I am a big fan of dividends and dividend growth. I have written several articles on the subject and I employ a dividend growth component within my total portfolio strategy that includes investing in North American equities, International equities, plus broad based bond ETFs and a sprinkling of high yield bond ETFs.
But along the way, some research and anecdotal observations on portfolio returns had me wondering "is dividend growth just a useful distraction"? Dividend Growth is a wonderful style in that it asks investors to focus on the yield and the potential for their companies to increase their yield over time, and mostly year over year. Reacting to drastic price movements of stocks or equity funds is the greatest failure of most investors. It is the reason why so many investors underperform the markets, and leave hundreds of billions of dollars on the table. If an investor can learn to ignore price swings, that is a wonderful gift. Dividend growth investing is then an amazing risk management tool at its core. And mostly certainly, it allows investors to grow their income in a reliable and lower risk manner, as compared to purchasing the broader market, or by diving into specific sectors.
But here's the thing; if a dividend growth portfolio in the wealth accumulation phase (when an investor is not yet supplementing their retirement income with the dividend income) does not outperform that broader market on total return, then the dividend growth strategy in the end becomes a very useful risk management tool that allowed the investor to stay the course. If another investor (non-dividend growth) accumulates the same amount of total return they can immediately go out and purchase the dividend growth investor's exact holdings - and hence immediately own the same yield and potential for dividend growth as the investor who spent decades accumulating and nurturing that dividend growth portfolio. The journey now becomes irrelevant (other than the fact that the risk management element allowed the dividend growth investor to stay the course).
The starting point in this evaluation will be "do dividend growth stocks provide greater total return than companies that do not pay a dividend"? Does purchasing companies that have a generous yield and a growing yield create a greater return? The answer according to a recent and very broad-based study says the answer is no. In fact, purchasing companies that grow their dividends will underperform the total market in total return.
A study "Global Dividend-Paying Stocks: A Recent History," produced by the research team at Dimensional Funds Advisors covered 23 developed markets over the period 1991-2012.
According to the analysis, the average annual returns were 9.1 percent for dividend-paying stocks and 11.1 percent for non-payers. However, the returns of non-payers were more volatile than for dividend payers.
That is likely not surprising for many, as dividend growth is not necessarily a total return strategy. And many dividend growth investors are quick to remind you of that. They are content to focus on the income stream, and the growing income stream, that at the same time can lower overall portfolio market value volatility (for those that also keep an eye on the bottom line).
But in essence, in exchange for lower total returns they are sacrificing potential for greater yield and dividend growth in the future - the future being that end date when you want or need to live off of the income of your portfolio. Because in the end the journey does not matter, total return can be the most important factor if an investor decides to make it so.
Here's why. If the retirement date is 20 years away and the investor does not need those funds or income in the wealth accumulation phase, the only determinant factor of final yield and potential for income growth (if required) will be that final dollar amount of holdings.
For example, Investor A uses the dividend growth model and accumulates $1,000,000. Her yield from investments at the time of retirement is $45,000 (4.5% current yield). And the recent dividend growth history supports the potential for an increasing revenue stream of 8%.
Investor B invests in riskier assets to grab that extra average annual return and accumulates $1,500,000. Investor B can then immediately purchase the exact same holdings as investor A and create $67,500 of annual income. Investor B also has the same potential for an increasing revenue stream of 8% annual gains.
We also know that there are simple strategies that outperform the market. The broad based market does not necessarily deliver the greatest potential for total return. And market history shows us that larger companies actually deliver smaller gains. The greatest returns are originated in the mid and small cap sector. In fact, given enough time, small cap sectors outperform the broader market by an average of about 3% per year. Once again, it's a risk return proposition. If you want bigger long term gains - go small.
Given those average annual returns we can see that those who have the stomach for smaller companies (in their more rapid growth phase)can reap the benefits over the longer term.
