Dividend Geese

Billy Chapel: Are you saying I should retire?
Gary Wheeler: Why not? It wouldn't hurt the negotiations. And it would serve those sons of bitches right.
Billy Chapel: I, uh. I don't know. I don't know what to say.
Gary Wheeler: Well, you can't tell me that you haven't thought about it. And you've been smart with money, right?
--For Love of the Game

Until recently, dividends didn't matter much to me. Like most investors, I focused on price appreciation potential. 

A few years back my brother reacquainted me with the value of cash dividend payouts. Managing my mom's portfolio, he invested primarily in stalwart dividend paying stocks. Over time, he built an income-producing machine capable of covering a large share of monthly living expenses. Yes, the portfolio gradually increased in value as well. But so did the dividend payouts.

The capacity of a well-designed stock portfolio to generate income--particularly 'replacement' income for retirees--impressed me, perhaps in part because I'm approaching retirement myself.

In the olden days, common wisdom was that aging people in need of income replacements should invest in bonds and other fixed income instruments. Being traditionally less volatile, fixed income was seen as less prone to big capital loss. Moreover, many fixed income instruments tended to offer yields superior to stocks.

In the late 1970s/early 1980s, for example, 10 yr Treasury yields traded north of 10%. Those cash payouts were far higher than dividend yields on stocks. Of course, inflation was also flying which negated much of those cash gains.

Since then, of course, T-note yields have been in secular decline--due largely to interventionary policies of the Federal Reserve. Dividend yields on stocks have also declined as shown by the yield in the S&P 500 since 1900.

Overlaying the two trends reveals a couple of things. One is that stock dividend yields have not always been lower than bond yields. In early decades of the 1900s, stocks generally yielded more than bonds by a couple of percent. The other note is that, more recently, the offset between stock and bond yields has narrowed to the point where cash returns on stocks once again looks attractive.

Index-to-index comparisons tend to understate the superior cash-yielding capacity of stocks. For example, the yield on the S&P 500 Index currently stands at about 1.3%. However, many stocks in the SPX pay tiny or no dividends. Investors can readily assemble a portfolio of reliable dividend payers from the SPX with an overall yield north of 3%. This handily beats the current 10 yr Treasury yield of about 1.5% (and nearly all other fixed income alternatives for that matter).

If Treasury yields should rise relative to stocks then the calculus changes, of course. That said, because central banks worldwide are determined to suppress sovereign yields, large increases in bond yields seem unlikely unless policy makers lose control of the interest rate markets. While this could certainly happen, it is likely to occur in the context of Big Inflation. Big inflation jeopardizes the attractiveness of bonds. Moreover, companies may be able to navigate inflationary environments in a manner that preserves value. Dividend payouts might even increase.

Preparing for retirement, then, I view the cash-generating capacity of dividend paying stocks as central to creating 'replacement income' when the paychecks no longer roll in. Essentially, the dividend payers write the checks instead of an employer. The more I can draw on steady-to-rising dividend payments, the less I will have to cut in on the principal that generates the cash.

Stated differently, I don't want to kill the dividend-paying geese that lay the golden eggs.