Personal Finance: Rediscovering the magic of dividends

Christopher Hopkins
Christopher Hopkins

The first American stock trades occurred under a Buttonwood tree on Wall Street in 1792. For most of that time, the principal attraction of owning shares has been the periodic cash flow paid out to the shareholders. Investors purchased stocks to obtain a stream of income payments, called dividends, and judged the attractiveness of a stock by the issuer's ability to maintain or even increase the dividend over time.

But with the surge in growth investing culminating with the great tech boom of the 1990s, dividend payouts diminished sharply as investors became more enamored with price appreciation than cash flow. By the end of 1999, the number of public companies that paid a dividend stood at just 20 percent, down from two thirds of all firms in 1978. Thankfully, many investors are now rediscovering the importance of regular cash distributions as a significant component of their total return, and devoting more attention to the maintenance and growth of dividends.

photo Christopher Hopkins

The term "dividend" comes from Latin for "something to be divided." It was first applied to the earliest publicly traded stock, the Dutch East India Co. dating to 1602. The East India Co. operated cargo vessels chartered to import valuable spices. Shares of the profits from the voyages were distributed in the form of dividend payments to shareholders, typically exceeding 12 percent of the initial investment. While the shares could be sold to another investor (potentially at a profit), the main attraction remained the income derived from the regular payouts.

By the mid-20th century, maintenance of a stable dividend policy by American corporations was so typical that the infant field of security valuation grew up around the premise of a predictable and growing payout. Known as the Dividend Discount Model, it posited that most firms pay consistent dividends, and that the fair value of a company today is essentially the present value of all future dividend payments, assumed to increase at a constant rate over time.

So why the disconnect in the 1990s, when investors lost interest in dividends?

It helps to remember that every nickel of profit generated by a company belongs to the owners of that company. Management has some discretion as to when and in what proportion those earnings are handed over to the shareholders or held in reserve by the firm for reinvestment in future growth. Dividends originally served as the mechanism for distributing a company's profits back to the shareholders to whom it ultimately belongs. Every quarter, management reassesses its estimate of capital needed for future expansion and announces a dividend distribution of the cash not retained for reinvestment.

As long as the Nasdaq was soaring and growth stocks produced double-digit gains year after year, the lure of the quarterly distribution dimmed. Shareholders encouraged management to retain all the earnings to reinvest in seemingly no-lose, high octane growth projects instead of paying out profits. After all, when a stock is racking up 20 percent annual gains, who gives a rip about a piddling 2 percent dividend check?

Ultimately though, what goes around comes around. Today investors are more focused on consistent dividend payouts, and rightly so. History suggests that over the past 90 years, over 40 percent of all investment returns to stockholders come from reinvesting the dividend payments. And in the brave new world of systemically low yields on bonds and CDs, the yield from solid dividend-paying stocks is even more compelling.

It must be remembered that dividends are not guaranteed, and investors must exercise diligence in assessing the stability of payouts. But investors' rediscovery of the role of dividends in a well-constructed portfolio is welcome indeed.

Christopher A. Hopkins is a vice president and portfolio manager for Barnett & Co. in Chattanooga.

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