Give Dividends Their Due, but Not Too Much
Wednesday December 15, 2:40 pm ET
By Charles L. Norton, RealMoney.com Contributor
RealMoney by TheStreet.com
Don't mail me any more proxies, please.
Tell me, incorporated tease,
Why don't you save the stamps and send,
Once in a while, a dividend?"
-- Margaret Fishback
Dividend investors, rejoice! More companies have increased their dividend this year than any year in nearly the past decade, and dividend-paying stocks have outperformed their nonpaying counterparts handily. However, a deeper look shows why it's wise not to make a radical adjustment to your allocations on this news.
First, some facts. According to data from Bloomberg, 833 companies in the Russell 3000, or 28%, have hiked their dividend in 2004. As the table below shows, that level of dividend increases hasn't been seen in recent years.
Last year's tax law changes that give more favorable tax treatment to dividends have been one reason that companies are returning more income to shareholders, and why investors are buying up shares of these dividend payers. Case in point: The average year-to-date return (excluding dividend income) of all the dividend-paying stocks in the Russell 3000 is 26% vs. the index's 9% gain over the same period.
Russell 3000 Dividend Increases
2004 is blowing away previous years.
Calendar Year Dividend Increases Percent of Index
2004 833 28%
2003 704 23%
2002 624 21%
2001 611 20%
2000 646 22%
1999 669 22%
1998 726 24%
1997 730 24%
1996 709 24%
Source: Bloomberg
And it's no wonder investors are using the reduction in the dividend tax rate to fall in love with income-producing stocks all over again.
Academic studies have found that a large portion of stocks' total return comes from dividends. Robert Arnott, editor of the widely respected Financial Analysts Journal, wrote last year that of the 7.9% long-term annual total return for equities, 5.0% is attributed to the return from dividends.
Just this week on RealMoney, Jim Cramer opined that the recent dividend increases are creating some real wealth for consumers that will eventually trickle, or flood, into the economy. He thinks the wealth-and-spend effect coming from these massive dividend increases can "impact the bottom line of the whole country."
One way for investors to gain access to a broadly diversified basket of high-dividend stocks is with the iShares Dow Select Dividend Index (NYSE:DVY - News). This index is a potpourri of banks, utilities and chemical companies and has an average dividend yield of 3.7%.
A bottom-up valuation of this index shows that it is roughly 13% undervalued. For this valuation analysis, I used the dividend discount model's theoretical value for each of the index's 50 members, applying the default assumptions from Bloomberg. I then compared this theoretical price for each stock to where it was currently trading, and multiplied this figure by the company's weight in the index. The sum of these weights shows that the index is currently undervalued by 13%.
No doubt, receiving that dividend check is rewarding, and thanks to the nature of compounding, all those little checks can grow into a nice little sum over time. But (of course, there's a "but") many of the market's biggest winners have never paid a dividend.
Just look at Microsoft (NasdaqNM:MSFT - News): Its stock gained 39,629% from its IPO before it declared its first dividend 18 years later. So limiting your investment choices only to stocks that pay large dividends may keep you from catching one of these supernova stocks with superb growth in sales, earnings and profitability.
Rather than pay a dividend, these fast-growing companies tend to reinvest their earnings in the business, allowing them to create new products, increase their sales force, or make strategic acquisitions. These efforts, in turn, further grow earnings.
All it takes is one big winner to make up for years and years of low-single-digit returns attributed to dividends. For example, the table below shows that the top 10 best-performing stocks in the Russell 3000 this year are up anywhere from 277% to a whopping 920%. None of these big winners pays a dividend, so if your investible universe was limited to only dividend payers, you'd miss a huge opportunity in catching a part of a triple-digit move.
With the dividend yield of the DVY exchange traded fund at around 3.7% -- and that's an annual yield figure -- it would only take a very small move in one of these big winners to more than make up the yield missed from an income-producing stock.
Russell 3000 Year to Date
The best-performing stocks in Russell 3000 don't pay dividends.
Company Symbol YTD Return Dividend Yield
Travelzoo TZOO 920% 0%
W.R. Grace GRA 424% 0%
Cheniere Energy LNG 356% 0%
Jupitermedia JUPM 338% 0%
Kmart Holding KMRT 330% 0%
Danielson Holding DHC 309% 0%
Taser Intl TASR 297% 0%
Hansen Natural HANS 294% 0%
PalmOne PLMO 279% 0%
Overstock.com OSTK 277% 0%
Source: Bloomberg
You'd have to go all the way down to the 17th best performer in the index, Chicago Mercantile (NYSE:CME - News), before you'd find a dividend payer, and only seven companies in the top 50 best-performing stocks pay a dividend.
So while dividends are a significant source of wealth creation over the long term, from my vantage point it's more important not to limit your investment choices only to stocks that pay a dividend. You'd be missing your chance at some stellar returns from companies with strong sales, earnings and profitability that don't pay one.
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