Understanding Dividends

In this podcast, Motley Fool host Ricky Mulvey caught up with Motley Fool analysts Matt Argersinger and Anthony Schiavone to talk about all things dividends.

They discuss:

• Whether "special dividends" are really special at all.
• Two "Dividend Knights" -- and a Cincinnati grocer that may rejoin the same ranks.
• Why investing is not just about revenue growth.

Note that Anthony misspoke: Texas Roadhouse serves lunch on the weekends.

Want to get some info on three high-growth dividend stocks for 2024? Check out this link.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Jan. 27, 2024.

Matt Argersinger: As an investor, you don't have to go out there and find the company that's growing its revenue the fastest. If someone's going to look at Dillard's and say, wait the revenues like flat or down, why would I even think about investing in this company? You ignore the idea of what's happening underneath the surface at the bottom line capital allocation, what management's doing, and you can ignore a lot of great, wonderful investment stories by doing that.

Mary Long: I'm Mary Long, and that's Matt Argersinger, senior analyst at The Fool, and a lead advisor on our dividend investor service. Ricky Mulvey caught up with Matt and Anthony Schiavone to dive deep into dividends. They discuss the case for making dividend stocks the focus of your portfolio. What makes some dividends particularly special? How line dancing and free bread roles have made a market beater.

Ricky Mulvey: Anthony Schiavone and Matt Argersinger, always good to catch up with you and talk about dividends. I know this is a topic you're passionate about and one that honestly we don't talk about on the show enough. Thanks for being here.

Anthony Schiavone: You bet Ricky. Happy to be here.

Ricky Mulvey: We'll kick things off for newer investors because we're still in January, and this is when people are getting interested in investing, and there's a lot of big stories about these huge growthy companies. But set the table with maybe the long term case for the dividend paying stocks.

Matt Argersinger: Sure. I think when most investors, especially newer investors, when they think about dividend stocks or companies that pay dividends, their immediate thought is, OK, well great, this is a company I'm going to invest in. It's paying out a quarterly or regular dividend and it's all about income. That's what I'm going for. I see stock, it's got a 3% yield are great. But if I'm looking for income, that's all fine. Our arguments though are that it's the place you really want to focus, whether you're a new investor or old investor who's going to retire, or even an investor who's 25 years old just looking to build capital because it turns out there are a lot of studies that support this, but one that we go back to, Anthony Nine, and Anthony actually found this data a while ago. It's data from the Hartford Funds and Ned Davis research, and it goes back and it looks like the S&P 500. The biggest market index out there looks at all the components of the S&P 500 going back to 1971 or 1973. It broke it down and looked at all the companies in the index and companies that pay dividends, companies that didn't pay dividends, and how they performed over this long 50 year stretch, and what it turns out is that if you look at the average stock in the index, the average stock in the index went up about 8% over that time span. The companies that paid a dividend though, went up over 9% on analyzed basis. Even more exciting for us, companies that grew their dividends consistently though increased over 10%. The amazing thing is you got better returns from companies that are paying dividends or growing dividends with much less volatility than the rest of the market. It's a smoother ride. You get income along the way and you're out performing to us that it set so many light bulbs for us, and that's why we started a dividend service here at The Motley Fool recently. But it totally for me, reframed how I approach investing, and what I'm looking for when I think about the core of my portfolio. The core of my portfolio today is dividend growth companies. That was not the case just a few years ago.

Ricky Mulvey: But Matt, let's say I'm a young company, I can't afford to pay this dividend because I have too many growth opportunities to invest in. This is the sign that I'm really growing.

Matt Argersinger: I'll say one thing I'll pass it over to Ant because he's got some interesting data on that. But even younger companies, Ricky, should think about paying a dividend because as it turns out, small companies, growing companies, great companies, large companies. Companies don't actually do a great job, believe it or not, of reinvesting their capital. We think of companies well there's Apple. Look at the great examples, Microsoft, Alphabet, Starbucks these companies of course they should retain their capital because they've earned such high rates of return for so long. It turns out that's really hard to do and there's only a very small number of companies that actually do that. As Ant is going to talk about here, companies actually are better off paying a lot of their earnings out in dividends and there are some interesting reasons why.

