The start of autumn is upon us. And that usually means a new set of fads—from fall fashion and a new tv lineup to the “hot” toys of the upcoming holiday season. There’s also another trend that’s been picking up steam—this time in the investment world: Dividends.
What is a dividend? It is a distribution of a company’s profits to shareholders. Paying a dividend is one of three main ways companies can use their profits—the other two are to reinvest in the business (to achieve organic or acquired growth) or buy back shares.
This dividend trend started earlier this year as battle-tested investors gravitated sought income. Moreover, in our opinion, it doesn’t appear it will wane soon. Actually, it may accelerate. Here are three reasons why.
3 reasons dividends may be a priority for investors
Reason #1: Investors are seeking returns.
The U.S. stock market has been in a downward trend since the beginning of the year. And even though the market has had some mini reversals—like the upswing during the summer—the decline has continued. So how can investors drum up returns in a down market?
Let’s break apart how stocks generate returns. Investment returns are a combination of price movement and dividend yield. Price movements are caused by earnings per share (EPS), reflecting business performance, and changes in valuation multiples, reflecting market sentiment. Historically multiple expansion and earnings have produced the bulk of the performance, while dividends have been a steady yet low contributor.
But this year, it appears that both valuation multiples and EPS may minimally, or even negatively, contribute to return. For example, since January, the trailing price-to-earnings ratio (P/E) has contracted from 23.1x to 19.8x.1
And while earnings have remained positive, the growth rate has slowed considerably. Just look at the second-quarter earnings growth rate for the S&P 500—it came in at 6.3%, the lowest rate since the fourth quarter of 2020.2 But more worrisome, Wall Street is lowering estimates for third-quarter earnings. So far, forecasts have fallen by over 5%.3
On the other hand, dividends are expected to maintain their steady low but positive contribution.
Reason #2: The Inflation Reduction Act favors dividends.
Companies can return money to shareholders in several ways, with share buybacks and dividends being the most common options. There are reasons why a company’s management may elect for one over the other, but a primary advantage is that share buybacks are more flexible than dividend payouts. Although dividends are not fixed, when a company decides to lower its payout, it tends to be a negative signal about its financial strength. So, companies often avoid changing payouts, making dividends slightly inflexible.
However, the recently signed Inflation Reduction Act may tip the scales toward dividends because it places a new tax on share buybacks, not dividends. The tax is small—only 1%. But in a world where earnings may decline and business conditions could worsen, paying a lower tax via a dividend payout instead of a share buyback may push companies towards paying dividends. Research suggests this 1% tax on repurchases could “induce a roughly 1.5 percent increase in corporate dividend payouts.”4
Companies, however, will have to weigh their potential tax benefit against the potential tax burden for individual investors. Individual investors may have to pay an additional tax from this shift because dividend income cannot be deferred by investors. And even if the dividends are reinvested, investors still pay a tax on the distribution.
Share buybacks, however, distribute earnings only to investors who sell their shares. So if investors retain their shares, they do not pay capital gains tax on share repurchases.
Reason #3: Dividend-paying stocks tend to outperform during bear markets.
Research shows that dividend-paying stocks tend to be less volatile than the broad market. From January 2000 through April 2020, all three categories of dividend indices—dividend growers, yield/quality blended dividend stocks, and high-yielding dividend stocks—had lower volatility than the S&P 500.5
During those two decades, there have been three significant recessions—the bursting of the tech bubble, the global financial crisis, and COVID-19. In all but the COVID-19 recession, high-quality dividend indices outperformed the S&P 500. (The data show that the COVID-19 recession caused a unique exogenous shock such that normal market behavior during this recession deviated.)
Similarly, another study showed that steady dividend growers had less volatility and outperformed non-dividend-paying stocks from 1990 through 2018.6
There are many assumed reasons for this performance. Some attribute it to the typically high relative profitability and lower debt—or strong corporate financial health—of dividend-paying companies. We believe this is true. Companies would not pay a dividend if they didn’t believe they could sustain the payout. In other words, their dividend payout strategy represents the predictability of their income. We think predictable income is a result of growing markets, sustainable competitive advantage, and intelligent capital allocation—the trademarks of Quality companies.
Others believe it’s due to sector selection. For example, some more volatile sectors, like information technology, are not common dividend payers, while more defensive, stable, lower-growth sectors, like utilities and real estate, are. And, in bear markets, defensive sectors tend to outperform.
In today’s market, investors want “safety”
We’ve heard the comparisons of the current economic environment to the 1970s. From the high inflation and fears of low growth to a possible recession and energy crisis in Europe, feeling anxious is reasonable. So many investors are seeking safety.
Dividend-paying stocks may be the answer. While dividends are in no way guaranteed, decreasing them tends to be a lever of last resort for a company. And in this current environment, they’re stable while other return components appear to be shrinking.
That’s what happened during the 1970s too. Then, 73% of stocks' performance came from dividends.5 This is why investors seeking more consistent income and the ability to generate robust long-term returns are often attracted to dividends.
Source: Morningstar. *In the 2000s, the total return was negative and dividends provided 1.8% over the decade Performance is in USD.
Why not invest in bonds instead?
As we mentioned earlier, investors are looking for total returns, with some relying on the income generated from their investments to sustain their lifestyle. Dividends can provide income. So can coupon payments from bonds. But there’s a difference in how they are taxed.
Qualified dividends are taxed at 15% for many taxpayers and up to 23.8% for high earners. In contrast, bond yields are taxed as ordinary income. As a result, the current top rate of 37% on ordinary income is significantly higher than the capital gains rate for dividends. This favorable tax treatment gives dividends a leg up on bond coupon payments for taxable accounts.