Looking For Stability? Stop Looking For Dividends

|
Includes: ACE, CB, CNP, CTL, FTR, HCP, IRM, MAT, MMC, NE, OKE, PCL, PEP, PG, POM, RIG, SRCL, T, XL
by: Investing Discipline

Summary

A number of investors buy dividend stocks for the wrong reason.

Contrary to popular belief, high dividend yielding companies do not provide stability to your portfolio.

If stability is the goal, there exist better, more straightforward approaches to achieving the desired outcome.

Introduction

Dividend investing is popular among investors who require regular income. Such investors often have the right reasons. However, a number of other investors have fallen victims to the fallacy that high dividend yielding companies are more established and stable, and therefore, likely to provide superior risk-adjusted total returns.

Nothing can be further from the truth. Dividend yield is really just another valuation multiple. Value investing in itself is risky, and value is a risk premium that can be captured by investors with a long enough time horizon. I wrote about the risk premium concept in my first article here on Seeking Alpha.

Investors who seek stability should instead focus on low volatility stocks. A simple quantitative long-only strategy that buys the bottom decile of S&P 500 stocks ranked by their 1-year trailing volatility has beaten the S&P 500 index by 0.82% per annum over the last 25.5 years with considerably less volatility.

As in my previous backtests, I use Datastream's historical lists of S&P 500 index constituents starting from Q3 1989. For each quarter end, I sort all S&P 500 stocks by their 1-year trailing volatility and split them into ten deciles. Each of the ten portfolios consists of an equally-weighted basket of stocks belonging to each decile. The portfolio is rebalanced at the end of each quarter, so stocks are allowed to move from one decile to another as the multiple changes. Cumulative returns for the decile with the lowest past volatility are shown below, alongside the top decile portfolio based on dividend yields.

High dividend yielders have outperformed the low volatility strategy only marginally, with much higher volatility, as shown in the below tables. As a result, the risk-return ratio of the high dividend yield strategy is lower.

Table 1: Returns and Volatility for selected deciles

Low Vol (1y)

High DY

S&P 500

Annualized Return

10.37

11.08

9.55

Annualized Std Dev

11.52

19.74

15.83

Annualized Sharpe (Rf=0%)

0.90

0.56

0.60

Furthermore, historical drawdowns and downside risk based on historical distributions are also considerably more severe for the high dividend yield strategy.

Table 2: Downside Risk for selected deciles

Low Vol (1y)

High DY

S&P 500

Semi Deviation

4.24

6.98

6.01

Gain Deviation

3.68

7.01

4.74

Loss Deviation

3.51

7.22

5.93

Downside Deviation (MAR=3.33%)

3.34

5.94

5.19

Downside Deviation (Rf=0%)

2.97

5.60

4.84

Downside Deviation (0%)

2.97

5.60

4.84

Maximum Drawdown

26.88

64.08

45.80

Historical VaR (95%)

-7.14

-9.88

-13.32

Historical ES (95%)

-9.97

-19.54

-15.82

Modified VaR (95%)

-7.23

-12.15

-11.47

Modified ES (95%)

-10.26

-18.67

-16.26

To provide more color, I have shown below the ten highest dividend yielders and ten least volatile stocks in the S&P 500 as of today. Most of the high yielders in the first table have been quite volatile last year and are likely to remain so. Which of these two groups' constituents do you consider defensive overall? PepsiCo (NYSE:PEP), Marsh & McLennan (NYSE:MMC) and Procter & Gamble (NYSE:PG) or Transocean (NYSE:RIG), Noble (NYSE:NE) and ONEOK (NYSE:OKE)?

Table 3: Top ten high yielders

Ticker

Name

Dividend Yield

Volatility (1 year)

OKE

ONEOK

5.82

32.26

CTL

CenturyLink

6.55

20.56

FTR

Frontier Communications

8.14

33.66

HCP

HCP

5.81

17.59

CNP

CenterPoint Energy

5.02

20.40

MAT

Mattel

5.94

25.10

T

AT&T

5.47

13.96

RIG

Transocean

16.34

48.81

NE

Noble Corporation

8.74

44.39

IRM

Iron Mountain

5.48

29.60

Table 4: Top ten low volatility stocks

Ticker

Name

Dividend Yield

Volatility (1 year)

CB

Chubb

2.35

12.92

MMC

Marsh & McLennan

2.13

13.02

PEP

PepsiCo

2.93

13.02

PCL

Plum Creek Timber

4.27

12.82

PG

Procter & Gamble

3.38

12.61

SRCL

Stericycle

0.00

12.11

POM

Pepco Holdings

3.99

11.92

ACE

ACE

2.52

13.08

XL

XL Group

1.71

13.08

DTV

DirecTV

0.00

9.87

Implementation

If you are not too worried about volatility due to your time horizon, should you buy dividend payers to achieve higher overall returns over the long term? In my opinion, value investors should focus on better indicators, such as Price-to-Book Value, Price-to-Cash flow or a composite value Z-score. These indicators focus on more broadly defined fundamentals of the underlying businesses and perform better in backtests.

Defensive investors, on the other hand, should ask themselves whether they are invested in dividend yielding stocks for the right reasons and consider low volatility as an alternative. Attempting to outperform the market consistently with less volatility may seem quite suspicious. Indeed, Robin Greenwood of the Harvard Business School once called the outperformance of low volatility stocks the "mother of all anomalies".

If low-beta/low-volume outperformance is purely an anomaly, should investors bet on its continued outperformance? One reason to believe the strategy will keep working in the future is related to the behavior of institutional fund managers. As these managers are typically benchmark constrained, they are forced to hold more volatile stocks than they would like to because significantly underweighting them would increase the tracking error disproportionately, potentially pushing them beyond their mandate's tracking error constraints. Such breaches are likely to get them fired, and this is how the current state of institutional investing is allowing the "little guy" to benefit by betting against them.

Conclusion

For Total Return investors seeking stability, low-volatility strategy works better than buying high yielders and re-investing dividends.

For income investors, the only good reason to buy dividend yielders may be related to transaction costs and taxes. Therefore, cost/benefit analysis should be performed by each individual income investor, based on his/her specific circumstances. It may be the case that regular withdrawals from a low-volatility portfolio could help achieve a better outcome.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.