I argue that the reality of price volatility, liquidity, and public temperament in the stock market is an argument
for dividend equity, not against. For it is the equity investors who have removed themselves from cash flow considerations who have the most to lose from price volatility. At the heart of this point is, well, math. If one is aiming for a 10% annualized return (to use a purely illustrative hypothetical), and the plan is to get 5% of it in dividend income and 5% in price growth, versus another aiming for 10% but with 1% in dividend income and 9% in price growth, the impact of downside volatility is not equally felt even if the 10% return ends up being averaged over time. A 5% dividend yield does not become -10% at times and +15% at others.
The yield is what it is, and properly managed does not go down at all,
but certainly never goes below 0%. You never have to pay the dividend to the company; it only pays it to you. But price appreciation, on the other hand, only comes from “up and down” volatility.
A stock portfolio or index that averages 10% per year rarely is actually up +10%. Rather, it may be down -20% in some years but up +30% in others (and plenty of other variances in between). The portion of a return coming from price appreciation is
by definition subject to more price volatility than a portion of the return that cannot mathematically go below 0%. Therefore, the volatility of two strategies pursuing 10% where one seeks to get half of the return via dividends, and one is content for just a 1‒2% dividend yield are categorically different.
But no matter what you have been taught, risk and volatility are not the same thing. The variance of a return around its mean is emotionally real, and in the context of a real-life withdrawal strategy, mathematically real (more below). But up and down price movements are not the same thing as the permanent erosion of capital. However, if one’s portfolio strategy requires a compounding annual growth rate that proves to be far above reality because of valuations or because prices drop and never recover, those are not volatility concerns—they are risk concerns. Real risk. Existential risk. And it is that risk that dividend growth seeks to eliminate.
First of all, valuation concerns… The market’s price-to-earnings ratio is high right now—very high. Any number of fiscal, monetary, or geopolitical developments could collapse that P/E substantially. The market has not priced in the very real possibility that:
- The structural growth rate of the economy has been altered by excessive government spending, and
- The monetary medicine in the next decade will be less efficacious than the last decade.
I do not view either of those contentions as even remotely debatable. The 2010‒2020 decade saw significant earnings recovery post-GFC, but also monetary policy facilitating reflation that boosted multiples (and then some).
I believe holding a high multiple will be impossible in the aftermath of what the economy faces. Going from $1 trillion to $20 trillion of debt happened without much structural impediment and with significant monetary facilitation. Getting to $30 trillion fed a lot of mal-investment, created excessive leverage, and further entrenched the economy’s dependence on something fundamentally unsustainable—namely a stimulative effect on monetary policy whose stimulative effects can only diminish over time.
Though the analogy is crude and uncomfortable, the high a drug addict gets from the initial stage of their addiction becomes less enjoyable over time. And worse, it requires more and more intake to get less and less of a high. The fiscal and monetary treatments we have used and will, no doubt, continue trying to use are in the “diminishing return” phase. Multiples may hold at a historical level (this would be an optimistic base case), but they are at a big premium to historical levels already, and require significant expansion, still, to achieve that aforementioned historical return.
Dividend growth equities, on the other hand, require less speculation than “growth stocks,” feature less frothy valuations, and offer return strategies far more connected to fundamentally knowable and repeatable phenomena than simple valuation growth. Where free cash flow is growing, and a company has a past, present, and future inclination to liberally share that free cash flow at an ever-growing rate with its owners, the impact of valuation volatility is muted. A company trading at 17X earnings is less exposed to a reversion to 16X than a company trading at 22X. And better still, a company paying 4‒5% in yield has less price appreciation need to get to an 8‒10% return than a company paying 0‒2%.
All of this is self-evidently true. Less self-evident is the inherent truth about the maturity of a company that can pay an attractive dividend and grow it from 6‒9% per year for year after year and decade after decade. These companies may be past a hockey-stick level of growth that requires very fortunate entry timing and even more fortunate exit timing, but they have achieved a scale, brand, balance sheet, and marketplace position (it can often be called a moat) that makes them superior companies. In other words, the capacity for such a dividend and such repeatable dividend growth is not merely the strength of an investment, but it is
evidence of the strength of the company. It both presents and reflects a superior investment proposition at the same time.
What are the characteristics of a company that can grow its cash flow this reliably, and achieve the balance sheet strength, competitive positioning, and operating consistency necessary to be a perpetual dividend grower? Well, for one thing, it had better offer goods and/or services that are consistently needed. In other words, an apparel company making a hot line of clothing for 16-year-old girls is wise to hang tight on dividend payments, knowing that next year 16-year-olds might possibly change their minds (just a hunch). But a consumer staples company that makes toilet paper or diapers or dish soap or soda pop or bottled water (or, maybe, all of the above!) might just have a more defensive business model. In a given part of the cycle, that 16-year-old girls’ clothing might print money compared to the consumer staple, but one leads to decades of dividend growth with good and sober management; the other might lead to Chapter 11 once the new school year starts.
There are many examples of companies that traffic in goods and services which are less subject to disruption or changing fads and preferences. Utilities, Health Care, Energy, financial advice, basic technology hardware and infrastructure, Real Estate, and many other sectors in commercial society offer opportunities for market leadership, profit generation, and consistency of results (with ongoing innovation) that lends itself to dependable cash flows.
And that is the story of the defense of a good dividend growth strategy—that it represents the best and finest exposure to the components of commercial society not prone to being blown over by the winds of cyclicality. Fiscal and monetary and geopolitical risk will still exist, and they will play out how they are going to play out. A remnant of companies will continue to generate profits (capitalism works), and they will continue to share those profits with us.
Another segment of companies will only monetize for investors if they time their entry well, time their exit well, and survive the vulnerabilities of policy error, policy distortion, and other macro events. They are exposed to hope, not strategy, unless that strategy is mere multiple expansion. It is an economic risk but also basic mathematical risk that exceeds logic and prudence.
The environment in which we find ourselves is screaming for reasonable valuation, a buffer of safety, a consistency of operating results, and a management team aligned with shareholders enough to share profits with them. In this environment the path to returns that can be “eaten”—truly received and made efficacious—is in dividend growth.