On the surface, a dividend is merely a source of income that investors receive as an incentive for holding a stock. But dividends have a lot more meaning than you may realize.
There's a reason why many dividend-paying value stocks are outperforming growth stocks this year. This isn't to say you should flip-flop out of growth stocks and into dividend stocks. But it's worth understanding the benefits that dividend stocks can provide -- particularly in a bear market. Here are three traits of dividend stocks that may surprise you and help you understand the advantages of adding quality dividend stocks to a diversified portfolio and holding them over the long term.
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By default, dividend-paying companies tend to be quality businesses
The most reliable dividend-paying companies are those that have track records of consistently raising their dividends every year. A Dividend Aristocrat is an S&P 500 component that has paid and raised its dividend for at least 25 consecutive years, while a Dividend King has done so for at least 50 consecutive years. To achieve a multi-decade dividend raising streak, a company must also be consistently growing its earnings and free cash flow (FCF) so it can support a higher payout. The very nature of paying a dividend means that a business earns more money than it needs, so it can return some of those extra profits to shareholders through the dividend.
Of course, an investor should double check that dividends are being supported by earnings and FCF instead of by debt. By looking at dividends per share (DPS) relative to earnings per share (EPS) and FCF per share, you can verify that a company can afford to pay out its dividend.
As an example, let's look at Procter & Gamble (PG 0.54%) which is a Dividend King that has paid and raised its payout for 66 consecutive years.
PG EPS Diluted (Annual) data by YCharts
P&G has steadily grown EPS and FCF to support its dividend, which has increased more than 10-fold over the last 30 years. What's more, P&G's FCF per share and EPS easily cover its DPS -- which signals that even if earnings and FCF should come down, the company would still be able to support its dividend without using debt.
In sum, a company's ability to consistently grow its dividend no matter the state of the broader economy is one of the easiest ways to identify a quality business. At its core, investing is all about finding good companies that you want to be a part owner of. A safe stock like P&G is particularly attractive for risk-averse investors because the company has a wide margin of error between its earnings and the cost of its dividend.
Stodgy companies are ideally suited for a bear market
Quality dividend stocks tend to be low- to moderate-growth companies with wide moats, which are the exact kind of businesses that do well in a bear market. The investment thesis for a stodgy dividend stock is less grounded in growth and more focused on capital discipline. A shareholder of P&G is probably more concerned with value and income than with growth. In this sense, P&G meets the expectations of its investors by returning value through share repurchases and dividend raises more so than through outsized growth.
The investment thesis for P&G is the complete opposite of that of a high-growth company with a premium valuation. These companies tend to not pay dividends or buy back their own stock because they prioritize reinvestment in the business. The expectation for a high-growth company is dependent on, well, growth.
In this bear market, we've seen the destruction of many growth stock valuations. Many once high-flying names are down over 80% off their highs. This drastic collapse in growth stocks relative to value stocks is partially because there's a completely different yardstick for measuring investor expectations between a high-quality dividend stock and a growth stock. Put another way, it can be far more challenging to sustain a high growth rate during a period of rising interest rates and a slowing economy than it is to sustain a growing dividend.
Passive income has multiple benefits
Dividend-paying companies give investors a realized return, usually quarterly, thereby generating income without the need to sell stock. There are a few reasons why that's particularly important right now. For starters, the risk-free three-month Treasury Bill rate is 4%, meaning there's an opportunity cost for keeping money in the stock market. A dividend yield, even if it's less than 4%, is still a meaningful incentive that can help alleviate the feeling of missing out on that attractive risk-free rate.
Additionally, collecting dividends during a bear market not only provides a source of passive income, but it can also be a relief when the value of your investment portfolio is down. For long-term investing to work, folks have to give their positions the chance to compound over time, which means not selling quality companies during a bear market. Dividends take the edge off a bear market and make it easier to hold positions over time. In this vein, dividends can do wonders to combat the fear and doubt that is commonplace during a period of high stock market volatility.
The power of dividend investing
When valuing dividend stocks, it's easy to fall victim to looking at the dividend yield alone. But the dividend yield is far less important than the track record of dividend raises paired with supporting those raises with growing earnings and FCF.
By understanding what it takes for a company to support dividend raises throughout market cycles, an investor quickly realizes the degree of difficulty associated with becoming a Dividend King or a Dividend Aristocrat. Dividend stocks can be your best friends during a bear market for so much more than just the passive income stream. Investing in quality dividend stocks can give you the confidence you need to hold stocks through periods of volatility, which is essential for unlocking the compounded gains that can come with long-term investing.
