A True and False Claim on Dividends

In our daily perusal of the financial news, we caught a curious, offhand comment in a piece about gold: Income streams are “the main driver of total returns from most investments.”^[i] This is a very weird statement, at once true and false. How so? Read on!

“Total return” refers to, well, all the money you earn from an investment. For stocks, that means price appreciation plus reinvested dividends. If we look at long-term charts, it seems clear that dividends play a very, very big role. You can see it in the S&P 500, where price-only returns since 1925 are 43,930.3%, which sounds very big until you compare it with the 1,566,638.3% return with reinvested dividends. Exhibit 1 shows the gap using a logarithmic scale to remove compounding’s skew on later returns (and to avoid looking silly). Exhibit 2 does the same for UK stocks, whose gap is smaller due to the MSCI UK index’s shorter history.

Exhibit 1: S&P 500 Price and Total Returns

Source: Global Financial Data, Inc., as of 9/19/2024. S&P 500 total and price return in USD, 12/31/1925 – 8/30/2024.

Exhibit 2: MSCI UK Index Price and Total Returns

Source: FactSet, as of 9/19/2024. MSCI UK total and price return in GBP, 12/31/1969 – 8/30/2024.

These are really, really big gaps! So big as to be almost meaningless, so here are the annualized returns. For the S&P 500, the annualized price return in this stretch is 6.4%, while total return is 10.3%.^[ii] The UK’s gap is even bigger, 6.0% for price returns and 10.4% for total.^[iii]

So yes, while it is probably a stretch to call dividends the “main driver” of total returns, given they account for less than half the long-term annualized return and contribute less to return today than they did in earlier decades, they are a really big piece. And that big piece tips stocks over the edge relative to other asset classes, so the statement is fair enough, we guess.

But also, not really, and the UK’s bigger gap illustrates the reason why. The UK has a heavier weighting to high dividend-paying sectors than the US (e.g., Energy and Financials). This is part of its general value-oriented tilt. And it is also a big reason why the UK’s price-only annualized return is lower.

You see, dividends are not a return on your investment. They are a return of your investment. It is a company paying your own money back to you versus investing it or buying back shares. Hence, when a stock pays a dividend, the stock price falls by the amount of the dividend. When our favorite fake company, Widgets ‘R’ Us, pays a $1 per share dividend, its share price falls from $38 to $37 on the date the dividend becomes official. In the lingo, this is called the ex. dividend date, because it is the date on which the stock price excludes the dividend. (Neat, huh.) This is one key reason why dividends are not equivalent to bond interest.

So because UK stocks pay more dividends, they have more dividends subtracted from the share price. Total return accounts for this by keeping them in place and assuming they are reinvested into the company, where they continue to grow alongside the rest of your investment.

In our view, the real lesson here isn’t that dividends are important to returns. Rather, it is that price-only returns are an incomplete measure. To properly gauge an investment’s long-term prowess in both absolute terms and relative to its competitors and peers, total return is the only level playing field.

Here is another way to see it. Widgets ‘R’ Us doesn’t have a monopoly on the widgeting world. It has stiff competition from KB Widgets … which doesn’t pay a dividend. So on the day Widgets ‘R’ Us pays its $1 dividend and its share price falls from $38 to $37, KB Widgets’ price holds steady at $38 (magically, they have identical fundamentals and the market was flat that day). For three years, they have identical percentage returns, but Widgets ‘R’ US has $12 worth of quarterly dividends backed out of its price in this span. Price-only returns would show it to be an inferior investment. Total returns, however, would rightly show the two as even-stevens.

That is kind of a mouthful, so here is a totally made-up chart. To keep it clean, we suppose that both companies’ stock prices rise 0.23% every day … except on the last day of the calendar quarter, when Widgets ‘R’ Us pays its $1 dividend. On this day, KB Widgets is conveniently flat, while Widgets ‘R’ Us drops by its standard -$1. Again, totally unrealistic, nothing here matches what an investor’s actual experience would be, STOCK RETURNS AREN’T STEADY, this is just illustrative.

Exhibit 3: A Totally Made-Up Example of Dividends’ Stock Price Impact

Source: Math and the thin blue air, where all hypothetical things come from. Assumes identical daily percentage returns and a $1 dividend paid by Widgets ‘R’ Us on the final day of each calendar quarter.

If you didn’t know Widgets ‘R’ Us was paying a dividend, you would think it is inferior. Only through total returns would it rightly show the two were performing identically—just with different philosophies about the best use of leftover dollars at the end of the quarter.

Again, dividends are important to returns! But only because total return is the most accurate representation of an investor’s experience and price returns don’t account for dividends in a relatable manner. Dividends themselves, we are agnostic on. Again, return of capital, not return on capital. They can get cut and reduced at any time, and loading up on them means you concentrate in certain sectors, which limits your opportunity set and disadvantages you when other areas do well. Some people like dividends for cash flow, but we think selling stocks is a fine way to generate “home-grown” dividends as part of general portfolio maintenance. Dividends can be nice, but we don’t think they alone are reason to own any stock.