Over the last few years we've seen a dramatic increase in interest in dividend paying stocks. The heightened interest has been fueled by both the media hype and the current regime of interest rates that are well below historical averages. The low yields available on safe bonds led even many once conservative investors to shift their allocations from safe bonds to dividend paying stocks. This is especially true for those who take an income, or cash flow, approach to investing - as opposed to a total return approach, which I believe is the right approach.
Given all the interest, I thought it worthwhile to look at some return data. Thanks to Standard & Poor's, we have data on the recent returns of both dividend-paying and non-dividend paying stocks within the S&P 500 Index (SPY). Through November, the 2013 year-to-date average return on the 418 dividend paying stocks within the index (equal weighting them) was 36.8 percent. The 82 stocks that don't pay dividends returned an average of 41.5 percent. The dividend payers underperformed by 4.7 percent. For the 12 months ending November 2013, the dividend-payers returned 39.7 percent, underperforming the 46.4 percent return of the non-payers by 6.7 percent.
Admittedly, these results are for a very short period. So we'll take a look at some long-term data from a study by the research team at Dimensional Fund Advisors (DFA). As you review the results keep in mind that classic economic theory says dividend policy should be irrelevant to stock returns.
DFA's March 2013 study, "Global Dividend-Paying Stocks: A Recent History," studied the data from 23 developed markets over the period 1991-2012. The following is a summary of their findings:
- The simple average annual returns were 9.1 percent for dividend payers and 11.1 percent for nonpayers. However, the standard deviation of the returns of nonpayers was higher than for dividend payers. The net result was that the annualized returns were the same - 7.6 percent for both dividend payers and nonpayers. However, by focusing on only dividend payers, an investor would exclude about 40 percent of firms, thereby sacrificing diversification benefits.
- The propensity of firms to pay dividends has shown a global decline - the percentage of firms paying dividends globally dropped from 71 percent in 1991 to 61 percent in 2012, with declines occurring in both U.S. and international markets. Thus, a dividend paying strategy has become less and less diversified. In 1991, creating a portfolio that captured 50 percent of global dividends required about 320 companies. By 2012 that figure had dropped to just 220. The typical portfolios we build for our clients contain over 10,000 stocks.
- Although less volatile than the capital gain component of stock returns, the aggregate stream of dividend payments is subject to the same broad, macroeconomic risks that affect capital gains. For example, in 2009, 14 percent of firms around the world eliminated their dividend, and 43 percent of firms reduced their dividend. In other words, dividends can provide an illusion of safety.
The evidence demonstrates that investing in dividend paying stocks is just another example of the "conventional wisdom" on investing being wrong - there doesn't appear to be any advantages to a strategy of investing in dividend-paying stocks. It's also important to note that the evidence is the same whether we are talking about the strategy of investing in dividend paying stocks or the strategy of investing in either the stocks of companies with low price-to-dividend ratio (as does SDY), or the stocks of companies with fast growth of dividends (as does VIG).
The historical evidence demonstrates that investors who seek higher returns are better served by investing in value-oriented strategies - strategies that focus on the stocks of companies with low prices relative to earnings, book value, and/or cash flow. Those all have provided higher returns than a strategy of investing in companies with a low price relative to dividends. Not only have those strategies produced higher returns, they have done so while also producing a higher Sharpe Ratio (higher risk-adjusted return).
By looking at current value metrics we see evidence that investors should expect the future to look like the past. The table below shows the value metrics of P/E (price-to-earnings), P/B (price-to-book), and P/CF (price-to-cash flow) for the SPDR Dividend ETF (SDY), Vanguard's Dividend Appreciation ETF (VIG), which buys the stocks of companies with rapid growth of dividends, and the two large-cap value ETFs with the most assets under management, the iShares Russell 1000 Value ETF (IWD) and Vanguard's Value ETF (VTV). As you review the data, remember that the lower the relative price, the higher the expected return. The data is from Morningstar as of the end of November 2013.
The above data makes clear that the expected returns for both SDY and VIG are well below that the expected returns of the two large value strategies.
As you consider the data, also keep in mind that for taxable investors, dividends are less tax efficient than capital gains (they cause you to pay taxes sooner and can drive you into higher tax brackets). And in tax advantaged accounts you lose the benefit of the foreign tax credit.
The bottom line is that you shouldn't get caught up in the hype of dividend related strategies. If you have gotten caught up in that hype, or believed in the conventional wisdom, hopefully the evidence will lead you to conclude that there's a better way.