which is important, because one-off dividends resulting from asset sales can actually be a sign of a business in decline. Two, shares whose yield increases over time contain the potential for hidden earnings, as dividend increases imply yield increases for shares purchased prior to the raise in the dividend payout. If, over a 10 year period, a stock’s price and dividend payout both double, the listed yield on that stock stays the same, but the yield on stocks purchased at the beginning of the period has actually increased, because the dividend has doubled relative to the share price at the start.

Of course, a large dividend yield is no reason to run out and put your entire net value in a company with weak fundamentals. However, for value investors with an eye on steady, long term, incremental progress, dividend stocks with a long term track record of consistent dividend increases can be a valuable asset for a diversified portfolio.