2) Dividend Growth Stocks Outperform the Stock Market over Time
While it may seem counter intuitive, companies that consistently pay and grow their dividends tend to outperform non-dividend stocks, further increasing the appeal of being a dividend growth investor.
The table below measures annual returns from 1972 through 2004 and shows that all dividend payers returned 10.1% per year, beating the S&P 500’s annualized return of 8.5%. To be fair, however, it’s true that this period was marked largely by falling interest rates since the early 1980s. This might have made dividend-paying stocks more attractive.
The chart below covers a much longer period of time, from the 1920s through the end of 2014. As you can see, dividend payers went on to meaningfully outperform non-payers.
How is that possible, when theoretically growth stocks are reinvesting all their earnings and cash flow back into their businesses?
The answer lies in long-term focused, conservative management. For example, a company like Facebook Inc (NASDAQ:FB), which is growing around 50% per year and is generating excellent 28% returns on invested capital, may seem like a much better choice than a boring dividend growth stock.
And for a while that may be true. But at some point Facebook Inc (NASDAQ:FB) is likely to reach a point where it’s scalable ad-focused business model reaches a point of saturation. Or to put it another way, they attract all the ad sales revenue that companies are willing to give it and struggle to find incremental growth opportunities.
At that point, the company will still be generating rivers of profits and free cash flow. But in order to grow? Well, management may have to look broader than its core business, the one that is generating those high returns on invested capital, for keep increasing revenue, earnings, and cash flow.
That kind of diversification can be a good thing, but it also poses a big risk because it can result in management making poor capital allocation decisions, such as making big splashy acquisitions that it might overpay for and end up writing down for huge losses later.
But a dividend growth stock? Especially one that has a solid long-term track record of growing its dividends over 10, 25, or even 50 consecutive years (the so called “dividend achievers”, “dividend aristocrats”, and “dividend kings”)?
Well such companies have not just proven themselves proprietors of stable and growing businesses over time, but management must also be more conservative, both with its balance sheet (how much debt they take on), as well as what growth investments it decides to make.
After all, if you are paying out 50% of profits or free cash flow to dividend-focused investors each year, then you have to be far more selective (i.e. careful), with what acquisitions or investments you make.
You can’t just throw money around because if you mess up, then you could put the dividend at risk, which could send the share price (stock options, and vested share grants make up the majority of executive compensation packages) cratering.
Simply put, a commitment to paying dividends places more discipline on management teams to invest in their highest-returning, most promising projects.
