Some investors shun dividend stocks because they believe dividends take away capital that could be put to better use investing in the company’s underlying business and/or through a stock buyback. They also believe dividends are risky because they are a discretionary payment that can be cut or suspended at any time.
But like many of my fellow Fools, I am a strong advocate of dividend investing, and believe that when executed correctly it offers investors the opportunity to achieve considerable investing success.
Let me explain why.
Reinvesting profits does not always produce a superior outcome
While there is certainly merit to the argument that by reinvesting earnings companies will generate a superior return, this is not always true. Investment decisions and their outcome can be affected by a wide range of factors, the most obvious being the quality of operational decisions, the operating environment and the economic cycle.
There is also the risk of “management capture” where senior management makes investment decisions based upon maximizing their own return, to the detriment of shareholders. An extreme example of this was Enron Corp., which was the seventh largest corporation in the U.S. before it virtually imploded overnight because of a stunning accounting scandal. This demonstrated to investors what can happen when a company’s management becomes obsessed with making profits at any cost.
Share buybacks do not always benefit shareholders
Not all buybacks are designed to reduce shares outstanding; some are used to amass shares for redistribution as stock options to management. Corporate cash spent in this way is simply transferred to the recipients of the options rather than shareholders.
Even where the goal is to reduce shares outstanding, the benefit to shareholders can be neutralized by the reduction of cash in the company’s coffers, causing its overall asset value to remain unchanged.
Dividends represent a significant portion of total market returns
Research by Standard & Poor’s shows that since 1956, dividends have made up 38% of the total returns generated by the S&P/TSX Composite Index. This is a huge chunk of returns that investors ignore at their own peril.
This is highlighted in the case of BCE Inc., which over the last 10 years has generated a total return, including capital appreciation and dividends of 184%, of which 78% is attributable to its dividend payments.
Dividends are tax-effective
In Canada, eligible dividends receive favourable tax treatment because they are paid out of profits on which the company has already paid tax. As a result investors, receive a tax credit equal to the amount of tax paid by the company to prevent double taxation.
Dividends reduce investment risk
“Blue chip” dividend stocks with wide economic moats that provide goods or service with relatively inelastic demand have a history of consistent, long-term earnings growth. This allows them to consistently hike their dividends providing investors with a steadily appreciating income stream.
Dividends also reduce dependence on capital appreciation as a means of generating returns, helping to shield investors from losses caused by broader market downturns or a decline in the macro environment.
An excellent example of this is electric utility Fortis Inc. (TSX: FTS). After commencing dividend payments in 1972, Fortis has hiked its dividend every year since, including during the global financial crisis when many companies were slashing or eliminating their dividend. This gives Fortis’ dividend an impressive compound annual growth rate of 7% since inception and a healthy 3% yield.
