Dividends of a particular type?
I’ve written a number of blog posts on generating retirement income, and have also dug a little more deeply into using stock dividends as part of your cash flow. In this post I’ll do two things. First, I’ll remind you of the background to generating retirement income, so you won’t have to look at all those previous posts. And second, I’ll do a deeper dive into whether some types of dividends (or dividends from some types of companies) might form a particularly useful base for your cash flow.
You know, of course, that my goal is simply to give you interesting ideas to think about, not to give you investment advice, which I never do. So you’ll also recognize that this post is about an appealing approach, but I don’t have a deep dive into statistical analysis to back it up numerically.
Let’s start with the background.
Post #67 told us that happiness comes from certainty about not outliving our assets. In fact, the fear of uncertainty is virtually hard-wired into us, which is why surveys show that this is our biggest financial fear in retirement. So, finding a way to cope with unexpected longevity is an essential part of retirement financial planning.
But (as Post #68 said) we have two other financial goals: safety and growth. And they are at opposite ends of the investment spectrum. In fact, Jan Tinbergen, who in 1969 became the first person to win the new Nobel Prize in Economics, reminded us that ideally each distinct goal should have its own instrument: that’s much more efficient than trying to use a single instrument to partially satisfy two or more goals. And that means that generating safe cash flow becomes a goal in its own right.
How? Well, you can keep a safety reserve large enough to give you some years of desired cash flow. But you can also generate at least some of your desired cash flow stream from the dividends paid by stocks, and that reduces the size of the required safety reserve.
Post #75 looked at how reliable an income stream you can get from stock dividends. And we found that the stock dividend stream is (or, more accurately, has historically been – there’s never a guarantee that the future will be like the past) reliable enough to be an important source of that safety income stream.
Remember that dividends are essentially how profits made by companies are repaid to their investors. In fact it’s not quite as straightforward as simply paying back the profits. There are three things that companies tend to do with their profits: pay some of the profits back, as dividends; retain some, to finance new ventures in the future; and the catch-all, retain some as a contingency reserve. A reserve for what? For the two other purposes. There may be unexpected new venture opportunities, and it’s convenient for a company to have money on hand and not have to go back to its shareholders for more. And a reserve for years when the profits are lower than the last dividend payment, so that the dividend amount can be maintained even if profits are low or negative.
Investors like that last feature very much. In fact, since we are hard-wired to like certainty, stocks with reliable dividend streams tend to sell for a higher price (other things being equal) than stocks with volatile dividend streams. And therefore companies (other than, for example, those describing themselves or behaving as “pure growth” companies) like keeping their dividends level or increasing.
It’s a fine balance between paying out such a high dividend that its maintenance is imperiled and paying out such a low dividend that a higher stream could be sustainable. So it’s not surprising to find that, from time to time, dividends are cut. But for a country’s stock index, representing a collection of its companies, somewhat greater stability is built into the dividend stream, because it tends to fall only when something negatively affects the economy of the whole country rather than a particular industry.
Using the best available data series (based on the US S&P 500 stock index), one that includes the negative effects of the Great Depression, I discovered a number of useful things.
First, the dividends have impressive growth over time, averaging roughly 2% a year higher than inflation. Compare that with the average Treasury bill real (that is, after inflation) return of 0.5%, and it looks good.
How about its volatility?
The annualized standard deviation of the dividend return series is 10.7%. That compares with 3.9% for T-bills, so real dividend growth is less stable than T-bill returns.
Well, if it’s not stable, let’s ask: how often is the real growth rate positive?
Answer: 63% of the years showed growth in real dividends, compared with 61% for positive real T-Bill returns. Extending the time horizon to 5 years or 10 years doesn’t improve the history of T-bill positive real returns, both producing around the same 60% outcome. But with the dividend stream for equities, extending the time horizon to 5 years shows that 69% of the time real dividend growth was positive, and periods of 10 consecutive years showed positive average growth 81% of the time.
Overall, then, the S&P 500 index has historically produced a dividend stream that is somewhat better and more reliable, in terms of real return, than an investment in T-bills.
One more question: how large a dividend yield is reliable? For this I looked at the real dividend each year and checked what was the biggest drop. Answer: over one-year periods, the biggest drop was 34%. Over 5-year periods, the biggest drop was 11%. And it was 4% over 10-year periods.
My interpretation of the one-year number is that, if you had started with two-thirds of the current dividend at any time, you could essentially have taken that amount as sustainable in real terms.
If you can create your own volatility reserve (as discussed in Post #71 [link]) for 5-to-10 year periods to cushion the one-year impact within those periods, then roughly 90-95% of the dividend yield has been sustainable, at least historically.
Right. That’s in the past, as far as my blog posts are concerned.
Now this post’s topic: are dividends from some companies in some way preferable to dividends from other companies? (And my thanks to my long-time friend Keith Ambachtsheer for the ideas he conveyed to me in correspondence on the subject last year.)
