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In the context of this article, higher dividend stocks are stocks paying an above average or well above average dividend, versus stocks paying a below average dividend, which includes stocks paying no dividend. Higher dividend stocks are inferior. This is demonstrable on a theoretical and numerical basis, as I will show.

There is a very good chance you are not aware that higher dividend stocks are inferior. Higher dividend stocks have become much-loved recently, as interest rates have become lower and lower. There are many dividend stock websites and articles, but I have never seen a no and/or low dividend stock website or article. Many people are promoting higher dividend stocks as a solution to low interest rates. All of this has contributed to higher dividend stocks being overbought.

There is another reason why investors are too focused on higher dividend stocks. Many investors have the misconception that they should be living on interest and dividends or the like. They view interest and dividends as what-they-can-spend. In terms of your retirement portfolio, living on interest and dividends is an inferior approach. Your spending should be designed so you will not run out money of before you die. The best spend amount is based upon your principal, your likely future capital gains or losses, your likely future dividends and interest, the number of years until the oldest you may become, etc. (I have an Excel spreadsheet tool I created to determine the spend amount for each year.)

Theory

In general, companies pay dividends because they do not have a better use for the money than giving it to you. If they thought they could make enough money investing in or expanding current operations or purchasing a new property or company, they would not give you the money. They would use the money themselves. Generally, paying a dividend is a negative indicator. It indicates less future earnings growth. By far, most companies are profitable most of the time. The existence and extent of a dividend indicates the extent to which you can invest the profits better than the company can.

Even though paying a dividend is a negative indicator, higher dividend stocks are not inherently less valuable than other stocks. Higher dividend stocks should trade at lower price-to-earnings (P/E) ratios and/or be in better financial condition than other stocks. The marketplace tends to adjust for things like less future earnings growth. The question is how well the marketplace is adjusted for higher dividend stocks at this point in time.

The correct question is not: Does the stock pay a good dividend or not? The correct question is: Am I getting the stock at a good price? This question is answered by estimating a company's future earnings, evaluating its financial condition, etc. Whether the company returns earnings to you as dividends or not is unimportant―unless the company is retaining a lot of earnings for which it has no relatively good potential future use, which rarely occurs. The complete return a stock will provide, including capital gains or losses and dividends, if any, is important.

Picture a dart board with tiny prizes scattered equally all over it. Each prize can only be won once, and each prize represents a stock at a good price. Investing in higher dividend stocks is like throwing darts at only a portion of the board. This is O.K. or good if an average or fewer number of people are throwing darts at the same portion of the board. This is bad if a greater number of people are throwing darts at the same portion of the board. Currently, a greater number of people are throwing darts at the higher dividend stocks portion of the board.

To use the much-referenced Warren Buffett quote: "Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful." Currently, investing in higher dividend stocks breaks one and a half of the two rules Mr. Buffett expressed above. Higher dividend stocks are the excitement and greed zone now. Non-dividend and lower dividend stocks are the fear zone. Also, dividend stock ETFs usually have higher expense ratios than comparable general stock ETFs.

Numbers

With all of this understood, you would think higher dividend stocks performed better than general stocks in recent years. They did not. Do not take my word for it though. Trust the unbiased numbers. Truly unbiased numbers can be hard to come by. However, one of the good things about the expanding availability of index ETFs is that it provides us with better data we can use to answer questions like: Have higher dividend stocks performed better than stocks in general or vise versa? We often do not need to depend on someone else's unverifiable back testing results or the guidance of an expert or supposed expert who may not have our best interest in mind.

Next, I will share the results of a total return analysis comparing dividend stock ETFs with general stock ETFs. Also, higher dividend stocks are often assumed to be lower-priced (since dividend percentage is sometimes an element determining which stocks are value stocks); and higher dividend stocks are often assumed to be financially stronger (as the companies can afford to pay a relatively large cash dividend). Are they? I will answer this question. Then, I will evaluate whether higher dividend stocks have more or less price volatility than stocks in general and bonds.

