Dividend stocks: What investors need to know

Dividend stocks have become an indispensable part of many investors’ portfolios. However, the differences between dividend stocks can be considerable. Systematic sector and individual stock selection as part of active management quickly separates the wheat from the chaff. The differences between the best and worst performing company within an index or sector and within just one calendar year can be up to 60 and 70 %. In exceptional cases, the difference can even exceed 100 %.

The level of dividends in relation to the earnings and cash flows generated is another important selection criterion for stocks. If companies in the S&P 500 Index since 1930 are divided into quintiles based on their dividend yields, considerable differences also become apparent. For example, the companies in the first quintile have paid out the highest absolute dividends. However, the dividend payers with the highest payouts do not turn out to be the best performers over the long term. On the contrary, the stocks in the second quintile often show a historically better performance than those in the first quintile. The highest payouts are therefore not the “best” in the long run.

A possible explanation for this phenomenon lies in the payout ratio, i. e. the share of dividends paid in the actual profit of the companies. While this value was 70 % for the companies from the first quintile, the companies from the second quintile paid out only 40 % of the profit as dividends. The conclusion is that the companies from the first quintile probably distributed too much of the profit. This has had an impact on long-term performance, as the capital distributed to shareholders was then lacking to develop the companies further. Investors should therefore make sure that the dividend payouts of their favoured companies are not at the expense of expansion plans, growth or innovative capacity.

Finding the “golden mean”

Consequently, when choosing dividend stocks, investors should pay attention to the relationship between the level of the dividend yield and the performance of the companies. Within the universe of the MSCI World Index, companies with median dividend yields of 2% to 4% and 4% to 6% often outperform companies that pay high (more than 6%) or very low (0% to 2%) dividend yields over the long term.

The actual decision of companies whether to pay dividends and whether to increase or reduce their dividend payments also influences performance in the long run. The connection between the attribute “reliable dividend payer with regular increases” and long-term performance is evident.

Share buyback returns are also indispensable for an overall view of returns to shareholders. In relation to the S&P 500, these share buyback yields are higher than dividend yields in many sectors (for example, financials and industrials). On a 20-year average, this even applies to many other sectors. In the same time span, the historical share buyback yield for the entire S&P 500 index of 1.7% is almost as high as the historical dividend yield of 2.1%. However, it should not be forgotten that share buyback yields in individual sectors can also be negative, as is currently the case in the real estate sector, for example.

In summary, steady and reliable dividend stocks can be identified on the basis of clearly defined criteria. Ideally, the payout ratio should be between 40% and 60%, i. e. neither too high nor too low. It is also important that dividend payments are covered by free cash flow. Reinvested dividends ensure a sustainable increase in value and can contribute significantly to the overall value development of the portfolio.

In this sense, the fund management team of the DJE Zins & Dividende (PA) fund relies on the established DJE dividend strategy, as dividends can make a strong contribution to performance over time due to the compound interest effect. Long-term analyses show that only around half of the gains are based on price increases. The other half is due to dividends. The fund management pays attention to recurring dividend payments as well as investor-friendly corporate policy with capital returns and share buybacks (total shareholder return). Stock selection aims for an above-average dividend yield when compared to the broader equity market.