It is a romantic notion. Save a portion of your hard earned wages over time, invest in dividend-paying stocks, and live your desired life of leisure on the strength of these dividend payments. In the pursuit of future dividend income, do income investors sacrifice capital appreciation? This article will examine the very long-run risk-return relationship of dividend-paying stocks versus non-dividend-paying stocks.
In data from famed Dartmouth professor Kenneth French, we have value-weighted monthly returns of dividend-paying stocks and non-dividend-paying stocks dating back to 1927. By value-weighting the portfolios formed by dividend yield, I constructed total return series of dividend payers and compared this sub-portfolio of dividend payers versus non-dividend payers. The cumulative return series are below:
Source: Kenneth French. Cumulative returns are assumed to be pre-tax.
Over this very long-time interval, the dividend stocks would have accumulated over 3.3x as much money as compared to the non-dividend payers. As shown in the table below, this translates into a 1.48% total return advantage each year. This return advantage is generated with meaningfully less risk as measured by the standard deviation of monthly returns. Higher returns with lower risk - that is the structural alpha we are collectively seeking - and dividend payers have generated nearly twice as much return per unit of risk over this long-run study. Dividend payers were also more likely to generate positive monthly returns and outperformed non-dividend payers in the majority of months.
While dividend-paying stocks have outperformed on average over time, they have not outperformed in all market environments. In the 1990s, as highflying tech stocks with limited earnings commanded premium multiples, non-dividend-paying stocks meaningfully outperformed, besting dividend payers by nearly 5% per annum. That trend reversed in the 2000s as the tech bubble burst and non-dividend payers produced a negative return. This was the second negative annualized return posted by non-dividend-paying stocks in the sample period - non-dividend payers produced negative returns in the Depression-era 1930s. This underperformance of non-dividend payers was likely a qualitative screen in that stressed market environment. The largest outperformance for dividend-paying stocks happened in the 1980s as the Volcker-led disinflationary monetary policy ultimately gave way to lower interest rates, which likely favored dividend payers. Dividend payers also outperformed in the stagflationary 1970s.
What do these historical relationships mean for the current market environment? Dividend payers are certainly benefiting from the drop in interest rates as dividend yields have largely moved above the yield on even long-duration government bonds. Companies that do not pay dividends often believe that they have business prospects that justify the reinvestment of cash flow back into their business instead of sending payments to shareholders. Not surprisingly, non-dividend payers tend to do best amidst periods of strong economic growth. With subdued economic growth and limited inflationary pressures that could drive interest rates higher, it would seem that divided payers would continue to outperform on a relative basis. Some investors may counter that these factors have contributed to elevated multiples on dividend stocks that will lower relative forward returns, but paying for non-dividend payers, which have historically been more volatile, may also be undesirable in a maturing business cycle.
For those with a long-term view, dividend stocks have produced higher pre-tax returns with less variability of returns. If I can write this article again in the distant future with another 90-year sample period recorded, I suspect that dividend stocks will again have produced both higher absolute returns with lower variability of returns.
Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term, risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance and investment horizon.
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.