In fact, with Keith I started with an even more basic question. Given that a dividend payment simply reduces the value of the company by the amount of the dividend, why bother with dividends rather than just selling company shares to generate whatever cash you need? Answer: selling shares generates transaction costs, which receiving a dividend does not. (There’s a more complex additional answer, but never mind: the point is made.)
OK, then, are there particular (types of) companies that you’d rather hold? Answer: yes. In fact, Keith credits Bartley Madden with developing the life-cycle theory of companies, in Madden’s book Value Creation Principles. Madden shows that there are potentially four phases in the life-cycle. Actually, Keith identified for me, off the top of his head, a three-phase explanation that I understood right away:
- Young companies use capital to eventually become profitable. Some don’t make it, many do, with a few becoming spectacularly successful.
- Successful middle-aged companies are profitable and must decide how much to reinvest and how much to return to shareholders, either as dividends or via share buy-backs.
- Ageing companies have limited reinvestment opportunities and should be returning all profits to shareholders (which they seldom do).
From that spectrum (which is entirely consistent with the explanation of dividends and cash needed for reinvestment, in my Blog Post #75 cited earlier), Keith is most comfortable with successful middle-aged companies with a demonstrated willingness to pay out cash they don’t need in the form of dividends.
That seems to me to be clearly expressed as well as sensible.
And that’s why I’m bringing you his notion that, if you’re using or planning to use dividend cash flow to satisfy some part of your safety goal, it potentially makes a difference which companies you include.
Actually, Keith goes further. He reminds me that Keynes, in his 1936 opus The General Theory of Employment, Interest and Money and in his work at the Bretton Woods Conference in 1944, showed how to prevent future Depressions and put the financial infrastructure in place to do so – which, Keith believes, reveals itself in lower economic and dividend volatilities post-WW2 than pre-WW2.
He also expects that that middle tier of companies will experience less volatility than the stock market as a whole, as the middle tier excludes high-volatility zero-dividend “growth” companies as well as high-volatility resource companies. His own portfolio, he tells me, reflects this experience.
A question arises naturally as a consequence of limiting your stock/growth-seeking portfolio to something smaller than the entire stock market: are you then increasing the risk of this portion of your assets, either with increased short-term volatility or by not reacting to events in the same way that the entire market portfolio would?
There’s a simple way to at least apply a test of history, even though (as always) we know that history is no guarantee of similar future behavior. Compare the historical volatilities of your limited portfolio and of the market portfolio (as Keith, as we have seen, has done). And measure their historical correlation. If the volatilities are close together, or tilted in favor of your portfolio, and their correlation coefficient is close to +1, that’s as good as history gets.
We’ve known that a stock dividend stream has an important use as a source of investment safety. Now we can identify a particular subset of companies as having the desirable characteristic of being successful middle-aged companies with a demonstrated willingness to pay out, as dividends, cash they don’t need for reinvestment.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.
Thanks again Don for another thoughtful piece. I looked at some data from an Australian perspective a while ago and came to a similar conclusion. There were only two decadal periods during the last century in which dividends did not keep pace with inflation: immediately after WWII when rationing led to high prices and during the oil price shock of the 1970s. Over the full century dividends (without reinvestment) grew significantly more than inflation.
On your question “Given that a dividend payment simply reduces the value of the company by the amount of the dividend, why bother with dividends rather than just selling company shares to generate whatever cash you need?” I agree with the comment on transaction costs but, as you state, it is more complicated. A company that never pays a dividend will be valued at a multiple of earnings that itself will fluctuate over time. Relying on the abilty to sell a share in order to generate an income in retirement reduces the security of that income.
Thanks, David, for the Australian perspective — I’m glad it confirms the findings I mentioned. Thanks also for that angle on those companies — you’ve identified an important difference in the perspectives of companies that pay dividends and companies that don’t.
Thanks to you and Keith. I’ve often wondered about this but never explored it.
Thanks, Ted, I’ll let Keith know.
Don, another insightful piece on generating income.
There is another Australian perspective to note here with the commencement of the retirement income covenant from 1 July 2022. Super funds will have to maximise ‘retirement income’ for their retired members. This includes the draw down of capital.
Dividends can produce a steady stream of growing income, but unless the capital is consumed the money available to the retiree won’t be maximised. Very few retirees can actually afford to run an endowment approach where all their capital can be left to the next generation. Companies generally are perpetual entities so they won’t return your capital. For retirees, who don’t live forever, even the index is (pinching your words): ” paying out such a low dividend that a higher stream could be sustainable”.
Dividends might deliver growth and safety but on their own they don’t maximise what a retiree can spend. For that you need a way to efficiently turn capital into cash flow.
Thanks, Aaron. Excellent comments, nicely summed up in the final sentence. I recall seeing an Australian report that 90% of retirement assets are left at death. I’ll bet it’s a similar story everywhere, it’s just that Australia is tackling it now.