Miller/Howard Investments

Why Dividends Matter

We believe that dividend income can help investors build wealth through the power of compounding.
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Hi. My name is Keith Thompson. I'm a Regional Director at Miller/Howard Investments. I'm here to talk about the opportunities of dividend investing.

There are three components we require for our dividend-focused strategies. We look for equities that we feel will likely provide high current income, as well as dividend growth income increases over time, and that have exhibited financial strength.

We believe high income tends to come from companies that historically have paid and grown dividends, taking advantage of the power of compounding. Based on Ibbotson data, if you hypothetically invested $100 back in 1926 in large-cap stocks*, the price-only return would be a little over $17,000 as of November 30, 2016. However, because of dividend growth and the reinvestment of dividends, Ibbotson shows the total portfolio would now be worth more than $590,000.**

You can see that, conceivably, compounding can be a powerful force. A high-cash-flow, high-dividend strategy aims to allow you to leverage that force. By focusing on companies that typically pay and grow dividends over time, unlike bonds with fixed coupon payments, you may provide "unfixed income" that could help meet income needs today and in the future.

Dividend growth is another factor we consider in portfolio investments, because it helps confirm past and current financial reports, and is often one of the best signals from management about current and future prospects for a company. If the income stream grows, it could help raise the value of that asset. Growth of income may also provide an inflation hedge that may be difficult to get with some bond or fixed-income portfolios. Take a client who retires at 60, where the inflation rate is at 3%. Twenty-five years later, when this client is 85, each dollar they've earned would then only be worth about 50 cents due to inflation.

Financial strength is the third major reason we like historically high-income companies. It's a positive sign when companies are strong enough to pay their dividend and then grow their business enough that they have increased their dividend through all phases of the business cycle. One of the ways they do this is by balancing their operating leverage and financial leverage. Operating leverage is going to affect how cyclical their earnings are, and we want to make sure they don't have a large amount of financial obligations to pay off when their earnings are down in the earning cycle. Continual payment of dividends and dividend growth are signs that the company is financially strong. We undertake a variety of analyses to assess whether a company can afford to pay its dividend.

Here are more reasons to include a high dividend paying strategy in a portfolio.

Dividend stocks have, in our experience, provided less volatility. Why? Because total return is made up of two parts: the price return and the cash return. We agree with Ibbotson's research that much of your volatility can come from the price side, and historically, looking at rolling 20 year periods from 1926 to 2014, more than 60% of the total return from US equities was driven by dividend income. For aggressive investors, a dividend strategy's lower volatility could fulfill the conservative segment of their portfolio. For conservative portfolios, the income component and its potential to generate growth could be the aggressive component.

Then consider endowments and charities, who often like to budget about 5% of their principal as a spending requirement to further their mission.*** If they are able to finance the overwhelming majority of their spending requirement from income, then they may not have to tap into principal nearly as much during a market downturns, such as we saw in 2008. For example, if a college endowment can't meet their scholarship needs out of current income, the endowment would have to sell securities from the account. Spending out of principal in a down market means that the portfolio has fewer shares, resulting in a more difficult time rebuilding the portfolio value in a market recovery.

And individuals can benefit from the compounding effect that may be associated with having high-cash-flow securities generating a growing stream of cash to buy more securities, and to generate more cash. So one can conceivably get the benefit of this virtual cycle, plus a potential rising income stream that helps put a price floor under the assets they own. Income going up protects them from price declines and also helps protect them from inflation. So you can see that even though a dividend strategy is often not a part of an investor's asset allocation, historically financial strong companies that have provided "unfixed income" really benefit most clients by giving them high current income, growing income, and a hedge from inflation. When combined, these factors could play a significant part in helping clients maintain their strategic position through the ups and downs of the markets.

*Large Cap Stocks: Large Cap stocks are represented by the Ibbotson Large Company Stock Index.
**Source: Underlying data is from the Stock, Bonds, Bills, and Inflation (SBBI) Yearbook by Roger G. Ibbotson and Rex Sinqufield.
***Source: "Why Do We Feel So Poor? How the Overspending of the '90s Has Created a Crisis in Higher Education" by Verne O. Sedlacek and Sarah E. Clark (Commonfund Institute, 2003), pp. 5-6 at COMMONFUND.

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