As attractive as today’s yields may look on certain dividend-paying stocks, they only tell part of the story when you’re choosing names for income. That’s because the real story behind a successful dividend play is the compounding effect of reinvesting – rather than spending down – the income those stocks generate over the long term, which can enhance the total return on your portfolio. “Reinvestment of the dividends is key to maximizing the compounding effect and the total return from the investment,” said Michael Arone, chief investment strategist, U.S. SPDR Business at State Street. “Not simply pocketing the income, but reinvesting it is kind of a powerful compounding effect to total returns.” Boosting those portfolio returns through dividends is especially key in a year when interest rates are expected to come down. The Federal Reserve has penciled in three rate cuts for 2024, and fed funds futures pricing suggests a roughly 47% chance that the central bank will ease up on policy as soon as March. Lower interest rates make other income-generating assets, including dividend-paying stocks, more attractive compared to the risk-free yields on Treasurys. The unsung hero Since 1926, dividends have contributed about 32% of the total return of the S & P 500, while capital appreciation accounts for 68%, according to research from S & P Dow Jones Indices . But these income payers took a backseat over time thanks to the rise of stock buybacks, falling interest rates and the rise of tech companies. Dividend stocks took their lumps during 2022 as the Fed embarked on its rate hikes – consider that the Vanguard Dividend Appreciation ETF (VIG) posted a total return of negative 9% in 2022 – and rate-sensitive income stocks in the utilities and real estate sector suffered. In 2023, they languished in the shadow of the roaring tech sector and fell out of favor with income-seeking investors. However, investors who are willing to ride out rough patches like these are ultimately rewarded in the long run, particularly if they reinvest the dividends. An analysis by CNBC Pro using FactSet data found that if an investor had bough $1,000 worth of IBM stock at the end of 2003 and then used the dividend to buy more shares, they would have posted a return of 228.1% and the value of that holding would be $3,280.95 as of the end of 2023. IBM has a dividend yield of 3.6% and paid a $1.66 per-share quarterly cash dividend in December, but these are just snapshots in the present and only hint at the potential for longer term returns. Had you spent down or pocketed the dividends, the $1,000 in IBM stock you purchased at the end of 2003 would’ve grown by just around 85%, and you’d have a market value of $1,847.61. Big-box retailer Target is another dividend payer that rewarded patient shareholders. A $1,000 investment at the end of 2003 would have grown to $5,691.95 20 years later – if an investor plugged the dividend payments back into the stock. That’s a return of 469.19%. Without the reinvestment, the appreciation would’ve been sizable, but less so: The Target investor would’ve had $3,708.85 by the end of 2023, a return of 270.89%. Check with your brokerage to make sure you have dividends reinvested as your preference for individual stocks and ETFs. Picking the right names Dividend investors are seeing 2024 as a potential rebound year for these stocks, anticipating a broadening rally. “They will make a comeback,” said Grace Lee, portfolio manager of the Columbia Dividend Opportunity Fund (ACUIX) . “I think there is valuation support, fundamental support, and part of it is the market does really have to broaden out from the Magnificent Seven.” To that effect, the S & P 500 Dividend Aristocrats – a group of stocks that have faithfully raised dividends annually for at least the last 25 years – may provide a good starting point for investors seeking individual names. “A company’s ability to consistently pay or increase dividends is a signal of its financial strength,” said Arone. “Often, companies that are able to do that have very stable earnings, healthy balance sheets, low debt equity and they have good cash flows. They are high quality.” Indeed, S & P Dow Jones Indices last week announced a rebalance of the Dividend Aristocrats, removing Walgreens Boots Alliance – which slashed its dividend nearly in half at the beginning of this year. Fastenal , a distributor of industrial products, will be replacing the pharmacy chain, effective Feb. 1. “There is this view that companies that grow dividends are old Mom and Pop companies, but the takeaway is to recognize these companies are the ones that have exhibited healthy earnings, stable balance sheets and good cash flow,” Arone added. “Given the current environment, those are attractive attributes. – CNBC’s Chris Hayes contributed reporting.
This story originally appeared on CNBC
