Slaughtering The High-Dividend Sacred Cow

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Facts, as founding father John Adams put it, are stubborn things, but our minds are even more stubborn. Doubt isn’t always resolved in the face of facts for even the most enlightened among us, however credible and convincing those facts might be. One reason is that, due to the well-documented phenomenon of confirmation bias, we undervalue evidence that contradicts our beliefs and overvalue evidence that confirms them. We filter out inconvenient truths and arguments on the side opposite our own. As a result, our opinions solidify, and it becomes increasingly harder to disrupt established patterns of thinking.

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This is especially true when it comes to investors who believe that dividend-based strategies are an efficient way to invest (even though the research suggests many investors don’t understand how dividends actually work). No matter the amount of evidence presented, or the logic supporting it, investors who believe in dividend strategies will ignore the facts and data.

At least for tax-advantaged investors, dividends are irrelevant: They are neither good nor bad in terms of forward-looking return expectations. Therefore, while there is no reason to exclude dividend-paying stocks, focusing solely on them leads to less diversified (less efficient) portfolios.

The individual investor’s preference for cash dividends has long been known. However, from the perspective of classical financial theory, this behavior is an anomaly.

In their 1961 paper, “Dividend Policy, Growth, and the Valuation of Shares,” Merton Miller and Franco Modigliani famously established that dividend policy should be irrelevant to stock returns. As they explained it, at least before frictions like trading costs and taxes, investors should be indifferent to $1 in the form of a dividend (causing the stock price to drop by $1) and $1 received by selling shares.

This theory has never been challenged, and for good reason – the historical evidence supports it. Stocks with the same exposure to common factors (such as size, value, momentum and profitability/quality) have the same returns whether they pay a dividend or not. Yet, many investors ignore this information and express a preference for dividend-paying stocks.

Even worse is that high-dividend strategies – which, as opposed to growth-in-dividend strategies, are basically value strategies – have provided the smallest value premium compared to standalone value strategies based on metrics such as price-to-book value, earnings, cash flow, sales and EBITDA.

Among the more commonly cited explanations for investors’ preference for dividends is that they offer a safe hedge against the large fluctuations in price that stocks experience. Another is that investors don’t have to sell any stock to generate cash flow. But these explanations ignore the fact that the dividend is offset by a fall in the stock price, and is thus a virtual substitute for (or equivalent to) the sale of stock in the same amount as the dividend. It’s what can be called the fallacy of the free dividend – the only free lunch in investing is diversification, not dividends. Further explanations are provided by behavioral finance professors Hersh Shefrin and Meir Statman, which I have discussed in detail elsewhere.

What is particularly puzzling about the preference for dividends is that taxable investors should favor the self-dividend (accomplished by selling shares) over dividends if cash flow is required. Unlike with dividends, where taxes are paid on the full distribution amount, when shares are sold, taxes are due only on the portion of the sale representing a gain. And specific lots can be designated to minimize taxes.

Thanks to Mebane Faber of Cambria Investment Management and Wes Gray and Jack Vogel of Alpha Architect, we can see just how inefficient a high-dividend strategy is for taxable investors, especially high-tax-bracket investors. Before we get to that tax impact, however, it’s worth noting Faber, Gray and Vogel examined the performance of a high-dividend strategy relative to a simple composite value strategy (using an equal-weighted ranking of four value metrics: book-to-market, EBITDA-to-total enterprise value, earnings-to-price and sales-to-price ratio) over the period from 1974 through 2015. In the tables that follow, EW refers to equal-weighting.

1975-2015 S&P 500 Largest 2,000 Stocks EW Top 100 Dividend Payers EW Top 100 Value Composite


Top 100 Value Composite EW ex-Top 25% Dividend Payers Top 100 Value Composite EW ex-Top 50% Dividend Payers Top 100 Value Composite EW ex-All Dividend Payers
Annualized Return (%) 10.8 12.8 13.9 17.4 17.2 15.9 15.6
Standard Deviation (%) 15.4 18.9 15.1 19.0 19.9 21.8 23.1
Maximum Drawdown (%) -51.0 -51.4 -55.1 -56.5 -52.6 -52.3 -52.0

By Larry Swedroe, read the full article here.

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