02 November 2017
For much of the 20th century, however, ownership of shares like AT&T was extremely widespread – primarily because, come rain or shine, they paid an annual dividend. As such shares were especially popular among those who couldn’t afford to take excessive risk and who counted on that bit of extra money in the bank, they were often derisively referred to as “widow-and-orphan” stocks.
Today, many investors think of dividend stocks as a relic of the past, like horse-pulled buggies or rotary telephones. That’s a pity – because dividend stocks can represent a surprisingly robust investment opportunity. This is particularly the case in the current low-yield environment across most asset classes; equites, and especially European shares, stand out thanks to dividend yield levels above the historical average.
Dividends still matter because, first and most obviously, investors should focus on total return, whether that’s achieved through dividends or price appreciation.
Dividends provide a regular income stream that is, typically, cash in nature and paid at least once a year, independent of share-price fluctuations. This is important because, if held over a lifetime, dividend flow can constitute, on its own, the return on investment. At the same time, certain investors, such as pension funds, require such a regular income stream to honor their own cash outflow commitments.
On a more fundamental level, it’s worth noting that a strong commitment to dividend distribution enforces capital discipline, leading to a more selective approach to capital expenditure. However, dividend payments shouldn’t inhibit value creation. So investors should look for firms that take a Goldilocks approach: committed to paying a reasonable dividend but not at the expense of future growth.
Similarly, cash dividends provide a check on financial statements, including earnings and cash-flow generation. By comparison, dividends paid in shares, known as “scrip,” should be viewed more cautiously; a scrip dividend is often just a capital increase by other means, rather than a true dividend payment.
History shows that dividend yields constitute the majority of stock-market returns in the main European markets, with dividend growth being the other main factor. Indeed, an average dividend yield on European equities of 3.5% represents more than half of the long-term equity return in markets such as Germany and France.
In terms of performance, contrary to received wisdom, dividend stocks perform on average and over the long term roughly in line with most benchmarks. Selecting individual dividend stocks, however, demands significant selectivity: figuring out which companies will be able to pay (and preferably grow) dividends over time can be extremely challenging.
Investors must look for resilient companies with a proven ability to generate and grow free cash flow – and which demonstrate a willingness to distribute part of that to their shareholders.
By comparison, buying companies based only on high historical dividend yields can be treacherous and lead to the “dividend trap,” where investors wind up stuck with shares whose inflated dividend is inevitably cut and whose underlying value may simultaneously depreciate.
This leads us to the so-called “dividend aristocrats,” companies that have consistently increased dividends over time. In the US, firms must have increased dividends for 25 consecutive years to make the list, while the requirement in Europe (where the starting base is higher) is 10 consecutive years.
In both regions, such dividend aristocrats – which tend to be large-cap blue chips and are as rare as their name implies – historically outperform the market and demonstrate lower volatility over the longer term.
While any investment requires a thorough understanding and analysis of strategy, market positioning, sector drivers and financials, there is no doubt that dividend stocks represent a potential opportunity worth considering – and not just by widows and orphans.