According to Ibbotson Associates, dividends have accounted for 40% of the S&P 500's total return from January 1926 through mid-2001. Forty percent. And that isn't factoring in reinvested dividends, which would put your total return several hundred percentage points ahead of the straight S&P 500's return.
From 1996 to mid-2001, though, dividends accounted for "just" 11% of the S&P 500's total return. People pointed to that and argued that the importance of dividends was waning.
They were wrong. The S&P 500 just happened to soar those years, making dividends appear less meaningful beside abnormally high capital appreciation. Now that stocks have declined, the dividend as an investing tool is rising like bas-relief to resume its place of importance. But dividends have always been important to us.
Dividends far from what they used to be
Still, as the dust clears from the fallen market, the dividend is not rising to nearly the height that it used to command. Even after the market's decline, dividend yields are near all-time lows. From 1980 to 2000, the dividend yield on the S&P 500 fell from 5.4% to 1.1%.
Meanwhile -- according to Wells Capital Management -- the annual growth of the average dividend payout declined from 12.5% growth in 1990 to negative 4.6% growth in the last quarter of 2001. This is partly due to the slashing of dividends at foundering companies like AT&T (NYSE: T) and Xerox (NYSE: XRX). But it's also because many companies like Corning (NYSE: GLW) and Nortel (NYSE: NT) ended years of dividend payments under the argument that they'd rather invest the money back in the business, where they can supposedly earn investors a better return. (AT&T used that argument, too.)
Problem is, that isn't always the case. If it were easy to invest money back into a business for superior returns, everyone would be doing it ad infinitum. In reality, in many cases money reinvested is money sacrificed to business lines that don't return anything near strong returns. Intel (Nasdaq: INTC) is suffering this, so far, with its networking line. So far, as an investor, I'd rather have received a larger dividend than see Intel throw money into this currently lackluster business.
Dividends are as important as ever to diversified investors
Many companies with strong management did not fall prey to the growth-crazed 1990s by slashing their dividends. Many great companies instead continued to increase their dividend, year after year, at double-digit rates. Johnson & Johnson (NYSE: JNJ), a stock that has continually made new all-time highs throughout this market debauchery, raised its dividend 12.5% annually since 1996. Pfizer (NYSE: PFE) and PepsiCo (NYSE: PEP) acted similarly with their dividend payments.
These companies may understand something about long-term value creation that other companies forgot. Over the past three decades, an investment in the average dividend-paying company has achieved double the total return of non-dividend paying companies, according to a study by Babson and University of Georgia professors.
And when the professors compared dividend-paying companies against the riskiest non-dividend paying companies on the market (such as young Nasdaq companies), the average dividend-paying company returned 113% more than the riskiest stocks over 20 years. The average dividend-paying company even returned 20% more than the "safest" non-dividend paying companies. (Safety was measured by beta, or volatility.)
Two years ago it was fashionable to scoff at dividend-paying companies as old dinosaurs. But reality is these companies generate a cash return with their business, unlike most young companies today. And when that return is shared through a regular dividend, an investor's total return grows handily over the years. Especially when the dividend is reinvested.
The tax issue
I know. People always whine that dividends are taxed twice, once as net income for the company, and once when shareholders receive the dividend, when the money is taxed as income again. So, people argue that companies should instead reinvest the money back in the business. But you know what? Great companies have more money than they need to reinvest. And great companies recognize that you can only reinvest so much each year and still hope for superior returns on the money.
So, paying the dividend makes sense for many great businesses. It's better than putting too much money into iffy business lines and lowering overall returns. And in the long run, it's probably better for shareholders than just sitting on endless cash that isn't serving a good purpose, Microsoft (Nasdaq: MSFT).
Seeking strong dividend-paying companies
We own great dividend-paying and dividend-growing companies, including J&J and Pepsi, but we could benefit by investing in a strong company that pays a considerably higher dividend yield. Do you have suggestions? (I'll provide two.) The only guidelines for you: The companies must have a fee-friendly Drip, and we will not consider utility or oil companies for this port (you should share them with each other, though, if you like). We've already covered that ground in past years and we aren't interested in buying industries that have so much potential for change and uncertainty.
We also aren't interested in buying risky double-digit dividend yielding companies that aren't growing their share prices, too. We want a world-class company that is growing its share price (in other words, growing earnings consistently) and that has a dividend yield above the S&P's average 2% -- perhaps the company yields 4% to 5%.
One such company: Philip Morris (NYSE: MO). It yields 4.86%. Obviously it has risks related to tobacco lawsuits, but not nearly the risks it faced three years ago. Another potential contender, yielding nearly 3%, is retailer The Limited (NYSE: LTD), which also offers a friendly Drip. This stock is so depressed that handsome capital appreciation is likely to be in the offing, too.
Can you name other companies with strong dividend yields, friendly Drips, and leading business potential? Please share your companies on the Drip Companies board. We'll follow up here next week.
Jeff Fischer owns the shares held by Drip Port. Of companies mentioned, he also owns shares of Pfizer, as shown on his online profile. He isn't taking any prescriptions, though, and hopes it remains that way a long time (knock wood). The Fool has a full disclosure policy.