A cow for her milk,
A hen for her eggs,
And a stock, by heck, for her dividends.
In his 1938 book, Theory of Investment Value, John Burr William believed dividends play an important role in determining the value of a stock, neatly captured in his simple poetic writings above.
“If a man buys a security below its investment value he needs never lose, even if the price should fall at once, because he can still hold for income and get a return above normal on his cost price.”
Together with Benjamin Graham, Philip Fisher and Charlie Munger, William had a major influence on Warren Buffett’s success today. And if he’s good enough for Buffett, he’s someone all serious investors like us should take note of!
If a stock doesn’t pay dividends, William would avoid it. Similar to William’s investment philosophy, investors should pay close attention to dividends for a few reasons:
1. Everyone loves passive income
It’s always a pleasure to see the stocks I invested in distribute a portion of its earnings to me in the form of dividends. Not only do I love dividends, heck, Even my aunt loves them too!
My aunt used to put her money in the bank, earning an interest of less than 1% p.a. When I learnt how to invest, I told her to put her money in the stock market to generate better returns. It plainly turned out to be true, with one of her stocks generating an annual dividend yield of 9%. I think anyone would be happy making that in passive income every single year. I know I would!
2. Dividends Improve Your Investment Performance (When Reinvested)
A study done by Stanford University, titled The Impact of Fixing Its Flaws indicated that if the Dow Jones Industrial Average took into account dividends reinvested from 1928 to 2000, the index would now be over 250,000 points (instead of just over 16,000 now). The study highlights a very important point for investors not spend those dividends away, but to reinvest them consistently.
And as you know, when the market crashes, stock prices drop everywhere. If you were smart enough to invest in a recession-proof company with a good dividend yield, your dividends can now snap up even more stock at knockdown prices, giving you even better returns over the long haul.
3. Provides clues if a company is doing well
One common theme for companies not paying dividends is when a firm is making losses. If there is no profit, usually there are no dividends. Thus if a stock pays higher and higher dividends year to year, it often signifies that the company is doing better and better.
For example, Coca-Cola has been paying consistent, growing dividends over the past ten years due to its revenue growth and timeless demand of its beverages.
Obviously, dividends alone are no way to invest in a stock. It is still important to assess the company’s financials to determine whether a company is fundamentally strong.
4. Is the money really there?
Though not a 100% foolproof way to detect fraudulent companies, dividends provide a good clue if a firm has a real business going on and actual cash in the bank. Companies can’t continuously pay and increase its dividends if the business is a sham with no real revenue or profit.
For example, in the emerging markets, some Chinese companies listed in Singapore and Malaysia have been widely known for refusing to pay any dividends even though the firm is reported doing “well” and even have a net cash per share value higher than their stock price!
Investors have been questioning whether the cash actually exists. In my opinion, if you intend to invest in Chinese companies, it is better to pick the better quality stocks listed on the Hong Kong Stock Exchange and do your due diligence.
5. Dividend yields can tell you of the overall market sentiment
During the Eurozone crisis in late 2011, the index of Real Estate Investment Trust (REITs) in Singapore was trading at average dividend yield of 6.4%. After the crisis passed, the sector went on a major bull run to the first quarter of 2013. With stock prices trending up, the dividend yield dropped to 4.9%.
It might seem like a slight drop but when it comes to REITs, dividend income investors expect a higher yield of at least 6%-10% minimum to compensate for the relative lack of capital growth. Investors who closely watched the overall dividend yield would have noticed a bubble forming at those kinds of valuations. True enough, the REITs sector hit a peak and dropped 20% half a year later.
To close off, we all know that investors love receiving dividends (who doesn’t, right?), but beyond the cash and passive income you receive, dividends are also a nifty way to examine a company’s true financial footing and the overall market sentiment of a sector. Use them to complement your research and analysis!