Morningstar’s recently published article called “Our Favorite Dividend ETFs for 2012” makes the case for investing in stocks on the basis of dividend yield. I also recently published an article in Advisor Perspectives on dividend-oriented funds called “Finding the Best Dividend Fund” that discusses why dividend-oriented investing makes sense. Both articles explore what makes an attractive dividend-focused stock fund and provide lists of dividend-oriented funds and their characteristics.
The Morningstar article states that high-dividend stocks have outperformed non-dividend stocks by an average of 3% per year from 1927 to the present. The source data for this analysis comes from Kenneth French, a well-known professor of Finance at the Tuck School of Business at Dartmouth. French is an expert on the behavior of security prices and investment strategies and has compiled and updates a data set that tracks this and related performance factors. A portfolio that was invested in the high-dividend stocks from 1927 through 2011 would have ended up with eight times the total value of a portfolio invested in non-dividend stocks, according to the Morningstar article. I have seen similar analyses for years.
The historical out-performance of dividend-paying stocks is a well-known anomaly in the financial literature. As with all historical analysis, however, we must be very careful about using past performance to predict the future. There are arguments as to why dividend stocks will continue to out-perform, but we certainly have the problem of hindsight bias here.
Other Benefits of a Dividend Focus
Even if we do not believe that high-dividend stocks will out-perform low-dividend or non-dividend stocks in the future, there are still a range of arguments in favor of dividend investing. In my recent article, I focus more on these other factors. Two factors that I find most compelling are:
(1) Better alignment of incentives between corporate managers and investors at dividend-paying firms.
For a detailed explanation of these effects, please see my article. In brief, managers at dividend-paying firms have a strong incentive to maintain and grow their dividends. Managers at non-dividend paying companies are more likely to receive a substantial amount of their compensation in stock options (which is quite common) and thereby have a strong incentive to take large, riskier bets with investing the company’s net earnings in new projects or acquisitions as opposed to paying out those earnings as a dividend because stock options provide the upside potential for significant price appreciation with limited downside risk while a cash dividend, while certain, is less likely to be significant in comparison.
(2) Easier verification that a strategy is working.
The second factor in favor of dividend investing (again, for a detailed explanation see my article) is simply that dividends provide a useful benchmark for performance. If you expect a specific dividend payment and you get it, your portfolio is doing what you planned. If you invest in non-dividend stocks and you expect an average return of 10%, you will need to hold that stock for quite a few years before you can verify that your expectation is accurate or not.
Beware the Value Trap
The main problem with investing on the basis of dividend yield is the so-called “value trap.”
When a stock or sector is in distress, the price falls to reflect the market’s view of the reduced prospects. Even as price falls, companies try to maintain their dividends. With a given dividend and falling stock price, dividend yield rises. Here’s where the “value trap” comes into play: by investing in high-dividend stocks, investors may inadvertently be buying into a collapse. Here’s an example.
The SPDR S&P International Dividend ETF (DWX) has a trailing 12-month dividend of 7.3%. This fund, classified as Foreign Large Value by Morningstar, has such a high yield because investors are concerned about the potential for a growing crisis in Europe. I am not saying that this is a bad fund, but rather that the high yield comes with exposure to a European collapse, at which point the companies in this fund would be likely to slash their dividends.
To avoid falling into the value trap, you must look not just at yield but also at risk. I have explored this approach in a range of articles.
Volatility Reminds Us Why We Like Dividends
Back in the days when the stock market was returning double digits, it was not surprising that dividend-oriented investing went out of fashion: Who cares about a 5% dividend yield when the S&P 500 is shooting upwards? With trailing 10-and 15-year annual average returns from the S&P 500 in the range of 4.5%-4.7%, and especially in light of the enormous swings investors are seeing from year to year, those 5% dividends start to look a lot more attractive. In addition, as the Baby Boomers start to draw income from their retirement portfolios, dividend investing provides a simple, easy to verify investment strategy. Retirees, wary of selling into a falling market in order to maintain their income, are likely to see dividend stocks as an increasingly attractive asset class.
While it is undeniable that dividend stocks can be very risky, a prudent dividend-focused strategy has much to recommend it.
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