Anthony Schiavone: I think that's probably one of the most overlooked part of dividend paying companies, is that when companies pay a dividend, the constructive tension that the dividend puts on the management team is pretty impressive. Say a company pays out say 50% of its earnings, debt management team really needs to make sure that the capital that is getting reinvested into the business is going toward the highest returning projects, and conversely, if the company is generating a lot of cash and they're not paying out a dividend, you're essentially as a shareholder, you're placing a lot of faith in the management team to reinvest that capital at a high rate, and not engage in like foolish behavior, like making a large value destroying acquisition. To that point, I actually came across a study from AQR Capital Management called Surprise. Higher dividends equals higher earnings growth. The study is a bit dated, it took place in 2003, but it contains 130 years worth of data. Ultimately what they found was just that when a company pays out a higher percentage of its earnings as dividends, future earnings growth tends to be higher. Conversely, when a company pays out a lower percentage of its dividends, future earnings growth tends to be lower. Some of the main reasons that the study cited was that major teams tend to pay out more when they have an optimistic outlook on the business. Since they're paying out a large portion of earnings, they're forced to be more prudent when allocating capital.

Ricky Mulvey: That's the long term. Right now things are a little bit different than they were just a few years ago. Interest rates are higher. You can get a treasury bill that's paying 4-5% a year. We've seen that hit companies like Charles Schwab. I can get debt funds. I never thought I'd be looking at bond funds, Matt and Anthony, but here I am. I bought a few of them because they're going to pay, and this is diversified across a bunch of companies. They'll pay, 6-8ish percent.

Matt Argersinger: No, I agree. The paradigm is certainly shifted and I think that's a really great point to bring up. We are looking in a world of higher interest rates and it's cool, man. You can get 5% on money market, 5% treasury, and these are risk-free for risk-free instruments. Why in the world would I look at a dividend-paying company which has all the risk to get a 3% or 4% yield or lower yield and my best argument would be when you're buying a company or investing in a company that pays a dividend and it's a good company, that company is going to be able to grow that dividend over time. That dividend you're getting is probably going to be protected by inflation and probably going to grow, it's going to vastly exceed inflation if you're finding the right companies and you just can't get that in a T bill or in a bond. It's a fixed payment, and even though those yields look really great today, I would still argue that with dividend paying companies, you're getting growth, you're getting that inflation protection, you're taking on a little more risk. But as we've seen throughout going back many years, that risk is well worth it.

Ricky Mulvey: Let's get into some of the filters that we use to find dividend-paying companies that are growing those payments back to shareholders. We've talked about it on the show before and I think you came up with it a few years ago. But I want to reintroduce it to listeners who may be less familiar to the concept of the dividend knights. Maybe they've heard of the dividend kings, the dividend aristocrats, but the dividend knights Matt a little bit less familiar so walk us through what's it take to be a dividend knight and maybe your thought process of putting it together.

Matt Argersinger: Sure. This was Anthony and me maybe trying to come up with a more foolish version, more Motley Fool version of the dividend aristocrats or dividend kings, achievers, all those more popular labels. We came up with this dividend knights idea. I think the reason we came up to it, the reason we like it, is because if you look at say, the dividend kings, which is a very impressive list of companies that have raised their dividend 50 or more consecutive years. It's remarkable, but oftentimes a lot of companies on that list will stay on the list by raising their dividend a fraction of a cent even in a given year, so they can actually claim. We raised our dividends, we still were still dividend king, even though the dividend went up a paltry amount. We said, what if we focused instead on the degree by which companies are growing their dividend, not just by 1% or one cent but let's say, what about companies that grew their dividend at better than 10% per year? Not only that, what about companies that beat the market as well? Not just stodgy dividend companies that are slowly raising their dividend over time, we want companies that are beating the market and raising their dividend at a double digit rate. Those are the core tenets of the dividend knights. For us, it's become an awesome source of new dividend paying ideas. Because if you think about a company that over the last 10 years, that's the time frame we use, over the last 10 years, has not only beaten the market, but raised its dividend at a compound annual rate of more than 10%. Well, that company is doing a lot of things. Who's us to study that company and figure out what's going on there and maybe recommend it? That's why we're so excited about this dividend knights concept.

