In case you haven’t noticed, the stock market has been a little choppy over the past few weeks. Business and consumer confidence are flagging a bit amid the growing concerns that a potential trade war could spark a recession that would eat into corporate profit growth, the mother’s milk of rising stock prices.
The recent market volatility has been especially acute in the names that have dominated returns over the past two years, primarily large, high-growth companies with rich valuations that depend upon economic momentum to justify their premium prices. Think Amazon, Tesla, Google and Nvidia to name a few, most of which are down by double-digit percentages this year. Meanwhile, another segment of the market that languished in comparison to these large cap growth companies has held up much better during the recent pullback, providing investors with a degree of shelter from the storm: dividend paying stocks.
A dividend is a partial payout of a company’s net income to its shareholders. It helps to recall 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. Dividend payers typically seek to maintain a stable, slightly increasing quarterly distribution policy by estimating their projected annual profits, retaining a portion for future capital needs and sending the rest to stockholders in cash. Many investors desiring a stable cash flow build a portfolio that includes consistent dividend paying stocks, while others may choose to reinvest the cash flows into more shares or into shares of other firms.
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 around 12% 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.
For much of history since the first stock corporations, the investors’ primary return was from the collection of cash dividends. 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.