Grace Groner was born in 1909 in Illinois and became an orphan at the age of 12. She attended Lake Forest College and, upon graduation, took a job at Abbott Laboratories, where she would work as a secretary for 43 years. She never married or had children.
By all accounts, Groner had few needs. She walked rather than own a car, bought her clothes at rummage sales, and lived in a small cottage that she inherited.
When she died in 2010 at the age of 100, she left behind an estate in excess of seven million dollars!
Prior to her death, Groner quietly established a foundation for Lake Forrest College, which is expected to generate $300,000 per year for scholarships, helping countless students in perpetuity.
When her incredible posthumous gift was revealed, she became something of a media sensation. How did this frugal, unassuming secretary accumulate such impressive wealth?
Groner had purchased three $60 shares of Abbott Laboratories stock in 1935. She never sold the shares, which had split many times over the years, and wisely reinvested her dividends. Her initial purchase, paired with heaps of discipline, grew into a fortune which will benefit deserving students forever.
It’s fun to talk about the winning stocks we’ve bought. Buy a stock at $10 per share and watch it grow to $100. They call that a Ten Bagger! True capital appreciation!!!
But rarely do you hear anyone bragging about the cash flow their portfolio produces from stock dividends.
Compounding Dividends
Reinvested dividends have constituted a significant portion of the market’s compounded returns over time. A reinvested dividend is the essence of compounding because instead of taking your dividend in cash and spending it, you use it to purchase additional shares of the same company or fund. The next time dividends are paid, you receive a dividend on the original shares plus a dividend on the new shares which you reinvested, and so on.
A $10,000 investment in the S&P 500 index in 1960 would have grown to $4,949,663 by the end of 2021, assuming all dividend payments were reinvested. If you were to exclude dividends, that $10,000 investment only grew to $795,000. Thus 84% of the total return of the S&P 500 index over that period came from the compounding power of reinvested dividends.
Dividend paying companies offer two potential ways to earn returns: dividend income and capital appreciation.
What is a Dividend?
A dividend is the distribution of a company's earnings to its shareholders. Dividends are determined by a company’s board of directors and are often distributed quarterly. They are commonly paid out as cash but can also come in the form of reinvestment in additional stock.
Dividends are generally paid by established companies with consistent cash flow. In contrast, growth-oriented companies typically reinvest their earnings into innovation, business expansion, and operational efficiencies.
The dividend yield of a stock is the dividend per share divided by the current stock price.
For instance, Apple currently pays a dividend (annualized) of $0.92 per share. Apple’s current price per share is about $170.00, so the current dividend yield is 0.54%. Exxon Mobile is currently paying $3.52 per share in dividends (annualized) with a current share price of roughly $92.00. That equates to a dividend yield of 3.83%.1
The current dividend yield of the S&P 500 index is 1.50% and has a historical average of 4.28%.2
Dividends’ contribution to total returns has varied by decade and yields have moderated since the 1990s.
There are three main reasons for this. The first is Federal Reserve intervention. Starting with Federal Reserve Chair Alan Greenspan in 1987, the Fed began responding to economic downturns by sharply dropping interest rates. This injected cheap capital into stocks, increasing share prices and reducing dividend yields.
The second is the rise in technology companies. Tech stocks have historically produced very little dividends, instead choosing to reinvest earnings to power growth. And grow they have, as the tech sector now makes up 28% of the overall market.3
And third, there has been a structural shift in corporate payout policy toward share repurchases, also known as stock buybacks. Instead of (or in addition to) paying a dividend, a company board can choose to use a profit distribution to buy their own company shares back. This reduces the overall shares available in the marketplace, potentially increasing a company’s earnings per share and driving up its stock price. According to S&P Dow Jones, “Since 1997, the total amount of buybacks has exceeded the cash dividends paid by U.S. firms. The proportion of dividend-paying companies decreased to 43% in 2018 from 78% in 1980, while the proportion of companies with share buybacks increased to 53% from 28% during the same time period.”4
Dividends Can Help Buffer Volatility
During normal market downturns and recessionary periods, income-producing assets such as dividend-paying stocks may soften losses. When dividends are paid out, they can act as a cushion to negative stock returns.
Looking back over the Great Recession, dividend stocks suffered a lower max drawdown than the overall S&P 500 (-41.86% vs -53.96.)
Year-to-date in 2022, dividend stocks have suffered a max drawdown of -14.68% vs. -22.99% for the S&P 500.
Taxation of Dividends
Dividends also have preferential tax treatment over ordinary/earned income. Outside of a tax-deferred retirement account such as an IRA or 401(k), dividends received are taxable each year. However, qualified dividends have their own tax brackets, which mirror capital gains tax rates.
A married couple filing jointly with no ordinary income could receive up to $109,250 in qualified dividend income in 2022 and pay no federal taxes ($25,900 standard deduction + $83,350 dividend income)!
Even those earning more than $517,201 in qualified dividends would pay a maximum of 20% in federal taxes in that bracket. (It’s important to note, the additional Net Investment Income Tax (NITT) of 3.8% for modified adjusted gross incomes above $250,000 would also apply.)
Another way to look at this: a single filer with no ordinary income could earn $472,700 in dividend income and only pay 15% in taxes ($12,950 standard deduction + $459,750 dividend income) on dividend income above $41,676. Again, the NIIT of 3.8% applies and for a single filer the modified adjusted gross income limit is $200,000.
To meet the IRS definition of a qualified dividends:
- It is paid either by a U.S. corporation or by a qualified foreign corporation. (Foreign corporations qualify if they are incorporated in a U.S. possession, are located in a nation covered by an income tax treaty with the U.S., or their stock is readily tradable in the U.S. securities market.)
- It is a regular dividend and not capital gains distributions, dividends from tax-exempt organizations, or payments in lieu of dividends. Ordinary dividends are shown in Box 1a of the Form 1099-DIV tax document that each company sends out.
- The investor held the underlying stock for more than 60 days during a 121-day period beginning 60 days before the ex-dividend date.
Not all U.S. companies are corporations. For example, real estate investment trusts (REITs) and master limited partnerships (MLPs) are not structured as corporations for tax purposes, and they pay nonqualified dividends – taxed as ordinary income.
Interest from savings accounts, money markets, and CDs is also taxed as ordinary income.
Bottom Line
This discussion is not a recommendation to buy any particular security nor is it a recommendation to change your investment strategy to overweight dividend paying stocks. I just wanted to shine the spotlight on an often-neglected part of overall portfolio performance. Reinvested dividends can enhance performance while improving the risk/reward relationship of your well-diversified portfolio.
As a warning, it’s not enough to pick a stock or fund based solely on its dividend yield. There are many factors and fundamentals that go into prudent security analysis and yield is simply one of those factors.
In fact, a high dividend yield can be a red flag. Many high yielding companies or sectors offer high yields for a reason- their price has been beaten up due to poor fundamentals and/or the company is paying out an unusually high (perhaps unsustainable) share of its cash flows relative to earnings.
Even with their current low yields relative to history, it’s nice to give dividends the credit they deserve.
Grace Groner understood the power of dividends, and she left a financial legacy that will help countless future generations of students because of that knowledge.
Happy planning,
Brian
Sources/Further reading:
1. YCharts – data as of 8/15/2022
2. As of 8/17/2022 - https://www.multpl.com/s-p-500-dividend-yield
4. S&P Dow Jones Indices – Research Paper, “Examining Share Repurchasing and the S&P Buyback Indices in the U.S. Market”, March 2020