Ricky Mulvey: Anthony, I'll kick it to you. Are there any companies, any members of the knights that maybe you want to put the spotlight on?

Anthony Schiavone: Yes, I recently did some boots on the ground research and went to Texas Roadhouse, ticker symbol TXRH. I went there for dinner one night, and it was pretty awesome. Great atmosphere. They had line dancing, which is unique at a casual.

Matt Argersinger: That's what drew you in the first place, he was the line dancing.

Ricky Mulvey: That was a passive-voice sentence there. Did you watch line dancing? Did you line dance yourself?

Anthony Schiavone: I watched it. But anyways, the food was awesome, especially the free rolls they give out as soon as you sit down. It was super affordable. I started to do some more research into Texas Roadhouse, which is a dividend knight, and the company is pretty impressive. They own 722 restaurants primarily in the US, but they also have some international locations too. They're dinner only. They do zero national advertising, zero limited time offers, and they currently have zero debt on their balance sheet. I thought this was pretty impressive. Since they're IPO in 2004, they've grown their revenue and earnings per share every single year except for 2020, when the restaurants were forced to shut down because of COVID. If I just looking at its dividend growth, it's grown its dividend by 16% over the last decade, and that even includes a dividend cut there in the pandemic. I think Texas Roadhouse is a pretty interesting one to keep on your watch list. I think it's a little expensive right now, but maybe investors will get a break in the future.

Matt Argersinger: I'll just add. The stock itself is up almost 400% over the last 10 years. It's crushed the market. I mean, I'm not sure a lot of people would think of Texas Roadhouse as this powerhouse little restaurant company, but it certainly has been.

Ricky Mulvey: That's actually something I don't think we talked about with the dividend knights list that I liked, is it does give companies the flexibility to cut their dividend for a little bit if they need to. What you mentioned, with the kings and a lot of the aristocrats list, maybe it's actually not in a company's best interest to pay a dividend for a couple of years. You think of Vail Mountain Resorts in 2020 when they have to shut everything down for the pandemic, but because the rules, you get kicked off the list, and that gives them a little bit of flexibility.

Matt Argersinger: Exactly, that's why. We're focused on just the growth of the dividend, not not necessarily the frequency or the consistency of it.

Ricky Mulvey: Also, I'll throw in a company that has recently got kicked off the list. Anthony, I know you follow it. It is the Grocer Kroger, it was there for a while when I checked last time. No more Kroger on the list. I think it's because it's not really beating the market anymore. Had a lot of pricing power over the pandemic, sales have dipped a little bit. There's a big question mark about whether or not it will merge with Albertsons. Anthony, what do you think it's going to take for that Cincinnati grocer to get back on the Dividend Knights list?

Anthony Schiavone: I think it's going to take some type of resolution to the Albertsons Kroger merger. I think there's a lot of uncertainty around it right now, but I think, either way, once that gets resolved, whether the FTC allows the deal to go through or whether they ultimately shut it down, I think just that certainty will allow the market to move forward with Kroger. You talk about Kroger, I mean, just a massive company, and really the competitive advantage comes down to their scale. They operate 2,700 stores, that's going to be around 5,000 stores. If the merger closes, their average store has about 80,000 SKUs. They have about 430,000 employees. This is a super complex business, and they only get razor thin margins. It's super difficult business, but ultimately the scale is really their competitive advantage helps them to leverage their distribution in advertising costs. I think once we get some resolution to this merger, I think it would be better for Kroger moving forward.

