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The impact of Stock Dividends on Total Return

In many posts I have stressed the importance of the income an investment provides as much as any capital appreciation you may hope to gain from the investment. In my last post I described a real estate investment I have held for the past 20 years and the income it provides. The importance of income in a real estate investment is rather obvious as real estate has a lot of ongoing expenses associated with it. But I think it is just as important to seek income in your stock investments as well. In this post I will again illustrate the importance of income in regards to stock investment.

I have selected a single Dow component to illustrate the importance of the income component of a stock investment. For this example I chose the pharmaceutical giant Johnson and Johnson (stock symbol JNJ). The reason I chose JNJ is because its performance has been about in the middle of all the DOW components the last 20 years. It is a typical Dow stock that has paid an ever increasing dividend for decades. As such JNJ illustrates the impact of dividend income on total return. The table below shows the return of JNJ if someone had bought 100 shares on 1 January 1992 at the then current price of $14.03 per share and reinvested all the dividends for 20 years.

The stock price had an average annual increase of 9.2% from January 1992 through December 2011. Additionally, over this same period JNJ’s annual dividend increased from $0.2225 per share to $2.40 per share, a greater than 10-fold increase. This represents an annual increase of 12.6%.

Notice in the table, by re-investing all the dividend payouts for 20 years, the investor ends up with 48.08 more shares than the 100 shares he/she started with. By re-investing all dividend income the investor, 20 years later, owns 148.08 shares worth about $9,711 in January 2012. $9,711 is almost 6 times the $1,403 initial investment the investor made 20 years earlier. As a comparison, if the original $1,403 investment had an annual return of 3%, roughly the rate of inflation, the investment in 20 years would be worth only $2,550.

The most important information in the table is the last row. The dividend re-investments contributed about 32.5% to JNJ’s total return over this 20 year period. Without the dividend income, the original 100 shares of JNJ stock would have been worth only $6,558 or $3,153 less.

Some may think if JNJ had not paid out any dividends and re-invested the cash in the business or purchased other related businesses, would not the stock price have risen higher than it did? Maybe….maybe not; in today’s stock market, do you feel lucky? That is the gamble you take when your investments are totally dependent on capital appreciation. I personally like to get paid back something from my investments every year. This is especially important to any prospective retirees who do not have an employer provided pension and want to retire before they are eligible for social security.

Additionally, I think dividend paying stocks exercise more corporate discipline. Due to the enigmatic rules of corporate accounting, a company can “massage” their earnings to look better than they really are. But cash payouts in the form of dividends cannot be falsified. The company must have the cold hard cash in the bank to make these payouts. And generally companies do not make dividend payouts if they are having financial trouble. To approve a dividend, the top management must feel pretty good about a company’s near term prospects.

Also companies that have been paying out dividends for decades have a different corporate culture in regards to their shareholders. These companies respect their shareowners and want to keep them happy. They work very hard to keep the dividend intact. If one quarter a company did not pay out the regular dividend or even reduced the dividend, their share holders would punish the stock price.

It is my firm opinion that, regardless of your age, you should have the majority of your equity holdings in dividend paying stocks. Especially now while we are in a long term bear market. Historically, the average return for the S&P 500 index stocks that pay a regular dividend is significantly higher than the stocks in the index that do not pay a dividend. But even if there is a period where non-dividend stocks outperform dividend payers such as the 1990s, the dividend payers generally have lower volatility and make for a smoother ride through the markets rough patches, such as the years 2000 to 2002 and 2008 to 2009.

Dividends should not be the only thing you consider when deciding to invest in stocks. You should consider the strength of the brand, their financial position, and their current valuation. The greatest single factor that determines the long term return in the stock market is the valuation at the time of purchase. That is, the lower the equity valuation at the time of purchase the greater the long term return. The dividend payments you receive can make it a lot easier to have the patience to wait until the rest of the market recognizes the low valuation.

I intended to discuss my first investment real estate transaction in 13 years in this post. However, I am still negotiating this transaction. I will detail the investment aspects of this purchase in my next post.

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