But, even as the world of zero interest rates appears to be ending—the US Federal Reserve (Fed) is now hiking short-term rates to tame inflation—dividend-paying stocks may still be worth a closer look. Here are three reasons why:
Reason 1: Income and Growth Potential
Bonds, once regarded as reliable sources of income, have struggled to pay investors any kind of meaningful yields, particularly during the two years in which the Fed held rates to near zero to combat the COVID-19 economic collapse. But even though rates are poised to rise in the coming year, they may still be sitting at historically low levels by the end of the year while profitable companies could be poised to grow their dividends.
That's because companies have been sitting on all-time high amounts of cash. As the economy begins to shift away from its COVID-19 emergency stance, increasing or initiating a dividend is likely to become a common use for corporate cash. It’s far from clear whether the expected rise in fixed-income rates can compete with the growth potential that steady dividend payers can provide. Furthermore, the recent success of cyclical- and value-oriented stocks has demonstrated a strong belief that there’s room for growth for undervalued dividend-paying companies with strong balance sheets and deep cash reserves.
Reason 2: Consistency Has Historically Been Rewarded
Recent research shows that companies that offer steady sustainable dividends without going overboard on payouts have provided the best returns over time.
The study, by Wellington Management,2 divided dividend-paying companies into quintiles, then ranked them from highest to lowest level of payouts. The companies that outperformed the S&P 500 Index landed, surprisingly, in the second-highest rather than highest quintile. That’s right: the “high” beat the “highest.”
This counterintuitive result suggests that some companies were making “excessive” dividend payouts and leaving themselves with less money to invest in future growth, while companies with more moderate payouts were re-investing their earnings and still retaining enough flexibility to pay steady dividends for the long term.
Reason 3: Dividend Growth—A Sign of Good Management
In another recent study, Ned Davis Research3 looked at dividends from the vantage point of corporate behavior. The study asked: Since 1972, what kind of company had the highest returns and lowest volatility over time: Companies that grew their dividends? Companies that cut or eliminated them? Companies that stood pat? Or companies that didn’t pay anything at all?
The results showed that companies that grew or initiated a dividend experienced the highest returns relative to other stocks—with significantly less volatility.
The study also noted a strong correlation between corporations that consistently grow their dividends and those with strong fundamentals, solid business plans, and a deep commitment to their shareholders.
Bottom line: Although they’ve gone in and out of favor throughout the years, dividends are once again showing they can still play an important role in providing income and growth potential, especially in today’s volatile environment.
