By: Board Member, Claudio Brocado
As young investors, YIS club members often focus on growth companies with which they are very familiar. Growth stocks are an important ingredient of diversified portfolios, but as “co-owners” in a company, stock investors should also look for some dividends out of their equity holdings. Just like owners of small entrepreneurial companies might depend on the earnings from their business to provide at least some of their living expenses, portfolio investors should receive some of the income generated by their equities in the form of dividends.
Over long periods of time, some two thirds of the total return of the S&P 500 index of large-capitalization stocks (over 70% by some estimates, depending on the specific time period) come from dividends. It is therefore very important to pay attention to the dividend potential of stocks. When I first started investing, and for a very long time thereafter (to be honest), I did not use to care much if the stocks in which I invested paid a dividend or not. The more I have learned, however, the more I care about dividends. I still have much to learn, as it is always my philosophy that everyone can (and indeed must) learn something new every day.
Because many young investors tend to focus largely on the price appreciation potential of the stocks they prefer, they may be overlooking the importance of dividends in the total return of equity portfolios over the long term. As we know, stock investing should only be done with money that one will not need in the near term. Young investors should then not really need the dividend income itself, so my recommendation is to reinvest the dividends (use them to buy even more shares).
So if we in theory do not need the dividend income in the short run, why should we even put some dividend-paying stocks in our equity portfolio? As I explained earlier, dividends have over time tended to represent a very important percent of the total return of the key stock index. In my opinion, one of the most important reasons for this is that the market appreciates the management discipline entailed in establishing and maintaining a dividend policy. It is plain and simple: historically, large cap stocks that pay a dividend do better than those which do not.
That said, many investors, even the professionals, tend to refer to “high dividend” stocks when the topic of dividend investing comes up. These are the stocks of companies that tend to sport a relatively high dividend yield, such as utilities and telecom equities, and perhaps REITs (real estate investment trusts), as well as some large cap energy stocks. The dividend yield is the annualized dividend divided by the stock price.
These types of dividend payers are not what I am talking about. I have a strong preference for dividend growth stocks. Those are the companies that don’t necessarily have already a high dividend yield, but are paying a dividend whose prospects are excellent for long-term growth.
Companies that still pay out a modest percent of their earnings in the form of dividends, but have ample cash flows to increase the dividend over time are what I refer to when I talk about dividend growth stocks. For the next five years, at least, I expect this kind of companies to provide excellent total returns. Again, I would advocate reinvesting the dividends so that the power of compounding works even harder in your favor.