Anyone who's read my past articles or viewed my portfolio is aware of my fondness for dividend-paying stocks. Today, in addition to covering why dividends matter and why current stock yields are more appealing than some think, we'll peek in on the dividend-paying Six-Pack Portfolio and see how it's performed vs. the S&P 500.
It's no secret that dividends have been somewhat back in vogue since the market downturn began. But, despite the harm many suffered at the hands of the go-go market, dividends -- and the companies that pay them -- still don't seem to get the respect they deserve. Over the last few weeks, I've even read a tidbit or two that claimed today's yields are so low, they're not worth the bother.
Here's a good reason not to believe that view: it's malarkey. OK, maybe my calling the point malarkey doesn't quite constitute a good reason, but there's a little data to back me up here.
Fatty and skinny
Today's 1.8% yield on the S&P 500 may sound pretty scrawny, especially when you compare it to the S&P's historic 3.5% yield. But that yield can be downright juicy when you look at the alternatives. For instance, the Prime rate hasn't been this low since 1958 -- 45 years ago. And that 1.8% beats the heck out of the 1.25% you could get on a two-year Treasury note, and is nearly double the current yield on a money market fund.
Now, because of the added risk, stock yields should be higher than the yields of those investments, but the point is that the spread between the yields is wider than it has been historically. This means that, in relation to comparable investments, stock yields are actually higher than they have been in quite some time.
Further, with more conservative opportunities for income drying up, investors looking to maintain their current lifestyle in retirement will ultimately find equity yields too good to pass up. Especially when they realize that, with the typical money market account yielding about 1% and a conservative inflation estimate of about 2%, they're losing 1% of their purchasing power each year. That's hardly the road to happiness in your golden days.
When you couple that with recent tax legislation allowing you to keep a bit more of those stock dividends in your pocket, you've got a reasonable case for becoming a dividend fan.
The image problem
Don't believe the image of dividends being for boring, old, stodgy folks that are completely risk-averse. Dividend companies are not just for your granddad -- though there's every reason he should own them, too.
This image primarily comes from the view that dividends are paid only by companies experiencing slowing growth, or by mature companies in industries on the decline. As is so often the case, perception doesn't equal reality.
The truth is that dividends require a successful company to make more efficient use of its capital. For example, let's assume a company called DivPayer Corp (Ticker: CHEK) is doing very well, generating a great deal of free cash flow from operations.
DivPayer is currently evaluating three projects that are available for investment. Projects A, B, and C offer returns of 10%, 8%, and 4% respectively. The fact that DivPayer must pay out a cash dividend each quarter means that it only has enough free cash to invest in two of the three projects.
In this example, DivPayer would choose projects A and B because of their higher returns. A company that pays no dividend, however, may have enough funds left over to also invest in project C, despite it being an inferior investment.
This is a simple example, but you'd be surprised at how accurately it can depict a company's decision-making process. The projects available to a given firm will generally have diminishing returns, and companies that pay a dividend are less likely to choose inferior projects simply because they have the money lying around to invest in them.
Certainly, some firms have stricter methods for choosing investments. But the fact is, many companies will simply spend the money because they have it, investing in projects that lower overall returns.
Proof and pudding
Need proof? Numerous studies have demonstrated that dividend-paying stocks have outperformed their non-dividend paying brethren over the years. One such study by Kathleen Fuller and Michael Goldstein showed that, since 1970, dividend-paying stocks achieved a monthly return of 1.4% vs. 0.9% for their stingier counterparts.
More than that, as Tom Jacobs pointed out in a recent article, dividend income provided more than 40% of the total return of the S&P 500 over the past 75 years, and dividend payers made their contribution while providing little more than 10% of the volatility contributed by non-dividend payers.
There have also been 10-year periods where dividends have provided the only return for the S&P 500. Even in the latest bull market, the lowly dividend provided 10% to 20% of total returns. Who cares about paying a few extra bucks in taxes to achieve those kinds of benefits?
As Jeff Fischer very presciently pointed out in a 2001 article, dividends today are more important than ever. If, like Warren Buffett, you believe stock returns will hover between 6% and 8% over the next decade, dividends will represent an even larger portion of your total return. So why not give dividends some love?
OK, since we're talking about dividend returns of the past, we'll wrap this up by taking a peek at how the Six-Pack Portfolio has performed. Only a few months have passed since the first six-pack article was published, so this is a pretty short-term view of performance. But it's still worth having a look.
In the table below, the purchase date is the date that you could have purchased the shares. The last column demonstrates how each stock, and the portfolio as a whole, performed vs. the S&P 500. We at the Fool always track our performance against the S&P, because a 10% return is really good -- unless the market has returned 20%.
Also, though it might seem crazy for the performance of a dividend portfolio to not include dividends, only a single company in the port has paid a dividend since I constructed this educational portfolio, so I chose to exclude them. Going forward, annual updates will certainly include dividends.
Purchase Company Purchase Total Return vs.Date Symbol Price Return S&P3/13/03 BLS $21.24 +27.4% +7.4% 3/13/03 CAG 20.00 +25.7 +5.73/6/03 MO 37.28 +15.2 -6.03/20/03 NWL 28.94 -00.6 -14.63/6/03 RPM 9.20 +40.8 +19.63/20/03 SWK 25.60 +09.0 -5.01Average +19.6 +1.2
As you can see, the portfolio had a total return of 19.6%, just beating the S&P 500 for the same period. While respectable, I still believe this portfolio has the potential to offer more significant market-beating returns over time. In the future, I'll continue to let you know how the Six-Pack, and my other picks, are performing. Until then...
Mathew Emmert has to rely on his dividends because The Fool still pays him in Chuck E. Cheese gift certificates. He owns shares in Altria, BellSouth, and RPM. The Motley Fool is investors writing for investors .