Reality, purity and dividends

• abnormalreturns
• January 11th, 2011

Dividends matter.  Dividends for many seem like a quaint relic of a bygone era.  However to ignore dividends is to ignore the long history of the stock market.  One need only check out the graph below from Visualizing Economics that highlights the difference in real returns to an investor than reinvests dividends and the real price return.

Source:  Visualizing Economics

A more modern response would be to note the change in dividend policy of firms.  This makes some sense since the popularity of share buybacks has changed the way many managements view dividends.  But even in the past ten years of so it is clear that the level and change in dividends has a relationship to stock prices.

Source:  Crossing Wall Street

Eddy Elfenbein at Crossing Wall Street writes:

I wouldn’t place the market’s dividend yield as one of my top valuation variables, but it’s still worth looking at the market’s relationship to its dividend payouts. First, there’s a purity to dividends. You never really know what a company’s cash flow or earnings are. But if a company is willing to part with money, then you know it’s real.

Eddy is somewhat sanguine about the relatively low dividend yield on the S&P 500 at the moment given the ability of many companies, like the big banks to comfortably increase their dividends and the belief that in a world of 0% short-term interest rates a near 2% dividend yield is not totally out of whack with reality.

What was clear is that the spike in the dividend yield around the time of the financial crisis provided investors with a signal that stocks were undervalued.  That period of 3%+ yields are now long gone and some investors are risking falling into “dividend traps” in certain sectors of the stock market. Brett Arends writing at WSJ is concerned about the state of the market’s dividend yield.  He writes:

Prof. Marsh at the London Business School cautions that you can’t rely on the dividend yield alone to try to time the market. Nonetheless, some things seem reasonably clear for any long-term investor: Dividends matter. They may be the one aspect of your return that you can rely on. And right now they are very thin on the ground.

As Arends writes “the future is always unknowable.”  However we do have one history of the stock market, and in that history dividends matter.  So for the market’s sake lets hope companies begin stepping up their game when it comes to paying dividends.

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