Wednesday, October 16, 2013

So Goes the Dividend, So Goes the Stock

The Government shutdown and looming default deadline are consuming the majority of headlines.  Our stance remains unchanged: we believe U.S. politicians will eventually reach a deal.  For more details, you can read last week’s article here.

Rather than join the ongoing government shutdown discussion, we want to take a step out of the short-term gloom-and-doom to look at what impacts long-term stock market growth or decline: earnings and dividends.

Our statistical models show dividends to be a highly significant predictor of long-term stock prices.  The chart below shows the basic correlation between nominal dividends paid and the S&P 500 index price over the past 20 years.

Commitment to the Dividend

Investors are placing a premium on stocks with a commitment to paying a dividend.  Companies are taking notice.  Out of the 500 companies in the Standard & Poors Index, 415 now pay a dividend to shareholders.  That is up from the previous 13-year record high of 405. 

Not only are more companies paying a dividend, but the majority has shown a commitment to growing that dividend each year.  Over the past 12 months, only 12 companies lowered their dividend.  A minority of 49 maintained them at the same level, while an overwhelming 339 raised their dividends. 

These dividend increases have been significant.  The 12-month dividend growth rate for the S&P 500 is 17.8%.  Analysts estimate that over the next 3-5 years, the dividend growth rate will be nearly 9% per year.

Dividend Increases to Continue

We expect companies to continue increasing dividends over the long-term.  Here’s why:

(1) Improving Global Economy

While the United States’ economy still muddles along, the global economy continues to improve.  China has been slowing less-than-expected and Europe has pulled out of its recession.  Many of the S&P 500 index companies have a great deal of international exposure.  As earnings grow along with the global economy, companies will have more cash available to pass along to shareholders in the form of rising dividends.

(2) Historically Low Payout Ratio

Since 1960, the average dividend payout ratio (dividends paid out divided by earnings) for the S&P 500 has been 50%.  After bottoming in 1999 at 27%, the payout ratio has been steadily increasing.  Today, the dividend payout ratio for S&P 500 is at 33.8%.  As companies return to more historic dividend payout levels, dividend growth will continue to outpace earnings growth for years to come.  

(3) Increasing Importance of the Dividend

Corporations are aware that investors are increasingly looking for dividend-paying stocks.  The continued low-interest rate environment has driven income investors out of fixed income and into stocks.  The S&P 500’s current yield of 2.1% growing at an estimated 9% (meaning it would double in 8 years) looks attractive, especially when compared the 10-year U.S. Treasury yielding 2.7% growing at 0%.

Dividends to Drive the Market Higher

The commitment to increasing dividends is a very positive indicator moving forward.  Despite the sluggish economy and fiscal headwinds, nearly 82% of dividend-paying companies increased their dividends over the past 12 months.  The Board of Directors do not set dividends higher unless they are confident in their own companies’ ability to pay it out to investors.  Dividends indicate overall business confidence in the economy looking into the future.

The uncertainty in Washington has made it clearer that the Fed will continue to stimulate the economy by keeping interest rates low.  When the debt ceiling and default debates in Washington are solved, we expect the overall market to move higher.  The long-term low interest rate environment will continue to drive investors into stocks – particularly those paying consistently growing dividends.  There isn’t anywhere else to go.