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When the market stops growing, dividends keep going

There are some persistent myths about dividend paying stocks, says this Canadian advisory, and they all prove false in times like these.

Remember Bre-X Minerals? The story had all the elements of a best seller — intrigue, bluff, fraud, mysterious disappearances and ultimately, tragedy. There was one thing it didn’t have. Dividends.

Not every stock that doesn’t pay dividends is a Bre-X, of course. And some dividend-paying stocks have taken pratfalls in the market and had to cut their dividend payments.

But by and large, if you’re looking for something solid in today’s topsy-turvy markets, the first thing you should cast your eye on is dividends.

That’s the opinion of one of Canada’s longest continuous stock advisories, The Investment Reporter. People tend to underrate dividends, the advisory believes, especially when the going is good.

There’s also a certain amount of misinformation out there about dividends, and the advisory thinks it should be cleared up.

Grasshoppers and ants

From October 2002 through 2006 stock prices rose quickly. At the risk of over-generalizing (a risk we’re never afraid to take), the case could be put this way.

The grasshoppers piled up nothing but fast-moving growth stocks while the market was hot, snickering all the while at the ants that plodded steadily along, building portfolios heavy with dividend-paying equities.

Or as the advisory puts it: “Friends asked why they should care about dividends. After all, they could earn big profits from takeovers and the market’s general rise.”

But the market can go cold overnight. When it does, share prices drop, but dividends keep soldiering on. “In fact,” says the advisory, “most companies keep on paying dividends only if they think they’ll manage to keep paying in the years ahead.”

But there’s another knock on dividends. Allegedly, paying dividends will stunt a stock’s growth. Nonsense, says this advisory.

The growth myth

“It’s often thought that companies with high payout ratios — high dividends as a percentage of profits — condemn themselves to slow earnings-per-share growth,” says The Investment Reporter.

The story goes that because they pay out so much in dividends, they reinvest less in their businesses. Firms that don’t pay dividends can prime their pumps with more money and thus generate more earnings growth. It makes sense on the face of it, but it’s a myth. So says a study by Mr. Robert Arnott of Quadrant LP and Mr. Clifford Asness of AQR Capital Management.

The study didn’t skimp on research. It covered 130 years of data on U.S. equities from 1871 to 2001. And it discovered that the higher the payout ratio, the higher the earnings growth over the following 10 year period. The lower the payout ratio, the lower the earnings growth.

The conclusion is inescapable. Companies that have the resources and the confidence to pay out dividends also have the resources to keep on pushing up earnings. “Since earnings ultimately set stock prices,” says the advisory, “it makes sense to choose high-yield stocks with above-average earnings per share growth.”

The market’s greatest mistakes

Opting for dividend payers also helps you avoid what this advisory calls “the market’s worse mistakes.”

While it is true that many perfectly good stocks do not pay dividends, preferring to put the receipts back in the business — at least for the time being — there are also the Bre-X’s of the world. These are the companies that count exclusively on selling enough shares to make their fortune, and have no interest in rewarding shareholders along the way.

Their sole object is to promote the share price, often without being too fastidious about the legal niceties. You may not remember Cartaway Resources or YBM Magnex, but their former shareholders do, with great regret.

Win-win

The best-case scenario is the one in which companies use increasing earnings to raise your dividends every year. As the advisory says, “you either get a higher and higher dividend yield as the years go by or, more likely, you get gains as income-seeking investors bid up your shares. But regardless of whether you earn ever-higher dividends yields or gains, you win.”

Take the Bank of Nova Scotia (TSX-BNS) for example. A decade ago it paid a dividend of 37 cents a share and traded at $13.67. Had the bank’s shares remained at that level, the dividend would now yield 13.8 per cent. But long before the yield reached that juicy level, other investors bid up the bank’s shares (to $48.65 at the moment). The bottom line is the definition of win-win. Whether the yield went up or the share price climbed, investors came out ahead.

There are further gains to be had, too. Reinvesting dividends magnifies your returns even further, says the advisory. A study that tracked the U.S. stock market from 1926 to the turn of the millennium had this to say: “$1.00 grew to $105.96 as a result of price appreciation, with no dividends reinvested, but that dollar grew to $2,591.76 with dividends reinvested.”

The simplest way to do this is with Dividend Re-Investment Plans (DRIPs), points out the advisory. Not all dividend-paying stocks have such plans, but a number of high-quality companies do.

Prime time for dividends

Now is the prime time to be collecting dividends, says the advisory. For all its ups and downs, the stock market has gone nowhere in 2007. Over the past 12 months, the market is up less than one per cent. “In times like these,” says The Investment Reporter, “dividends can make the difference between losing or making money.”

When other investors recognize this and start buying dividend-paying stocks, investors holding those dividend-paying stocks just get richer.

We have nothing against good growth stocks that pay no dividends (or against grasshoppers, for that matter — they probably work just as hard as ants, even though they look like they’re just hopping around having fun). But there is a good deal of evidence to suggest that when the going gets tough, dividend stocks get growing.