Matt Argersinger: I think the scrutiny has been so interesting because they're already saying they're going to divest a certain number of their stores. A significant number of their stores actually, to get this merger done. But even after the merger goes through, they're distant second to Walmart in terms of grocery sales. I'm trying to figure out why it's getting so much regulatory scrutiny, especially since they are divesting because in certain markets. It's not going to be a complete a merger as originally designed, yet the process here is taking forever, and I just don't see why that's the case.

Ricky Mulvey: I think there might be some pressure, you have a little bit more of a administration that is hungry to stop a lot of large mergers. There might also be some political pressure from the grocery prices that people are paying. It's a sensitive topic where it's not a secret that grocery prices have gone up. Even for a company like Kroger, sales have declined over the past year, but the margin has gone up, and I think that might capture some folks attention. I'm going to concern troll a bit on Kroger, because I'm a shareholder, so I'll start with that. But I worry it could be like a utility, where it passes that snap test, people would immediately recognize if Kroger was not there, it would be ruinous. But maybe it's not a market beater over the long term, and it's only paying me about 2.5% to wait.

Anthony Schiavone: I don't think Kroger will ever be a high-growth business, and it probably, well, never will be. I don't think. But I think labeling as a utility or some type of infrastructure companies is definitely reasonable. I would just say that it's current valuation around 10 times earnings, gives it the market-beating potential. Between dividends and buybacks, management aims to return around 5-6% of the company to shareholders each year. I mean, then if you look at you get 3-5% earnings growth each year. The total return starts to look around high single digits, low double digits. Then with the trading at 10 times earnings, maybe you get a little bit of multiple expansion. Then maybe you're looking at a market beater.

Ricky Mulvey: There you go. I want to move on.

Matt Argersinger: Hold those shares, Ricky.

Ricky Mulvey: I'm on. I want to move on to a topic I don't think we've done on a previous podcast. That is one level down on basically when you google a company, and you see their dividend pay out, and that is the special dividend. A few months ago, Costco announced that it was paying $115 special dividend to shareholders. Setting the table, why do companies pay out special dividends? What is the strategic capital allocation reason?

Matt Argersinger: It's an interesting question. It's funny that here in the US we call them special, because we're very unique to other developed market economies and stock markets. In the US, we have a culture and tradition where companies tend to pay regular dividends; quarterly, semiannual, sometimes annual dividends. Shareholders get used to that. A company will declare the dividend. We're paying a 15 cent dividend in a month. Then we're likely going to pay that same dividend three months from now, and so forth, and it goes on. We get used to that. But then now and then a company like Costco or another company will come out and say, "Well, not only are we continue to pay our regular dividend, we're going to throw in $15 special dividend." It's like, "Wow, that's incredible," amazing shareholders feel good about that. This is actually common practice in a lot of European or Asian stock markets. That's because a lot of those companies will tend to tie their dividend to their earnings. If a company has a good year for earnings, they have excess cash flow.

They declare a dividend that's appropriate to that level of cash flow. In the US, we can do it differently. It's more of a surprise. It is more special. But I think a company like Costco does it absolutely right. You have a regular dividend, investors get used to that. It gets mentioned that discipline that we talked about earlier about we have to pay this dividend every quarter, but in good times when we have excess cash flow, and we want to share more profits with our shareholders, we're going to pay a special dividend as well. Costco tends to do it pretty regularly, so their special dividend is almost becoming a regular dividend. I think it's important when it is a company like Costco, factor that into your yield. Factor that into your return expectations. You might look at Costco's regular dividend yield. It might look pretty paltry. I think it's less than 1%, but if you factor in those special dividends, it's got a much higher yield over time.