This analysis is relevant for individual stock investors too. Investing in Exxon Mobile (NYSE:XOM) is not probably better than investing in Apple (NASDAQ:AAPL) because XOM's dividend is somewhat larger. AT&T (NYSE:T) is not probably a better investment than like-or-greater-sized companies because T has the largest dividend. Microsoft (NASDAQ:MSFT) and General Electric (NYSE:GE) are not probably better investments than Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) and Google (NASDAQ:GOOG) because MSFT and GE have relatively large dividends and BRK.A/B and GOOG have no dividend. I will present results relevant to individual stock investing as well as ETF investing.

Numbers: Total Return

The performance of seven dividend stock ETFs are evaluated below. These are the four domestic (U.S.) dividend stock ETFs with the longest track records and the four domestic dividend stock ETFs with the most assets. These ETFs appear to be well-representative of the higher dividend stock world. Five of the seven ETFs require an increasing dividend over a 5, 10, or 20 year period. The average stock size for the ETFs varies from one which approximately matches the S&P (Large-Cap) 500 Index to one which approximately matches the S&P Mid-Cap 400 Index, with a strong leaning toward the large stocks.

The evaluation periods range from 9.24 to 6.02 years. These are good periods to use because dividend and capital gains U.S. tax rates were equal for about the last 10 years, so these tax rates do not affect the results. The Like General Stock ETFs were determined based upon stock size profile. The Price Changes are from the Morningstar, ETFs, Chart webpage. This is a total return analysis, so the results include dividends. Expense Ratios and 12-Month Dividend Rates were different in the past than they are currently. The calculations used assume they were the same.

The seven dividend stock ETFs evaluated are:

· First Trust Value Line Dividend Index Fund (NYSEARCA:FVD)

· iShares Dow Jones Select Dividend Index Fund (NYSEARCA:DVY)

· PowerShares High Yield Equity Dividend Achievers Portfolio (NYSEARCA:PEY)

· PowerShares Dividend Achievers Portfolio (NYSEARCA:PFM)

· SPDR S&P Dividend ETF (NYSEARCA:SDY)

· Vanguard Dividend Appreciation ETF (NYSEARCA:VIG)

· Vanguard High Dividend Yield Index ETF (NYSEARCA:VYM)

FVD, DVY, PEY, and PFM are the ETFs that meet the longest track records criteria. DVY, SDY, VIG, and VYM are the ETFs that meet the most assets criteria.

The four general stock ETFs used for comparison are:

· Guggenheim S&P 500 Equal Weight (NYSEARCA:RSP)

· SPDR S&P 500 (NYSEARCA:SPY)

· Vanguard Total (U.S.) Stock Market (NYSEARCA:VTI)

· iShares Core S&P Mid-Cap (NYSEARCA:IJH)

Div Stock ETF (1)

Like Gen Stock ETF (2)

