Building Wealth Through Dividend Investing by Harlan Sonderling, Columbia Threadneedle Investments
- We believe a disciplined dividend strategy that focuses on rising dividends is a necessary component for building long-term wealth and consistently growing income.
- Companies that successfully increase their dividend typically do so because there is growth in operating free cash flow.
- Quality acts to mitigate risk and offers downside protection during times of market stress. By limiting losses in down markets, there is less ground to be made up when markets rebound.
The Federal Reserve’s recent decision to delay raising rates reinforces an opinion we expressed at the beginning of 2014. Namely, it appears central banks will attempt to keep rates low for longer due to a prolonged bout of sluggish growth in the global economy. Does a rate increase come at some point? Probably, but the question is will it really matter? Any rate hike will, in our opinion, be modest and come with the message that subsequent rate increases are not imminent. Investors seeking income will continue to be challenged. We believe interest rate increases, regardless of the catalyst, combined with higher inflation eventually overwhelm the purchasing power of fixed investments and even produce losses in asset classes widely perceived to be safe. Investors will need to generate consistent income while simultaneously seeking protection against potential inflation to maintain purchasing power in retirement. Given higher life expectancies, we believe it is increasingly important for investors to be mindful of outliving their investments. The standard playbook of simply allocating savings to fixed income upon reaching retirement could be more risky than in the past. So, how can investors build wealth over time and consistently grow income in a relatively low-risk equity strategy? We believe a disciplined dividend strategy that focuses on rising dividends produced by high-quality companies with growing free cash flow is a necessary component to accomplishing this goal and should be a core part of any investors’ asset allocation.
For long-term investors, dividends provide a source of repayment on their initial investment. The more they get upfront, the less they have to rely on less predictable capital appreciation for the cash return on their investment. As Exhibit 1 demonstrates, the standard deviation, or variability, of returns from capital appreciation is significantly higher than from dividends.
Exhibit 1: Income provides a much more stable source of return than capital appreciation
Sources: Morningstar Direct and Ibbotson. Data from 1926–08/15.
Historically, dividends have been an important component of total return. Dividends have accounted for 43% of total return since the 1920s (Exhibit 2). Moreover, more than 25% of total return in every decade during this period has been derived from dividends. The 1990s are the only full decade that dividends comprised less than a quarter of total return, driven by the tech craze which briefly encouraged investors to speculate rather than invest. Conversely, in four of the past eight decades, dividends accounted for between two-thirds and 100% of total return.
Exhibit 2: S&P 500 Index returns by dividends and capital appreciation
Source: Ned Davis Research, 12/31/14
Past performance is not a guarantee of future results.
When considering a dividend investment, we think it makes sense to look at a disciplined, time-tested strategy that focuses on dividend growth rather than yield alone. A high yield does not necessarily translate to good performance. The best opportunity for total return resides with the stocks of high-quality companies that can sustain and grow their dividend over time (Exhibit 3). Companies that successfully increase their dividend typically do so because there is growth in operating free cash flow. As the amount of cash generated by a company increases, so does the company’s intrinsic value which is typically reflected in a higher stock price. A corporation must be able to generate cash returns that exceed what it needs to grow the business. This provides the firepower for dividend growth and other shareholder-friendly actions. Dividends not supported by free cash flow are far more likely to disappoint investors.
Exhibit 3: Look to high-quality companies that can sustain and grow their dividends
Source: Ned Davis Research, 12/31/14
Past performance is not a guarantee of future results.
There is no guarantee that these trends will continue. This information is intended for illustrative purposes only. It is not intended to be representative of specific portfolio holdings.
Importance of active management
Assessing a company’s potential to raise its dividend in the future is an important component of successful dividend investing. The ability to forecast out 2-3 years is crucial to make an educated decision about the direction of a company’s free cash flow rather than simply relying on a historical screen of dividend payments. A history of paying a dividend doesn’t necessarily mean a company can increase or even maintain the dividend in the future. For example, prior to the financial crisis, many banks had long histories of paying and even growing dividends. But most were forced to cut or eliminate dividends because excess leverage had deteriorated the fundamental strength of the companies. In fact, during the 2007-2009 timeframe, 24 of the largest U.S. banks cut dividends by an average of 90%. Simply relying on the past as a predictor of future dividend actions is like driving your car while looking in the rearview mirror.
Quality is a factor we believe is underappreciated, yet stands the test of time. There are certainly periods when low-quality stocks outperform. This includes most of the post-financial crisis period as the Fed has injected substantial liquidity into the system in an effort to push investors out on the risk curve. Quality acts to mitigate risk and offers downside protection during times of market stress (Exhibit 4). By limiting losses in down markets, there is less ground to be made up when markets rebound. Limiting downside is an important ingredient for successfully building wealth.
Exhibit 4: Performance during market stress
Source: Leuthold Group
Finally, keeping a close eye on the amount of annual cash flow consumed by the dividend is important to assess the future ability to grow dividends and avoid dividend cuts. Very often investors look to the payout ratio based on a company’s earnings. We believe this can be misleading and instead prefer to focus on the percentage of annual operating free cash flow consumed by the dividend. Earnings are based on accrual accounting which can more easily be manipulated than cash flow, and sustainable dividends must be paid from operating cash flow.
To conclude, we believe a disciplined dividend strategy that focuses on rising dividends produced by high-quality companies with growing free cash flow should be a core part of any investor’s asset allocation. For patient, long-term investors, such a strategy can offer:
– Consistent, rising income with a lower tax rate than other income-producing asset classes;
– A hedge against inflation and higher rates to maintain future purchasing power;
– A lower risk profile that protects on the downside yet captures enough upside to produce solid, risk-adjusted returns over a market cycle.
