By Kevin Kroskey, CFP, MBA
Dividend investing is a decades-old idea that many investors continue to follow today. Many think: the higher the dividend and the longer the company has been paying, the better. This idea causes investors to reach for higher dividends. Just because an idea has been around a long time doesn’t mean it is a good one.
Total Return Versus Yield
The return from an investment is comprised of two parts—price appreciation (or depreciation) plus yield. Investors tend to have a behavioral preference for dividends, because they can easily see the dividends paid from the stocks they own.
In the case of a stock or stock-based fund, this is equivalent to capital gains (or losses) plus dividends. A stock’s dividend yield would simply be the dividend per share divided by the price per share. For example, a stock pays a $2 dividend per share and the stock price is $100 for a dividend yield of 2%.
A high dividend yield implies the company’s growth prospects are not robust. Rather than reinvesting in new opportunities to produce additional profits, profits are returned to shareholders in the form of dividends.
The goal of a rational investor would be to maximize the total return of an investment for a desired level of risk. Stated another way: who cares where the return comes from—appreciation or yield—as long as it comes and with a risk level that allows me sleep at night. Given this goal, the appropriate question would be: Does favoring dividend-paying companies produce better risk-adjusted returns?
Pros and Cons of Dividend Investing
Dividends are one method of defining value companies from growth companies. On average value companies have a higher dividend yield than growth companies. For example, the Morningstar large cap value index has a dividend yield as of May 31, 2011 of 2.8%. Comparatively, the Morningstar large cap growth index has a dividend yield of 1.5%.
Value companies produce on average one to three percent annually more than growth companies over time and tend to offer better risk-adjusted returns—so far so good for our dividend strategy. Over ten-year periods from 1926 through 2009, value companies outperformed growth companies 96% of the time. This percentage is even higher in international markets with data from 1975-2009.
Several studies have examined various fundamental accounting metrics to delineate value from growth. These metrics have predominantly included dividend to price, cash flow to price, earnings to price, and book value to price. Studies have consistently shown a company’s dividend yield does not do as good a job as book value in identifying value companies and producing better risk-adjusted returns.
I can hear the dividend investors yelling as they read this, “I focus on the best dividend payers—the ones that have a high yield and regularly increase dividends over long periods of time.” And this is the folly that investors often make, focusing on a few stocks that meet these criteria. In doing so, they concentrate their portfolio and subject themselves to greater risk by forsaking diversification and trying to out-smart the market.
What are the potential costs of lack of diversification? The US stock market return, as represented by the University of Chicago’s CRSP Index, returned 10.4% from 1980-2008. If you were selecting stocks and you missed the top 10% over this time period, your return fell to 6.6%. Missed the top 25%, and your return went to a negative 2.1%. A portfolio of carefully chosen stocks could easily wind up negating the top performers and produce very poor results.
Remember, the goal of a rational investor isn’t to try to obtain the highest possible returns via searching for needles in the haystack. The goal is to maximize your risk-adjusted return and not to die poor.
Implications for Investors
It used to be that most US companies paid dividends. In 1978, 66.5% of companies paid dividends. In 2000, just 20.8% paid dividends. That leaves nearly 80% of US companies that don’t pay dividends. One reason for this is companies have favored repurchasing their shares over paying dividends. Share repurchases have risen to 50% of total payouts (dividends plus repurchases) as of 2003. Share repurchases have the same net effect to shareholders in terms of total return when compared to dividend payouts but are more tax-efficient than dividends.
Though following a dividend-paying strategy is a familiar concept to many investors, it is not a great way to invest. While dividend yield does help to identify value companies and produce greater risk-adjusted returns, other metrics such as book value better identify value companies and do so in a much more diversified fashion. Following a more modern strategy to identify value companies produces better risk-adjusted returns and helps to ensure your money lasts longer than you do.
Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and businesses with their overall wealth management, including retirement planning, tax planning and investment management needs.