Eval Yrs

(1) Price Change

CAGR

(2) Price Change

CAGR

(1) Exp Ratio

(2) Exp Ratio

(1) 12-Mth Div Rate

(2) 12-Mth Div Rate

Div Stock ETF Total

Gen Stock ETF Total

Div Ind Stocks Total

Gen Ind Stocks Total

FVD

RSP

9.24

10.40%

1.08%

69.33%

5.87%

0.70%

0.40%

2.76%

1.55%

3.84%

7.42%

4.54%

7.82%

DVY

RSP

9.04

9.78%

1.04%

59.36%

5.29%

0.40%

0.40%

3.48%

1.55%

4.52%

6.84%

4.92%

7.24%

PEY

IJH

7.93

-38.83%

-6.01%

48.32%

5.10%

0.60%

0.15%

4.20%

1.25%

-1.81%

6.35%

-1.21%

6.50%

PFM

SPY

7.17

4.94%

0.67%

10.42%

1.39%

0.60%

0.09%

2.23%

2.02%

2.90%

3.41%

3.50%

3.50%

SDY

RSP

7.01

5.13%

0.72%

23.88%

3.10%

0.35%

0.40%

3.29%

1.55%

4.01%

4.65%

4.36%

5.05%

VIG

VTI

6.57

14.92%

2.14%

6.45%

0.96%

0.13%

0.06%

2.11%

1.91%

4.25%

2.87%

4.38%

2.93%

VYM

SPY

6.02

-4.28%

-0.72%

-1.35%

-0.23%

0.13%

0.09%

2.96%

2.02%

2.24%

1.79%

2.37%

1.88%

Average

7.57

0.29%

-0.15%

30.92%

3.07%

0.42%

0.23%

3.00%

1.69%

2.85%

4.76%

3.27%

4.99%

Long Record

8.35

-3.43%

-0.81%

46.86%

4.41%

0.58%

0.26%

3.17%

1.59%

2.36%

6.01%

2.94%

6.27%

Most Assets

7.16

6.39%

0.80%

22.09%

2.28%

0.25%

0.24%

2.96%

1.76%

3.76%

4.04%

4.01%

4.28%

As you can see, the dividend stock ETFs had an average annual total return of 2.85%, whereas the general stock ETFs had an average annual total return of 4.76%. For the individual stocks held by the ETFs, the average annual total return for the dividend ETF stocks was 3.27%, whereas the average annual total return for the general ETF stocks was 4.99%. The general stock ETFs and general stocks performed better than the dividend stock ETFs and higher dividend stocks. This is despite the fact that higher dividend stocks are very much in favor now.

Numbers: Pricing and Financial Strength

Determining whether higher dividend stocks are lower-priced and/or financially stronger is tricky. For example, Morningstar has price-to-prospective-earnings data for ETFs; but they have the same issue other data sources have. If a company's earnings are negative, they skip the company or treat its price-to-earnings (P/E) as 0 in calculating. There are other data quality issues as well. Some ETFs data, like P/E, is not dependable. To get dependable data, we need to start from the more detailed data for individual companies and calculate correctly. For example, if we average the earnings per share, whether positive or negative, for all of the companies and divide it into the average share price for the companies, we get an accurate equal-weight P/E ratio for the companies.

Last year, I compiled, verified, and corrected data from Zacks, Finviz, and MSN Money to create a complete set of data for 499 of the companies in the S&P 500. The data is as of 7/19/11. I sorted this data to separate the 249 companies with the highest dividends from the 249 companies with the lowest dividends. After doing so, I calculated the following data which characterizes higher dividend stocks versus lower or no dividend stocks.

S&P 500 Stocks as of 7/19/11

# of Stocks

Avg Div

P/E Using Est Current Yr Earnings

Current Yr EPS Growth % Est

Next Yr EPS Growth % Est

5 Yr EPS Growth % Est

Est Cash Per Share as Share Price %

Debt / TE + Debt

# of Stocks w Neg TE

Higher Div Stocks

249

2.98%

14.01

9.16%

11.40%

9.85%

8.56%

65.71%

62

Lower Div Stocks

249

0.49%

17.83

24.33%

17.99%

14.65%

10.85%

54.62%

40

As you can see, the higher dividend stocks were lower-priced based upon P/E ratio. The lower dividend stocks were currently growing their earnings faster and were projected to grow their earnings faster in the future. The higher dividend stocks were not financially stronger though. The lower dividend stocks had a higher percentage of cash per share and a lower debt level. Also, fewer of the lower dividend stocks had a negative tangible equity.

I know the results of this evaluation have been surprising to many people. We are not done yet though. There is another surprise to come.

Numbers: Price Volatility

Many investors think higher dividend stocks have lower stock price volatility than stocks in general. If higher dividend stocks did have lower stock price volatility, it would help justify using them as a substitute for bonds. Higher dividend stocks tend to have significantly lower betas. By this measure, they do have lower stock price volatility; but this is not the stock price volatility with which we should be concerned. The correct question is: Over an extended period of time, what price volatility do higher dividend stocks exhibit? More specifically, the correct question regards downside risk which is positively correlated with general stocks downside risk. Hence, more specifically, the correct question is: Over an extended period of time, what downside price volatility do higher dividend stocks exhibit which is positively correlated with general stocks downside price volatility? In other words, when higher dividend stocks and general stocks both fall in price for an extended period, how far do higher dividend stock prices fall?

What we need for this analysis is an extended period in time where higher dividend stock prices and general stock prices both fell. It is best if this period is during a recession; or, better yet, it will be during a financial crisis. Fortunately (for the purpose of this analysis), we just had both. The combination recession and financial crisis provided a great test for how higher dividend stock prices can be expected to behave under large stress.

