Invested: The power of dividend growers in your investment portfolio

Myles Zyblock, Chief Investment Strategist of Scotia Global Asset Management – which manages over $200 billion* for millions of investors in Canada and around the world – shares his latest market and investing insights.

This month, Zyblock explores how dividends serve as a powerful indicator of a company’s financial health, reflecting its ability to generate stable earnings and to outperform its non-paying counterparts.

Dividends have been used for many years by management to distribute corporate profits to shareholders. From an investor’s standpoint, they have become an important part of portfolio construction as reinvested dividends can compound and account for a substantial portion of accumulated wealth over time. For investors such as retirees, these payments can also serve as a steady cash stream. The need for income is enough that modern practitioners have engineered methods to create synthetic dividends to meet this demand. These range from the simple sale of shares for cash to complex derivative strategies. Regardless of how it’s done, however, what’s most important to us is the reliability of current and future payments.

With this in mind, we believe the importance of an active dividend policy extends beyond the simple mechanism to return cash. It speaks to the quality of a company and its ability generate stable earnings. We found that companies that pay traditional dividends outperform those that do not. Furthermore, firms that raise dividends do even better. Looking at the fundamentals of these payers, particularly the growers, we found that they have more stable earnings, tighter earnings estimate dispersion, higher cash flow margin and superior return on equity.

It pays to pay

We found that companies that pay a dividend have higher compound annual growth rates compared to companies that do not. The margin is particularly wide for Canada and the overall international market. In the U.S., there is still a difference despite the stellar performance of non-paying growth biased firms over the past two decades.

Turning to return variability, payers also exhibit a lower standard deviation (a measure of a stock’s volatility). Without needing to do the math, higher return and lower volatility translates to a better return-to-risk ratio.

Dividend growers are even better

Among the payers, we found that firms that increase the dividend amount from the previous year have outperformed those that either reduced or left it unchanged. While the bump is often modest, the act of raising at all can be seen as a sign of strength. Management is confident the firm has the earnings potential to support it or a strong enough balance sheet with sufficient retained earnings to continue to pay during hard times. A well-managed company can have both robust earnings and a healthy balance sheet.

The return volatility of dividend growers is also lower compared to the other payers and certainly compared to the non-payers. Again, higher confidence around the sustainability of future dividends tends to compress the magnitude of short-term share price fluctuations.

A steady earnings stream is the base of a consistent dividend payer

A dividend can be declared only if there is sufficient profit in the current year or from the past (i.e., retained earnings). Management teams that are confident earnings will increase, or at least be sustainable in the future, are more likely to raise the payment. Similarly, potential investors seeking steady income should assess a firm’s ability to comfortably make those payments. That assessment starts with earnings analysis and consistent earnings power is what makes a dividend a going concern.

If we compare the aggregate earnings stream of dividend payers versus non-payers, we see that the former fluctuates less. When it comes to meeting a dividend policy, a steady and reliable earnings path is often favored over one with higher potential but more uncertainty.

A closer look at fundamentals

Dividend payers tend to be larger with a tighter dispersion of estimates and lower variability in historical earnings. Additionally, both return on equity and free cash flow margin are higher. These attributes support a firm’s ability to meet ongoing dividend obligations.

Growth-style factors such as high projected earnings growth and momentum are not as important for dividend payers and most will score lower on these factors.

Even higher quality found in dividend growers

Raising a dividend takes more confidence from management than maintaining one. Thus, we would expect dividend growers to have superior stability and reliability versus the non-growers. Indeed, dividend growers have even lower estimate dispersion, lower earnings volatility, higher return on equity and free cash flow margin compared to non-growers.

It is interesting that despite growing dividends these firms have slightly lower earnings growth projections on average. On top of that, they trade at a premium. Investors tend to pay more for higher growth potential but in this case the premium given to growers is based on something else. We believe that this type of investor cares more about consistent income and would pay more for a reliable and steady (or modestly increasing) earnings stream. 

Myles Zyblock is a recognized North American strategist, regarded for his investment insights that blend finance and psychology to capture major inflection points in financial markets. Myles has over 25 years of experience in guiding and advising on asset allocation for a diverse set of institutional and retail advisors globally. Myles joined the firm in 2013 as the Chief Investment Strategist, working closely with the Investment Team. His experience spans multiple asset classes and geographic regions.