Dividend Growth Investing - Dividends Don't Matter

I will now present the case against the dividend investment strategy to provide a balance and a challenge to dividend investing. This case also seems to be gaining ground with financial advisers (or rather, is already enshrined in standard financial advice). So here we go...

Dividends do not matter. Corporations can use their capital to invest in future projects, fund the research and development or fund mergers and acquisitions. If they do not do any of these things with their capital, which would happen if none of the activities would be expected to provide an acceptable return, then they will return capital to shareholders. 

Returning capital to shareholders happens in one of two ways, dividends or share buybacks. Dividends are paid in cash while buybacks reduce the outstanding shares on the market increasing the amount of profits that accrue to the remaining shareholders. Both have the same net result to shareholders. Keeping in mind that dividends do not matter to your returns, dividend growers, or companies with a long history of increasing their dividends, have had great historical performance. 

From 1999 through December, 2017, the S&P 500 Dividend Aristocrats index has beaten the S&P 500 by a whopping 3.37% per year on average. But, there's more to the story The magnitude of capital of return to shareholders in the U.S. market, that is both dividends and share repurchases, averaged about 4.4% of total market cap from 1973 through 2016. Dividends were far more prominent in 1973 but buybacks grew steadily over time. In recent years, there has been about an equal split between share repurchases and dividends. And the total payouts have been near the long-term historical average. The fact that companies returned capital to shareholders about equally using buybacks and dividends should be further indication that dividends do not matter. 

Why would a company that returns lots of capital with dividends be better than a company that returns lots of capital through share repurchases? The answer is that there is no reason. The fascination with dividends can mostly be attributed to the mental accounting bias. It feels good to have cash appear in your investment account. It feels like getting a paycheck for doing nothing. Unfortunately, dividends are net neutral in terms of your wealth, before taxes are considered. When a company pays a dividend, it drops in value by the amount of a dividend. If we think about two investors who each own a different $10 stock, one stock pays a dividend and the other doesn't. If investor A's stock pays them a $1 dividend, they now have $1 in cash and a $9 share, while investor B has a $10 share. 

In a real market, prices are fluctuating all the time so investors never get to see it as explicitly as in our clean example, but whether you see it or not, this is exactly what is happening. It should be clear by now that a dividend does not bring you any benefit. With this in mind, it's also important to understand that chasing dividends leads to many unfavorable characteristics in a portfolio. A dividend-focused portfolio would exclude 35 to 40% of the opportunity set of stocks to invest in, which inherently decreases diversification.

While it is true that dividends have been less volatile than the capital return of stocks over time, dividends are by no means a guaranteed source of income. In 2009, for example, 14% of firms around the world eliminated their dividend and 43% of firms reduced their dividend. In a 2013 paper from Dimensional Fund Advisors, the returns of global developed market dividend paying stocks were compared to non-dividend payers. In the sample period spanning 1991 through 2012, all dividend payers had a compound average annual return of 7.6%, while non-payers had the exact same compound average return. 

This is what we would expect if dividends play no role in explaining differences in returns. In a 1998 paper, Eugene Fama and Kenneth French examined dividend yield as a potential value factor, or a quantitative metric to identify value stocks. They tested dividend yield, price-to-book and price-to-earnings ratios, and found that dividend yield produced the smallest value premium. This has important implications for dividend investors. If dividend payers tend to be value stocks then observing higher returns of dividend payers over time could really be the value factor in disguise. If this is the case, targeting value stocks directly as opposed to accidentally by chasing dividends would be a much more sensible approach to accessing the value premium. 

So far, we have talked about dividend payers versus non-payers in general. Any seasoned dividend investor will be scoffing at me. You don't just buy any dividend stock, you buy good solid companies with a long history of increasing dividends and you buy them at a good price. Let's unpack that. Is buying a good solid company like BMO or Fortis a good investment? Only if you know something that the market doesn't. When a company is rock solid, it is no secret that it is rock solid. The whole market knows that, so those expectations are already included in the price. If the company does what it is expected to do, you might expect to earn something close to the market return, while also taking on the risk of that individual company not delivering on its expectations. It is only if the company exceeds current expectations that you would expect to do better than the market. And there's no good reason to believe that you can anticipate those results, at least not consistently. 

Now I know that there are a lot of dividend investors out there who have had lots of success with their portfolio. They may have even been able to retire and live off of the dividends, the dividend investor's dream. I would argue that this has nothing to do with the fact that they own dividend paying stocks and everything to do with having a philosophy that they can get behind and stick to. The story of buying solid companies that you are familiar with is compelling. It is not backed by data, but it is a good story. Good enough to keep people invested through bad markets and get them excited about consistently socking away a good chunk of their income to buy more stocks.

I think that dedicated dividend investors probably have a great time reading dividend investing blogs and searching for the next good buy. This is not a rational activity, but if it motivates someone to be a disciplined saver and investor, then it makes sense that they would have good long-term results. However, it is extremely important to identify why they were successful. Based on the data, they were very unlikely to have been successful due to buying the right dividend stocks at the right time and much more likely to have been successful due to paying low fees and staying disciplined over the long-term. 

Both the Canadian and U.S. Dividend Aristocrats Indexes have decimated the broad market in recent history. This should raise some eyebrows. Don't worry, there is a sensible explanation. Dividend paying companies, especially dividend growers, do tend to have exposure to the known factors that explain the differences in returns of diversified portfolios. They tend to be value companies with robust profitability and conservative investment. For example, the strong performance of the S&P 500 Aristocrats Index is well explained by excess exposure relative to the S&P 500 to the factors that explain the differences in returns between diversified portfolios.

Simply put, the difference in returns is explained by the Aristocrats Index having exposure to more value stocks, more stocks with robust profitability and more stocks that invest conservatively relative to the broad market. This starts to get a little nuanced. So try and stick with me for a second. There's an extremely important distinction between a company with exposure to the factors and a company with a long track record of increasing its dividend. The distinction is that not all stable dividend payers have exposure to the factors, and many stocks that do have exposure to the factors are not dividend payers. The implication for an investor is that by targeting stocks that have increased their dividend over time, you might get naïve exposure to the factors which could improve your outcome, but because you were not intentionally targeting the factors, your factor exposure may not be consistent over time. 

The price that you ended up paying for that naïve and potentially inconsistent factor exposure is the loss of diversification. You are excluding many of the companies in the market simply because they don't pay an increasing dividend over time which we have established as irrelevant. Buying dividend paying stocks may offer exposure to the known factors of higher expected returns over some time periods, but that factor exposure may be inconsistent over time. 

The price for a chance at this naïve factor exposure is a substantial lack of diversification that is likely to do more harm than good over the long-term. 

There is no meaningful evidence that dividends alone are an indicator of strong future returns, and there is definitely no evidence that investors can successfully pick dividend paying stocks consistently in order to beat the market. As usual, most investors are probably better off investing in low-cost total market index funds to capture the long-term returns of capitalism as a whole. If you going to bet on a factor, the well-researched factors such as size, value and profitability are much better bets than dividends.