February 18, 2014
Should investors favor dividend-paying stocks over non-payers? A long-held investment tenet contends that they should. But in a controversy that has pitted two highly respected investment firms – New York-based Tweedy Browne and Texas-based Dimensional Fund Advisors (DFA) – against one another, advisors are being asked to reexamine this issue.
Larry Swedroe, a well-known advisor, author and columnist, has argued that building a portfolio solely on the basis of dividend yield is misguided. Supported by DFA’s research, Swedroe and others have concluded that screening stocks for high yield is a weak form of value investing and that investors will be better off by selecting stocks on the basis of low price-to-earning or price-to-book ratios.
In March 2013, DFA published a white paper, “Global Dividend-Paying Stocks: A Recent History,” which compared portfolios of dividend-paying stocks to portfolios of non-payers and all stocks from 1991 to 2012. This paper is notable because much of the commonly cited research on dividend investing is U.S.-based. One of the paper’s primary assertions is that portfolios that are selected on the basis of dividends sacrifice diversification. The new paper, along with a recent analysis from Morningstar, motivated me to revisit this critical issue, which I explored previously in this November 2012 article.
I will provide a brief overview of the theory behind the advantages of dividend-based investing and discuss the historical performance of dividend strategies. I will then delve into the question of diversification. I conclude by returning to the question of why investors might favor dividends in portfolio construction.
The theoretical advantage of dividends
Unless a theoretical advantage to dividend-based investing exists, any outperformance could be the result of data mining or an artifact of historical data that is not likely to persist in the future. Let’s look at the theoretical justification for a bias toward dividends.
Stocks with above-average dividend yields tend to be those that are trading at low prices based on their fundamentals, such as book value and earnings per share. Dividend-payers are unlikely to be glamourstocks that become overvalued on the basis of media hype. In other words, dividend-paying stocks tend to be cheaper than average, based on value-oriented metrics. Depending upon market conditions, however, there will be periods in which investors bid up the prices of dividend stocks so that dividend portfolios are not cheap relative to the market. There also remains debate as to whether dividends are the best way to select those low-priced stocks (more on this later).
|SDY||Seeks to match returns and characteristics of the S&P High Yield Dividend AristocratsTM Index|
|VIG||Seeks to track the performance of stocks of companies|
with a record of growing their dividends year-over-year.
|IWD||Russell 1000 Value Index|
|VTV||Vanguard Value ETF|
|VFINX||Vanguard 500 Index Fund Investor Class|
Source: Morningstar as of 2/13/14
The exchange-traded funds (ETFs) SDY and VIG currently trade at a premium to the market (VFINX) and to the value oriented ETFs IWD and VTV, based on fundamental metrics (price to earnings, price to book and price to cash flow).
Dividend stocks tend to have lower beta than the broader market, and academic research shows that low-beta stocks have historically outperformed higher-beta stocks. Portfolios formed on the basis of dividends also have lower beta than portfolios formed using other value metrics such as low price-to-earnings or low price-to-book ratios.
One explanation for the advantage of low-beta stocks is that so-called glamour stocks tend to have high-beta. Their valuation is boosted by media exposure, but on average they perform poorly. A study in the most recent edition of the Financial Analysts Journal found no anomalous outperformance associated with low-volatility stocks. This paper is an exception, however, with a number of studies concluding that low-beta stocks out-perform. There is no ultimate agreement as to why low-beta stocks have outperformed, but the effect is very well documented. If an advantage exists for low-beta stocks, it may not be causally related to dividends, but dividend portfolios tend to be low-beta portfolios.
Dividend payers tend to have higher quality (more consistent) earnings streams than non-payers. As such, they are less likely to experience earnings surprises that cause unexpected shocks in valuation.