It's easy to see why stock dividends draw investors. Dividends are much more reliable than gains in stocks prices. Companies commit to paying a quarterly dividend and work hard to follow through on the commitment. Investors like that steady, near-term dependability.
If dividends are good, are higher dividends better? Not necessarily. To build a solid investment strategy, it might be better to put dividends in the context of overall income.
Companies reward shareholders in many ways besides dividends.
Share repurchases are an example. Repurchases have the effect of lifting income per share. A repurchase reduces a company's outstanding shares. Afterward, if a firm pays the same amount of money as dividends, the dollar amount per share is higher. In fact, repeated rounds of buybacks can mean increasing dividend income for shareholders, even if a company continues to pay out the same amount in dividends. Such companies can become income growers — possibly even more attractive to investors than companies that pay high dividends.
Since the 1990s, companies have increasingly rewarded shareholders more by repurchasing shares than paying larger dividends. Among large companies in the Russell 1000 Index, dividend yields have declined, but total yields — dividends and stock repurchases — have increased.
Share buybacks have grown over the past three decades
Average yields for companies in the Russell 1000 Index
Source: Putnam.The values in the total yield column may not sum due to rounding.
Aside from dividends and repurchases, companies can also reinvest for growth. This might seem unattractive to investors looking for dividends. But to maintain a long-term dividend policy, companies need to keep their earnings strong.
Taking all of that into account, forming an investment strategy that seeks income from stock investments is not as simple as finding the highest dividend yields.
What a dividend communicates
A dividend is best understood as what the company intends to pay investors. It's an important signal to the market. But, it's not an obligation, like a required payment on a company's debt. A firm can cut or suspend its dividend at will. Doing so wouldn't violate a contract. It wouldn't be considered a default. But it would be bad for the stock price, almost always.
Seeing the big picture on income
Sometimes a firm aims too high, hoping to pay a big dividend to keep investors interested in their stock. Discerning whether a dividend is too high takes skill and research. "If you look closely at the numbers, you can gain confidence that the dividend is solid — and might even grow," says Lauren DeMore, CFA, a Portfolio Manager for Putnam's Large Cap Value strategies who evaluates companies daily, looking for multiple dimensions of value. "Or, you can have doubts and walk away."
Walking away means you can avoid disappointments — a pitfall for dividend investors. In fact, companies intending to pay the highest dividends are more prone to disappointment, DeMore says, describing some findings in Putnam's research. "If you rank big companies by their dividend plans, you find that the firms in the top 10% have the highest share of letdowns."
"The better place to be is in the middle," DeMore adds. "We find that companies that are in the middle are in a pretty good position to increase their dividends."
Darren Jaroch, CFA, who manages two strategies at Putnam working alongside DeMore, sums it up as dividend power: "A company that has dividend upside, because it is managing itself for future growth and thinking creatively about share buybacks, gives us the consistency and dependability we want."
Darren A. Jaroch, CFA
Lauren B. DeMore, CFA
Active investors evaluate dividends in a framework for understanding a company's overall financial picture. This involves understanding a company's finances as well as how its executive leadership stewards company cash. For some firms, paying out dividends might make sense. But others might be better off reinvesting to either defend or grow their business.
An experienced investor with an understanding of a firm's overall operations and its industry is in a great position to compare companies' intentions and their ability to sustain their dividends.
A little art, a little science
To pursue income from stocks, consider three things: the proportion of a company's income used to pay dividends now, a company's investments to make future dividends viable, and a company's plans to repurchase shares. Companies in a position to be income growers for shareholders may be the most attractive. Casting a net for income growers can snag companies with more robust growth profiles in terms of earnings and revenue.
Income growers had better growth characteristics than dividend yielders
Average income, earnings, and revenue growth, 1990–2021
Source: Putnam. Income growers are stocks in the Russell 1000 Index that rank in the top 50% for five-year total income growth and profitability, and that pay annual dividends above a rate of 0.25%. The high-dividend yielders are stocks in the Russell 1000 Index that rank in the top 25% for dividend yield. Income growth includes both dividends and stock buybacks.
For informational purposes only. Not an investment recommendation.
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