The following spreadsheet uses data from Yahoo! Finance, Historical Prices. The Peak prices are the highest 2007 prices. The Trough prices are the lowest prices at the market bottom in early 2009.

Div Stock ETF (1)

Like Gen Stock ETF (2)

(1) Peak

(1) Trough

(1) Fall

(2) Peak

(2) Trough

(2) Fall

Diff

FVD

RSP

$17.80

$8.26

-53.60%

$52.67

$20.59

-60.91%

7.31%

DVY

RSP

$75.55

$26.42

-65.03%

$52.67

$20.59

-60.91%

-4.12%

PEY

IJH

$16.65

$4.06

-75.62%

$92.23

$40.45

-56.14%

-19.47%

PFM

SPY

$18.17

$8.23

-54.71%

$156.48

$68.11

-56.47%

1.77%

SDY

RSP

$65.89

$27.30

-58.57%

$52.67

$20.59

-60.91%

2.34%

VIG

VTI

$58.98

$30.55

-48.20%

$77.75

$33.70

-56.65%

8.45%

VYM

SPY

$55.66

$22.93

-58.80%

$156.48

$68.11

-56.47%

-2.33%

Average

$44.10

$18.25

-59.22%

$91.56

$38.88

-58.35%

-0.86%

Long Record

$32.04

$11.74

-62.24%

$88.51

$37.44

-58.61%

-3.63%

Most Assets

$64.02

$26.80

-57.65%

$84.89

$35.75

-58.74%

1.08%

As you can see, the dividend stock ETFs fell slightly more in price than the general stock ETFs did during the recession and financial crisis.

During the recession and financial crisis, the dividend stock ETFs fell much more in price than ETFs for investment-grade corporate bonds, investment-grade municipal bonds, TIPS, mortgage-backed securities (MBS), and standard Treasuries. Mortgage-backed securities and standard Treasuries ETFs prices increased. It goes without saying that CDs and non-defaulting individual bonds held to maturity essentially did not fall in price at all. In the chart below, the dark blue line is VYM, the red line is iShares iBoxx $ Investment-Grade Corporate Bond Fund (NYSEARCA:LQD), the light blue line is iShares S&P National AMT-Free Municipal Bond Fund (NYSEARCA:MUB), the yellow line is iShares Barclays TIPS Bond Fund (NYSEARCA:TIP), the green line is iShares Barclays MBS Bond Fund (NYSEARCA:MBB), and the blue-grey line is iShares Barclays 7-10 Year Treasury Bond Fund (NYSEARCA:IEF).

(click to enlarge)VYM and Bond ETFs Chart

Conclusion

There is good evidence that, historically, value stocks outperformed growth stocks; and dividend percentage is an element sometimes used to determine if a stock is a value stock. If value stocks, and, maybe, higher dividend stocks, performed better historically, it is only because investors more often overpaid for growth stocks. Also, there were extended periods where growth stocks performed better.

Currently, investors seem to overpaying for higher dividend stocks. They are doing this because interest rates are exceptionally low, because of the greater hype regarding higher dividend stocks, and because of the misconception that they should be living on interest and dividends or the like. Also, higher dividend stocks have not performed well in the intermediate-term. This indicates higher dividend stocks were overpriced even before the recent exceptionally low interest rates and associated increased hype regarding higher dividend stocks. It would make sense for certain investors to pay more for higher dividend stocks if their prices were much less volatile, but their prices do not appear to be less volatile in the way that matters.

Do not follow the crowd. Follow the facts. The facts indicate your chances are better with non-dividend stocks, lower dividend stocks, or stocks in general. This is especially true if the tax rate for qualified dividends is revised so it exceeds the tax rate for long-term capital gains, as it did before 2003. Qualified dividends are scheduled to be taxed at regular income tax rates again in 2013, whereas long-term capital gains would still receive favorable tax treatment. If qualified dividend tax rates end up being higher than long-term capital gains tax rates again, higher dividend stocks are going to be worth less than they are now in comparison to other stocks.

Source: Higher Dividend Stocks Are Inferior