Ricky Mulvey: It's also a specific choice for management. We'll focus on the American companies to not buyback shares and pay out those special dividends especially when you have companies doing a mix of both. Maybe they're saying, you know what? In our view, these shares aren't undervalued.

Matt Argersinger: No, I agree. I would say we could do a whole show on buybacks. [laughs] If you ask Anthony and me, we're so much more in favor of dividends and special dividends, because management teams like they reinvest capital, they tend to buy back their shares at really bad times as well, and so a good mix of both. If you can find a company that does a good mix of both, maybe an emphasis on the dividend and buybacks are more of the infrequent capital allocation choice, that tends to be the right mix from our point of view.

Ricky Mulvey: I got a company that's buying back a lot of shares in about 30 seconds. So you guys focus on dividend-paying companies, are there special something you hunt for? Or is there something where maybe investors can find companies that are a little bit better about paying these special dividends especially when it's not as visible on that surface level search when you're looking at a company on google and it shows up is a paltry dividend, but you may not know that they're paying out 15, 20 bucks a share on a regular basis?

Matt Argersinger: That's a good question. It's not a big part of my process. In other words, I'm focused on the regular dividend because I like to see the history and the growth over time and the special dividends tend to distort that. You can't really get an easy gauge on, OK, well, if they paid a special dividend one year and they waited three or four years to the next one, is that really something I should factor into my return expectations for the stock? It's a little wonky. To me it's still a bonus. You can find a company like a rare company like Costco that does it both does it really well, that's a bonus to the research. But generally we're focused on regular dividends.

Ricky Mulvey: I want to talk about a dividend night that we don't talk about on the show that I've been dying to talk about. So Matt, I appreciate you signing up to talk about Dillard's with me. It's a big clothing store and it's a survivor in terms of anchor stores at the mall. E-commerce didn't kill it, and e-commerce is not a big part of its business. This is another one where I'm a shareholder of. I have a small position and here's the story. It's a family run company. A ton of inside ownership. Very little short term debt. Enough cash to pay off its entire debt load. Long term debt load. It's not a revenue growth story, but what they're trying to do, is basically pay a lot of special dividends to the employees which own a lot of stock in Dillard's through their 401(k) plan. Also the Dillard's family, which I would assume likes receiving those special dividends. You have some ownership, at least as of 2021, from Ted Wexler, who's on the Berkshire Hathaway team. I don't know. Give me your take, shoot some bullets in my arguments on Dillard's.

Matt Argersinger: I don't know, no bullets here. Maybe Anthony has some bullets. But I am just amazed by this story. But this is a story, believe it or not, that I think would be you said if you told someone, one of the best performing stocks over the last 5, 10 years is a department store in a mall, in mostly southern Midwestern states, I think most people would just know, no way. But that is true, but this is actually something that's a little more common in companies that we tend to follow. That's because, take a company like Altria just to use a bad example. But there's a company, Philip Morris Brand Cigarette brand. Revenue hasn't grown at all. In fact, revenues declining. Just like Dillard's, you said it's not a revenue store. I was looking at Dillard's. Their 10-year revenue change, this is cumulative for Dillard's 3%. In other words, the revenue is only 3% higher than it was 10 years ago. But then look at the normalized earnings per share, up 540% over the last 10 years. That's because of buybacks, by the way. Look at the stock price change, 340%. Look at the dividend change, 320%. So this is a company and a management team and a board that made a decision a while ago. It's not about revenue, it's not about opening new Dillard stores because there's not a great future for that. But it's about maximizing the efficiency and operations of our existing stores and allocating a ton of capital to our employees and our shareholders and just see if we can have this profitable business that generates great returns. Look at it, look what it's done. There are a lot of examples of this, actually and why Anthony and I will tend to preach this. But as an investor, you don't have to go out there and find the company that's growing its revenue the fastest. If someone's going to look at Dillard and say, wait, the revenue is like flat or down, why would I even think about investing in this company? You ignore the idea of what's happening underneath the surface at the bottom line, the capital allocation, what management is doing and you can ignore a lot of great, wonderful investment stories by doing that. I would say it's not always about finding the fastest growing companies, the companies can grow their sales the most, the companies that have the biggest market opportunity in something like AI or something. You can find some amazing invest investments digging in the surface, looking at companies that just simply are allocating capital well.

