May 02, 2019 Equities

Five things investors should know about dividends

Dividend stocks can be a key driver of long-term investment success. However, investors should consider a wide range of factors to select the right stocks.

  • Alongside price appreciation, dividends make a significant contribution to stocks’ performance – but their long-term effect is often underestimated.
  • Studies show that dividend-paying stocks can bring stability to a portfolio, especially when prices are fluctuating.
  • However, in certain circumstances, a high dividend yield can be a sign of weakness, for instance after a sudden price slide. Investors should therefore never rely on just one indicator when selecting stocks but should also consider other criteria.
4 min to read
The hunt for dividends is underway. According to a study by the Deutsche Schutzvereinigung für Wertpapierbesitz (German Association for the Protection of Security Holdings, DSW), German companies plan to distribute more than 57 billion euros to their shareholders this year. That represents growth of 6.6 percent on the previous year, according to Manager Magazine[1].

But what should shareholders consider when selecting dividend-paying stocks? And what role do these stocks play in a portfolio’s long-term success? We summarise the five most important points.

Dividends have contributed significantly to the Dax’s positive performance in the past decade.

1. Dividends can be a key driver of long-term investment success

Investors often underestimate the long-term effects of dividends on a portfolio’s success. A look at the German benchmark index, the DAX, provides a clear idea of dividends’ potential influence on performance.

The DAX is normally portrayed as a performance index. It is assumed that the dividends companies pay out to their shareholders are not withdrawn but immediately reinvested in new shares. The DAX therefore shows the performance of Germany’s 30 largest companies including the amounts they have paid out in dividends to their shareholders year on year.

However, if we calculate the index by looking only at share price performance, a different picture emerges. The appreciation of the so-called DAX price index in the past ten years was only about half as much as that of the performance index. This shows that the Dax’s overall positive performance in the past decade was not just down to share price performance but also to a large extent to dividends.

This is due to the compound interest effect. Reinvested dividends make an additional contribution to portfolio appreciation  in subsequent years. And the longer an investor pursues this strategy, the greater the appreciation can be.

Stocks associated with constant or rising dividends over many years can bring stability to a portfolio in uncertain times.

2. Dividend-paying stocks can bring stability to a portfolio in uncertain times

Studies also show that companies that distribute constant or growing dividends over many years can bring stability to a portfolio when prices are fluctuating. The dividend-paying shares are comparatively less volatile and appear to cope better in challenging economic times.

According to Thomas Schüßler, global co-head of equities at DWS, it is therefore no surprise that high-dividend stocks seem to be back in favour with investors since the market correction that started in early October 2018. Schüßler manages DWS Top Dividende, a popular retail fund with 19 billion euros under management, and is convinced that dividend-paying stocks should play an important role in the portfolio in an uncertain environment.

"Conservatively managed dividend funds can help to cushion losses during a market correction and can therefore ease investor nerves in highly volatile market phases," he says.

3. Dividends are not the "new interest" – but an alternative in a low-interest environment

Dividends are sometimes called the "new interest". And dividend returns of two percent or more do indeed look tempting at first glance – especially when compared with the interest that can currently be earned on the money markets or even with good-quality bonds.

"The comparison is flawed, though," says DWS equity expert Schüßler. "It's true that dividend stocks can help to mitigate the low-interest rate environment – but they cannot be equated with bonds. Price risk remains, and investors must take that into account in their calculations."

The reason is simple: bond buyers transfer outside capital to the issuing company or state for a limited time. In return, they receive regular interest payments but they do not participate in profits and losses. By contrast, purchasers of shares in a company provide it with equity capital – and therefore become shareholders. Investors then benefit from profits in good times but also participate in losses if the company gets into economic difficulties.

"Dividends can be an attractive source of income,” says Schüßler. “If you want to earn a decent return these days, you simply cannot avoid taking a certain degree of risk."

Dividend stocks may be a good opportunity for investors in a low interest rate environment but they cannot be equated with comparatively safe bonds.

When selecting stocks, investors should not just look at the dividend yield but also consider other key figures.

4. Sound analysis essential when selecting dividend-paying stocks

A high dividend yield sounds tempting at first – but should never be an investor’s sole selection criterion. The dividend yield is determined by dividing the dividend per share by the share price and multiplying by 100. This shows that a high value does not necessarily mean greater shareholder participation in net profits (higher dividends); it could also be the result of a slump.

Shareholders should therefore consider other indicators and try to evaluate a company’s overall economic situation. Sound analysis will also look at the question of how dividends are financed. It is important that they are more than covered by the company’s profits, so that it still has enough capital for potential (re-)investments. Dividends should also grow over time, because only a fundamentally sound company is in a position to pay and consistently increase dividends over the long term.

5. Shares usually offset dividend payouts relatively quickly

For investors to be entitled to dividends from a German company, they must buy shares no later than the day of the AGM. The share price is adjusted to reflect the dividends paid on the so-called "ex-dividend day". Consequently, cash holdings and the company’s value are reduced by the amount distributed. Dividends sometimes are not distributed until a few days later, but no later than the third working day after the decision at the AGM.

Shares often recover the dividend payout relatively rapidly – but there is no guarantee of this. A look back at history shows that, on average, DAX shares close the gap within two months' trading. Above all, trendsetting stocks – that is shares that have developed particularly positively in the past – have historically compensated for dividend payouts comparatively quickly. Investors who want to minimise the risk to the existing price should diversify their portfolio over a range of equities.

To diversify the portfolio even more widely, it can be worth looking beyond Germany. US corporations, for example, pay shareholder dividends not just once a year, but quarterly. This means investors can have the chance of attractive regular returns in summer, autumn and winter, as well as spring.

This article was translated from German.

After the dividend payout, a share‘s price falls, but the ex-dividend markdown can usually be regained relatively quickly.

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