The Power of Dividends

The Power of Dividends

As Published in the Spring 2014 Edition of NJ Lifestyle

Dividend paying stocks have received a lot of attention over the last few years as interest rates have fallen. With the yield on the 5-year Treasury note dropping below 1%, investors shifted their focus to stocks as prices were down and the yield on the S&P 500 surpassed 2.5%. As of July 2013, nearly 30% of the stocks that make up the S&P 500 Index had dividend yields that surpassed the yield on the 10-year U.S. Treasury. Low fixed income yields coupled with favorable tax treatment on dividend payments and the ability of dividends to help mitigate market volatility have made dividend paying stocks an important component of investor returns for decades, and can be a powerful tool for your portfolio.

From 1930 through 2012, dividends have contributed roughly 45% of the S&P 500 index’s total return. Broken down by decade, that percentage has ranged from a high of 68% during the 1940s, to a low of 15% in the 1990s when investors favored capital appreciation. During the 50s, 80s, and 90s, decades where the average annual return of the index was in the double digits, the contribution of dividends to total return was 30%, 28%, and 15% respectively. However, during the decades where the index averaged less than 10% per year, the contribution of dividends became much more important. The 40s, 60s, and 70s saw dividend contribution rates of 68%, 44%, and 73% respectively. Whether the current fad in the market is to favor growth or to favor fundamental investing, dividends can be a significant contributor to a portfolio’s total return.

When dividends are reinvested back into a portfolio, their contribution to total return significantly increases. Research from Morningstar shows that $10,000 invested in the S&P 500 Price Only Index in December 1960 would have grown to $245,426 through the end of 2012. That same $10,000 invested in the S&P 500 Total Return index, which includes reinvested dividends, would have grown to $1,241,459. The total return contribution equates to approximately 80% from reinvested dividends, while only 20% is attributable from price appreciation.

Not all dividend paying companies are created equally. A high-yielding company doesn’t necessarily signify a successful company. On the contrary, it could signal a company whose stock price has depreciated and will soon need to cut its dividend to stay solvent. Lower yielding companies that have strong fundamentals and the ability to increase their dividend year over year can be strong candidates for a portfolio. Johnson & Johnson (JNJ) is a great example, as the company has been able to increase its dividend payout for the last 51 consecutive years. An investor who bought shares in January 1980 has seen their annual dividend payments increase from $0.046 to $2.64. That dividend payment represents a great return on original investment as JNJ stock was trading at $1.65 back in 1980.

The current 10-year Treasury rate is 2.77%. An investor who purchases the 10-year bond will be locked into an annual income of $277 for every $10,000 invested. If 5 years from now rates are much higher, that investor will still be collecting $277. Dividend paying stocks can be a great alternative to the “fixed” income generated through bonds. Consider Proctor & Gamble, which has raised its quarterly dividend from 0.25 to 0.6014 per share over last decade; a 9% average annual increase. The current annual dividend payment per share of $2.41 represents a 3.07% current yield. If Proctor & Gamble continues to raise its dividend on average 9% per year moving forward, in five years we can estimate the dividend to be 0.9253 per quarter, or $3.70 per year. Based on today’s share price of 78.45, the increased dividend would represent a 4.72% yield on original investment. Dividend paying stocks can be an alternative to locking in a fixed bond yield, and can offer investors a rising income stream.

Finally, favorable tax treatment of dividends makes them an attractive investment. Individual and couples in the two lowest tax brackets (10% & 15%) enjoy 0% tax on qualified dividends. The tax rate increases to 15% for investors who fall between the 25%-35% tax brackets, while the maximum rate on qualified dividends jumps to 20% for investor’s in the top marginal bracket of 39.6%. This favorable rate contrasts with the taxation of interest income, which is taxed at an investor’s marginal tax bracket. Before investing, it is important to determine if stocks are appropriate for your investment portfolio. High quality companies with strong balance sheets and a consistent dividend can be great candidates for inclusion in the equity allocation of a portfolio. Low interest rates, favorable tax treatment, and the potential for rising income are just a few of the many reasons dividend investing can be rewarding.