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The Importance of Dividends And What To Look Out For

Here’s some interesting data for you compiled by my colleague Morgan Housel from the Motley Fool.

Back in 8 March 2011, the S&P 500 Index (a widely followed American stock market barometer) was at 1,319 points. Adjusted for inflation (i.e. in real terms) since 1871 however, and its value plummets to 74.35. That’s not a typo: the S&P 500 was at seventy four point three five points in real terms.

Now, here’s the kicker. The S&P 500, after adjusting for inflation and with dividends reinvested, stood at 38,531 points. That’s not a typo either: a dividend-and-inflation-adjusted S&P 500 was at thirty eight thousand, five hundred and thirty one points.

That’s the power of dividends and its impact over the long-term, as we’ve seen, is tremendous.

Of course, the ridiculously long time frame of 140 years had a huge role to play in widening the gap between the three different measures of the S&P 500. But, even with shortened time frames, the impacts are not trivial.

Using 1990 as a base and calculating the S&P’s value till 8 March 2011, the index’s real value was 759 without dividends. After reinvested dividends were added in, the S&P 500’s value moved up to 1,182.

So, simply said, dividends are vital for investors’ overall returns over the long run.

Fortunately, investors here in Singapore seem to have their eyes fixed on dividends based on my anecdotal observations.

I could be wrong but for now, let’s say I’m right and investors are indeed concerned with their dividends. That’s a good thing. But here’s the rub: their focus can be wrong. If the current dividend yield of a share is all that matters to them, then it can be a dangerous game to play.

In the same article written by Housel that I provided a link for in the first paragraph here, he also wrote about the differences in returns for four American companies when comparing two scenarios: one where dividends are reinvested and one without. His figures are tabulated below:

Company Return from late ‘60s to March 2011 Return from late ‘60s to March 2011 with dividends reinvested
Pfizer 4,200% 13,200%
Johnson & Johnson 9,700% 21,400%
Coca-Cola 4,700% 14,300%
Altria 10,800% 255,000%

The differences in the returns are striking. But what might not be obvious at all, is how Johnson & Johnson, Coca-Cola, and Altria have had virtually uninterrupted annual dividend increases since the late 1960s. Meanwhile, Pfizer’s no slouch either as it had a solid history of at  least 25 years of yearly dividend hikes that was broken only in 2009.

I don’t have hard numbers, but I highly doubt the differences between the reinvested-dividend and no-dividend returns would be that wide had those companies not been able to raise their pay-outs so regularly.

And this brings me to an important point about investing for dividends that I’ve mentioned earlier: the focus cannot be on a share’s yield alone.

A share’s yield tells us nothing about how reliable its dividends are in the future, nor can it tell us how capable a company is of growing those dividends.

For that, there are a multitude of factors investors can dig into, which includes the strength of a company’s balance sheet; the reliability of its cash flows; and the subjective gauge on whether there’s room for the company’s businesses to grow profitably without any high risk of serious competition encroaching on its territory.

In addition, a fixation on yields alone can also cause investors to miss the forest for the trees. Just take the example shown below for the three shares: SingTel (SGX: Z74), Super Group (SGX: S10), and Jardine Matheson Holdings (SGX: J36).

30 June 2007 18 Nov 2013
Company Price Dividends* Yield Back Then Dividends* Yield based on 1 Nov 2007’s cost basis
SingTel S$3.40 S$0.205 6% S$0.168 4.9%
Super Group S$0.97 S$0.016 1.6% S$0.071 7.3%
JMH US$23.80 US$0.50 2.1% US$1.35 5.7%
*Dividends are based on the annual pay-out for the last completed financial year on that date

Back then, Singapore’s telco giant SingTel was carrying a dividend yield of 6%. That’s really attractive when compared against the Straits Times Index’s (SGX: ^STI) average dividend yield of 3.7%  in 2007.

The problem though, is that SingTel’s dividends have since shrunk while the other two companies with yields that were initially unattractive have since grown their dividends to provide a superior yield-on-cost.

Foolish Bottom Line

I’ve admittedly cherry-picked my data for the local shares above, but it serves to bring home the point about how investors should also keep an eye out for other dividend-related factors other than a share’s yield.

Dividends are very important in the grand scheme of things when it comes to investor’s returns. But, if the focus isn’t right and investors are only chasing yields, then those high-yielding shares might well turn out to be duds in the long-run.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing owns shares in Super Group.