Pay yourself first. A hallmark of financial planning. You have no doubt heard this advice and hopefully heeded it. Accomplishing your financial goals starts with paying yourself first. Keep your money before you have a chance to spend it. Are your investments doing this for you? Do they regularly pay you for using your capital?
You’ve probably guessed it; we are talking about dividends. Dividends are the primary way for companies to return capital to shareholders. They reward shareholders for using their capital and provide them a stream of income without needing to sell their investment. A track record of steadily increasing dividends is a sign of a properly managed business. Dividend policy is important to investors. A company that regularly raises dividends is considered healthy. Whereas a company that lowers dividends could be in trouble.
Can dividends hold up to inflation? A stream of income is only as good as its buying power. Luckily, we have history on our side. The dividend growth rate of large U.S based companies has outpaced inflation handily since the 1940s. Even here in 2022, where inflation is higher than we’ve seen in decades, the dividend growth to date in the S&P 500 is approximately 10.64% (source: Standard & Poor’s). It wouldn’t be far-fetched to imagine companies wanting to use corporate cash for other purposes. Families are certainly tightening spending habits. That’s the power of the dividend policy Once it starts, companies do everything in their power to keep the income stream running.
Companies have another way to return profits to shareholders: share buybacks. This is an effective tactic with growing popularity. Buybacks work a little differently. Instead of sending cash directly to shareholders, the company chooses to buy its own shares from the market. This serves to reward current shareholders with fewer total shares outstanding and a bigger piece of the business. Buybacks can also improve certain ratios used by analysts. For example, your earnings per share, moving forward, are higher with fewer shares outstanding. Share buyback plans also tend to be more flexible for the company. They often have an allotted amount to spend, over a specific time frame. They may or may not use all the allotted dollars, and suspending buyback plans often comes with less fanfare than a dividend cut would.
A combination of these tools is the favored mix for most companies. A strong commitment to growing dividends rewards the shareholders. A well-structured buyback plan provides flexibility for capital without tying down future cash flows. Your investment manager should share that commitment to consistent dividends and proper capital management. Ask your fiduciary how your investments will grow your income stream.
Patrick E Gauthier | CFP®, MSAPM
Senior Portfolio Analyst