Pretty much since the beginning of the stock market, and certainly over the last century and a half, dividends have been a substantial component of overall investment return. However, there have been some periods; the most notable during the 1990s tech boom, when investors not only lost their appetite for juicy dividends but actually came to view them with negatively. The appetite during these short-lived periods was for growth, not a paltry few percentage points income return, but double-digit, triple-digit, and even quadruple-digit growth. The perception from the market was that a dividend was a sign of slowing growth and this sent many investors out of the respective stock in search of the next big growth story.
As we saw with the tech bubble, the arrival of this flavour of investor mentality typically results in a massive contraction of overvalued prices of growth stocks. Often it can take many years for a bubble to finally burst but the when the investors turn their backs on “tried and true” methods of investing in favour of what anyone should know to be unsustainable, then that is a signal for the intelligent investors that the market is treading on unstable ground.
The truth is that in any healthy market dividends are a primary source of investment return. In fact, over the last 20 years, it is believed that dividends and income distributions have accounted for approximately 70% of total stock market returns. So by this logic, an investor who does not have a significant portion of their portfolio invested in dividend paying securities is essentially limiting themselves from assessing over half of potential returns. In an environment where market indices are posting anemic returns, the adoption of dividend stock investing has become a basic requirement for reaching financial goals or even generating a positive investment return at all.
But in the current market, many investors believe we have come full circle since the tech boom of the 90s. Interest rates are at historic lows, which have almost eliminated investment-grade bonds as a significant source of investment income. The global economic picture remains shaky which has resulted in back and forth volatility in the major stock indices, limiting or eliminating capital appreciation potential. And the result is that dividends and stocks that pay them have come back into vogue with a vengeance. So understandably many investors are now questioning whether the same type of stocks that were viewed with apathy in previous market bubbles have now become the bubble of the present day.
In many ways we encourage this line of thinking because it acts as a counterbalance to greed. However, we would also argue against the notion that dividend stocks in general have delivered such substantial performance over the past two years. In fact, if you were to take a quick look at the S&P/TSX Dividend Stock Index you would see that the price return in 2011 was negative and the price return year-to-date in 2012 is still in the low single digits. Although the Dividend Stock Index has outperformed the TSX Composite Index in both years, the level of outperformance has actually been fairly limited at less than 4% in 2011 and only about 1% so far in 2012. So it is actually pretty clear that the simple act of paying a dividend is not propelling stocks to unjustifiable prices.
Nevertheless, it is absolutely indisputable that numerous dividend stocks have produced outstanding returns over the past 3 years. So what is it that the index isn’t showing? The answer lies in a concept that has made many a great investor very wealthy and that we have been expounding for years – individual stock selection. While dividend stocks have indeed produced decent overall performance over the past 3 years, it is the individual outperformers that have been getting most of the buzz. The truth is that the payment of a dividend itself doesn’t really say anything about a company. Dividends are nothing more than a method of returning capital to shareholders. But companies that pay a dividend supported by strong free cash flow and that are able to retain and reinvest a significant portion of this free cash flow for growth have indeed exhibited very impressive performance in this largely lackluster market. In KeyStone’s research we call them Dividend Growth Stocks and as much as the income, it seems to be the growth that is infatuating investors.
For readers who are interesting in learning about the dividend growth stocks coverage in KeyStone’s Income Stock Report (ISR) research service, please visit www.keystocks.com.
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