Why Dividends Matter

by: Geoff Considine

Well-known financial columnist and advisor Larry Swedroe recently penned an article suggesting that investors who have a preference for dividend-paying stocks are "misguided." This is not a new argument from Mr. Swedroe, who has persistently argued that dividends don't matter and that a dividend-oriented stock selection strategy is simply an inferior form of value investing.

In this new piece, Mr. Swedroe cites research from DFA that examines the performance of dividend-paying stocks vs. non-payers from twenty three countries over the period from 1991 through 2012. The compound annualized return of dividend-paying stocks over this sample is equal to that of non-payers. The research also showed that the dividend component of returns is less volatile than the price appreciation component of returns, although dividends can be reduced or eliminated. Reading Mr. Swedroe's summary of the DFA research, I conclude that dividend stocks have done as well as non-dividend payers over this 20+ year period and across twenty three countries. I am not sure how or why Mr. Swedroe believes that this DFA research is evidence of the inferiority of dividend strategies. On its face, this research suggests that there has been no harm to investors who prefer dividend payers.

The next leg of Mr. Swedroe's argument is that "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." This is the standard case that he and his firm have made for years and this is a more nuanced argument which I analyzed in an article for Advisor Perspectives in late 2012, The Superiority of Dividends: A Comparison of Value Strategies. Over long periods of time (1952-2011 in my article), stock portfolios created on the basis of low price-to-earnings (low P/E) have, indeed, slightly out-performed portfolios created on the basis of dividend yield. This supports Mr. Swedroe's point. This out-performance can be explained, however, on the basis of uncertainty in future return.

As Mr. Swedroe points out in his new piece, the dividend component of returns is less volatile than the price appreciation of returns. While companies sometimes cut dividends, trailing dividends are a pretty good predictor of future dividends. In statistical terms, it can be stated that there is less estimation risk in the prediction of returns from dividends than price appreciation. Now we have reached a crucial point in the analysis of dividend strategies vs. other value strategies. In a widely-heralded research paper, Robert Stambaugh of Wharton and Lubos Pastor of the University of Chicago shone a light on this extremely important form of risk that is traditionally ignored: estimation risk. I have explored the implications on their paper here. We make decisions about where to invest based on some form of estimation of expected future return and risk. Pastor and Stambaugh claim that the uncertainty in these estimates is of crucial concern. The standard 'stocks for the long run' kind of argument entirely ignores estimation risk and assumes that the average returns to be expected from price gains can be calculated just as well as the average return from dividends. This assumption is incorrect.

As I discussed in my article, investing for dividends means that you are sacrificing potential upside in growth for a known payment now. Dividend-paying companies are giving earnings to shareholders rather than investing in growth. When a company retains earnings for buybacks or expansion, the ultimate return is uncertain. When a company returns earnings to shareholders, the returns are concrete. There is nothing inherently superior about this approach. It is very clear, however, that estimation risk is higher for price appreciation associated with reinvested earnings or buybacks than it is for dividends. In some historical periods, price appreciation will be higher than your estimation and in others it will be lower. The same is true for dividends, but the range of uncertainty is smaller with dividends.

Pastor's and Stambaugh's research is highly relevant to the discussion of different investing strategies and particularly to the discussion of the relative merits of dividend investing vs. other strategies. If investors are concerned with more accurately estimating their future returns, a dividend strategy can make perfect sense.

There are a range of other research studies that examine why investors might rationally choose a dividend vs. a buyback or other reinvestment of earnings. The earnings streams from companies with dividend-paying stocks tend to be more persistent (higher quality) than those from firms that do not pay dividends. A company repurchasing its own stock sometimes actually destroys shareholder value. Another interesting study on this topic can be found here. These mechanisms are all part of the total historical returns from dividend-payers vs. non-payers, of course, but they provide additional insight.

A key final consideration with regard to high dividend stocks and their historical performance as compared to non-payers or low-payers is the range of behavioral finance issues that come into play with the decision of whether or not to pay dividends. Managers who receive a large component of their compensation in the form of stock options have a direct incentive not to pay dividends because dividends reduce the stock price while buybacks raise the stock price. Stock options have become an ever-larger component of executive compensation in recent decades. Because stock options have unlimited upside and no downside, executives with large stock grants have more incentive to 'swing for the fences' as opposed to building long-term sustainable earnings streams. Stockholders hold more downside risk exposure than managers with stock option grants, which creates the potential for agency problems.

All of these points notwithstanding, there will be times when investors over-pay for dividend stocks. A dividend focus does not mean that investors can afford to ignore measure of value such as P/E ratio. In this, I agree with Mr. Swedroe. More broadly, however, I am at something of a loss to understand his negative attitude towards dividend-oriented investing in light of compelling research to the contrary.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.