Ricky Mulvey: Well into your point, that's because it's not necessarily about revenue, it's about total shareholder return. While I know y'all aren't a huge fan of the share buybacks, Dillard's has executed it to a tremendous degree, they've more than half their shares, they're very interested in buying back their own shares. It gives you a 5.5% dividend yield over the past year if you include the special. If you look at Google Finance, it's less than a percent, but they're very much, this is relatively new within the past few years, paying 15, 20 bucks a share back to their shareholders, which aligns you with the management a little bit.

Matt Argersinger: Exactly. You mentioned the buybacks. So I'll just point out last 10 years shares outstanding for Dillard's down 63%. So they've bought back 63% of the business over the last 10 years. Amazing.

Ricky Mulvey: I will say one thing it has in common with Altria, both are trading at less than nine times earnings, single digits there. We have focused on individual companies. But building a portfolio of dividend paying stocks, you don't necessarily need to just pick companies. There's a lot of ETFs you can get. I like dividend ETFs for the defensive part of my portfolio. Maybe this is good for helping someone else invest in your family. Maybe they don't like picking stocks. I know this is something that's happened recently for you, Matt. Let's talk about some of the dividend ETFs. Are there any you want to talk about or any that you have used personally?

Matt Argersinger: One that I've followed for a while and invested in is the US Schwab Dividend Equity ETF, ticker is SCHD, and it's got a great track record. Up until about a couple of years ago, it was handily outperforming the market. Then recently, with the rise of the rebound of the Nasdaq and rest of the market, it's fallen a little bit behind. But it is a wonderfully managed ETF, really focused on high-quality dividend-paying companies that can grow their dividends over time. Recently we decided to roll over one of my wife's old 401(k)s to an IRA. It was a big lump sum, and rather than try to invest in individual stocks, which would take a while, this was the end of last year, I said one of the ETFs that I love, that's really lagged that I think is going to have a great future is the Schwab Dividend Equity ETF. So I said, you know what? We're going to do, we're going to take 50% of this new IRA and we're going to put it right into the Schwab ETF. We'll think of it as our core dividend index of this IRA that we're just going to invest whole, reinvest the dividends over time. Then with the rest we'll probably buy some individual stocks. But I wanted that to be one of the core investments of that new IRA. I'll say one more too, if you're interested in dividend growth specifically, and we talked a lot about that in the show, it's our preferred strategy, there is the Vanguard Dividend Appreciation ETF, V-I-G, VIG and it also has a pretty good track record and there with that ETF, you'll see a smaller yield because it's investing in companies that are tending to grow their dividend fast rates over time. That also has really done well as well. That's just another, again, another low cost big ETF, dividend ETF that's out there that you could invest in as well.

Ricky Mulvey: Matt Argersinger, Anthony Schiavone. They also work on a service at The Motley Fool. You can guess what it's about. It's called dividend investor. Appreciate your time and talking about investing with me on this Saturday.

Matt Argersinger: Thank you, Ricky. Always a pleasure.

Anthony Schiavone: Thanks, Ricky.

Mary Long: If you enjoyed this show or are interested in learning even more about dividends, we've got something for you. Some of The Motley Fool analysts behind Stock Advisor, our flagship investing service, have put together a list of three dividends stocks to buy this year. We're sending the report to Motley Fool Money listeners for free just as a thank you for checking out the show. No purchase necessary. Go to fool.com/2024dividends, and we'll email the report directly to your inbox. We'll also include a link in the show notes.

As always, people in the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy yourself stocks based solely on what you hear. I'm Mary Long. Thanks for listening. We'll see you tomorrow.