Dividends vs. Total Return
By Steve Singiser
Restaurant server to a breakfast customer: “Would you like a dividend in your coffee cup?” Friend returning from vacation: “We had a wonderful time and the sunny weather was a real dividend.” These are pleasant little bonuses that provide us with momentary pleasures. The dividends this article will discuss are those paid by companies whose stock you own in your investment account. These dividends are tangible and real. They will pay for your restaurant coffee and expensive vacation.
When purchasing shares of stock there are two distinct ways you may be rewarded: capital appreciation and cash dividends. Combined, they add up to what is called “total return”. Capital appreciation is the increase in value of the shares. This will, of course, vary as the price goes up or down and is called an “unrealized capital gain”. The gain is only yours to keep when the shares are sold. There is no guarantee you will realize a gain on your purchase. Cash dividends, on the other hand, are paid directly to you by the company and are a fixed amount regardless of the price of the stock. Once paid, dividends are yours to keep, spend, or reinvest.
It may be argued that dividend income is the primary reason to invest in stocks. Yet, investing for high current income is often a fool’s errand and short-term thinking. For the longer term, investing for total return will reap greater rewards for the investor. Total return is the most reliable measure for how your investments are doing.
The text and selective stock charts that follow will show how dividends play a meaningful role in successful stock selection, not for their high current yield, but as a reflection of earnings growth that support yearly dividend increases. The charts contain a wealth of information for the twelve-year period ending December 31, 2018.
What to look for on the charts:
- The monthly price range looks like a crazy picket fence.
- Earnings per share are shown as a black line connecting black dots.
- Yearly dividends per share is shown as a line of white dots that look like rising steps.
- The rectangular box in the upper left corner shows growth rates for the past 1, 5, and 10 years of the stock prices, earnings, dividends, and resulting total return.The genesis and life cycle of a corporate cash dividend parallels the success of the corporation itself. A company is successful when revenues increase, leading to increased profits, providing cash to pay a dividend to its shareholders. These are the stocks we want you to own. They are your best hedge against inflation.
The Genesis and Life of a Corporate Cash Dividend in Three Phases
Phase One: A hypothetical company opens for business, with limited capital, some revenues, but no income. It cannot afford paying a dividend. With time, revenues grow, profits follow but are reinvested in the business to provide future growth. Amazon is an extreme example of a company that invests its income for future growth and pays no dividend. Will they ever pay a cash dividend? Probably, but not in the foreseeable future. So far, their strategy has worked unbelievably well. When earnings started declining in 2011, the company was able to move aggressively into many new areas. By 2015 earnings started recovering at an extremely high rate. Since 2009, even taking into account four years of poor earnings, Amazon’s stock price increased annually at a compound rate of 40.2%. Because the company pays no dividend, 40.2% is also the annual total return. A $1,000 purchase on 1/1/09 has increased in value over the next ten years to about $27,270.00. What a rewarding investment this has been! However, Amazon does not meet everyone’s comfort level or income requirements due to the lack of a cash dividend.
Phase Two: For our hypothetical example, revenues continue to grow, the company shows higher profits, the balance sheet is stable, and there is cash left over after paying taxes and all other expenses. It is time to share the profits with shareholders by paying an initial cash dividend. Some of the profit is held back to invest in the company for future growth. This is called retained earnings and is an important way of planning for the future. In this way, successful businesses may enjoy many years of revenue/income/dividend growth. Phase Two is the “sweet spot” phase of stock investing, as both price appreciation and cash dividends contribute to the total return. Many excellent companies qualify for inclusion. I have selected one of my favorites, McCormick & Co. Inc., the spice company whose products are well known to everyone.
Notice how dividend growth of 9% is comparable to earnings growth of 8.5% for the past ten years. (The two plotted lines run parallel to each other and are rising at the same consistent rate.) The dividend paid each year is about one half the company’s earnings, indicating a well-managed company.
Annual dividend increases provide a source of spendable income to their shareholders, and the balance of retained earnings is reinvested for the future. Note: A $1,000 purchase on 1/1/09 increased in market value over ten years to $4,375. In 2009 the company paid a cash dividend of $0.96; in 2018 they paid $2.12. Annualized total return for the past ten years was 17%. This is well above average. McCormick has been an outstanding investment opportunity over many years.
Phase Three: Success does not last forever. Companies and industries mature. Bad business decisions and competition take a toll on products that are no longer valued. When growth in revenues slows or is eliminated, income growth follows. Annual dividend increases are no longer supportable. The buggy whip industry, when the automobile was invented, is a silly but classic example. Eastman Kodak is a better example of product obsolescence and General Electric of poor management
decisions. AT&T is a good example of several converging negatives. Size, competition, new technologies have all held back continuing growth.
Beginning in the late 19th Century AT&T was the leading telecommunications company capitalizing early on the invention of the telephone. By the late 20th Century their dominance led the Government to force the divestiture of many of their regional telephone companies. That was the beginning of ongoing challenges that had a negative effect on AT&T’s ability to increase profits. The advent and popularity of wireless communication resulted in a rapid change from the traditional telephone to Smart Phones and a significant reduction in profitable land line revenues.
The AT&T chart shows very little growth during the past 10 years in price (0%), earnings (1.8%), or dividends (2.3%). The total return for this period was only 5%, primarily because of a generously large cash dividend. During this same period, by comparison, Apple’s annual growth in earnings was 31% and total return 30%. A modest cash dividend was initiated in 2012 that has increased each year from $1.52 to $2.92 a share.
If you are a fan of Starbucks coffee, you may be curious as to how their stock has done. It has done very well. If you really like their product, you may not regret buying their coffee, instead of their stock. Since 2009 Starbucks’ stock price has increased annually 30%. A $1,000 investment in their stock ten years ago is worth about $14,000 currently. This year you would receive at least $288 in cash dividends. If Peter Lynch drinks coffee, he probably owns shares of their stock. Who is Peter Lynch and why should we care if he is invested in Starbucks? Some of you may know the answer. For the those who don’t know, I will answer the question in our July Newsletter.