How to Use Dividends to Boost Your Stock Returns

When you decide it is time to inch back into the stock market, dividend-paying stocks can help you boost your long-term returns. Cash dividends represent a distribution to the company’s owners (the holders of its common stock) of a portion of corporate profits. They must be approved by the Board of Directors and most often are paid once a quarter (although they may be paid as often as once a month or as infrequently as once a year).

It is easy to dismiss dividends as you make your investment decisions, because they often seem modest relative to a company’s share price. For example, if you buy shares in a company with a share price of $20 per share and an annual dividend of $0.50 per share, the dividend return (or dividend yield) on your investment is 2.5%. Chances are, when you decided to buy the stock, you were hoping for capital appreciation of well over 2.5% annually to compensate you for the risk related to making this investment. As a result, the additional return from the dividend probably seemed inconsequential.

In fact, history tells us that dividends have been substantial contributors to long-term stock returns. For example, according to a study done by Thornburg Investment Management, approximately 26% of the total return of the S&P; 500 from 1974 to 2004 came from the reinvestment of dividends. Given this historical performance, dividends should not be ignored as you make your investment decisions.

As you do your research on dividend-paying stocks, here are a few important points to keep in mind.

  1. Look for the stocks of companies that have an extended record of dividend payments and, ideally, a record of steadily increasing dividends.
  2. Consider whether there is any reason the company might not be able to maintain its past record of dividend payments going forward. This is especially important at a time of financial turmoil such as today, when we have seen companies like General Electric with decades of dividend payments behind them not just skip a dividend hike but announce a dividend cut. Be especially wary of industries, like the banks, that have been cutting dividends, and seek out companies and industries where revenue and earnings have held up despite the economic downturn.

One way to evaluate a company’s dividend-paying ability is to follow the cash. You can do this by checking out the cash being generated by the company’s operations relative to its capital expenditures and other investments (these figures appear on its cash flow statement) and its cash dividend payments. Also, check to see if it has any substantial amount of debt coming due in the next few years. If cash generated by the company’s operations is sufficient to fund these capital requirements, that is a positive sign for the safety of the dividend (though, of course, not a guarantee).

  1. Find out when the company last paid a dividend, when the dividend was last increased, and the company’s most recent comments about the outlook for the dividend. If the dividend was increased in 2009 (and a surprisingly large number have been so far this year), despite the turmoil in the financial markets, and the commentary from management and/or the Board has been upbeat about the prospect of maintaining and growing the dividend, obviously these are encouraging signs.
  2. Beware of companies with exceptionally high dividend yields. Recently, the average yield for all the companies included in the Standard’s and Poors 500 Index was about 2.8%, so a double-digit dividend yield could be a red flag. Therefore, be extra vigilant in investigating super high-yield stocks.

Once you have identified dividend-paying stocks in which you want to invest, see if they have dividend reinvestment programs. If they do, consider taking advantage of this method of using the cash you receive from dividend payments to buy more shares (at no or low cost) in order to maximize your future dividends.

Sources:

Ken Ziesenheim, www.thornburginvestments.com, On the Importance of the Dividend, Thornburg Investment Management

www.indexarb.com, Dividend Yield for S&P; 500, Sorted by Dividend Yield

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