That's using the price charting tool at yahoo finance. It does not include dividend reinvestment. But thanks to the tools at low-risk-investing.com we can also include dividends and chart IJR vs. the broader market.
We still see an incredible outperform of the small cap index. Even in a time of flight-to-safety, coming through two massive market corrections, we see the small cap index delivering 200% gains from the year 2000. Over the last 10 years, IJR has delivered 12.25% average annual gains. IJR has a 12-month yield of 1.49%.
Once again, the risk reward proposition holds true. Small cap stocks are riskier than large cap stocks. The broader market is riskier than the big and reliable dividend growth stocks. But over the longer term the trend (and investing axiom) holds true that if you take on more risk you will be rewarded with greater returns. There is unrealized and unrewarded long-term value in many smaller cap companies. Whereas the large caps cannot hide in plain sight.
Or can they?
As an indexer I have to ask the question - can the dividend growth style of investing outperform the broader market with respect to total return? There have been many studies on the components of the S&P 500 and how to harvest the greatest total return.
Here's a great chart that's worth another 1000 words.
According to the Ned Davis study for Morningstar, dividend growers beat dividend payers and the broader market over the longer term.
And here's another chart that shows the effect of yield on total return for the S&P 500 components.
Higher yielders beat lower yielders. And here's a chart that reflects the ideal mix of yield and payout ratio.
The greatest total return for components of the S&P 500 is created with the ideal mix of higher yield and a low payout ratio. Of course that is the definition of dividend growth investing. And my guess (and as many have written) is that the reason for the outperform is a result of a reverse canary in the coal mine phenomenon. Companies that can pay a healthy dividend with a low payout ratio are companies that are well managed, and are able to grow revenues and earnings on a consistent basis. They often have strong brands and strong leadership across the entire organization.
And that total return outperform at times may have little (or less) to do with the actual dividends that are being distributed.
We can see that in a period when the dividend payers delivered an incredible outperform (1991-2006) dividends were contributing at its lowest level. The outperform was largely due to stock price appreciation.
In essence for those that love dividends and dividend growth and also seek total return for the flexibility it can deliver on that retirement date, DGI allows investors to have their cake and eat it too.
There is a high probability that DG investors will be rewarded with a very nice outperform against the broader index. But that's not a guarantee. There have certainly been periods when dividend stocks have underperformed - see the late 1990's tech boom.
And let's not forget that riskier sectors can certainly deliver the greatest potential for total return.
While I've gone with the moniker the Scaredy Cat Investor at times, I will admit that I was able to greatly outperform the market during a very volatile period. In my first article "Confessions of a Scaredy Cat Investor", I certainly bragged that I had outperformed the Canadian and U.S. indexes. From 2007 through to the end of 2011 I managed a 74% total return. I accomplished that (somewhat) by taking on more risk - with a higher risk materials ETF, a BRIC ETF, plus some smaller cap energy companies. And some of that outperform was also thanks to my gold holdings - but that's another asset class, and article.
So what did I do with my extra gains when I outperformed the broader market by a very considerable amount? I turned that juicy total return into a reliable income stream. And that growing income stream is still in our accounts today, largely sitting in dividend and dividend growth ETFs, broad based Canadian, U.S. and International indexes and a 1-5 year laddered corporate bond ETF. For a few years, this Scaredy Cat took on some risk and was handsomely rewarded. And that reward in the end was turned into a larger and growing income stream.
I am now content to know that with a generous dividend growth component in my portfolio I can grow my income stream with the potential of outperforming the broader market in total return.
For investors with a long time horizon, dividend growth still might be a very useful distraction and risk management tool at its core. But by looking the other way, dividend growth investors who stay the course just might get that added surprise of a total return outperform.
When it comes to creating a generous income stream and a growing income stream - there's certainly more than one way to skin a cat.
Disclosure: I am long DIA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. Streetwise Portfolios offer Canadians low-fee, complete, index-based portfolio options. Dale’s commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.