- I think that one of the single biggest challenges
for investors is understanding that dividends do not matter.
Dividends do not matter.
Corporations can use their capital
to invest in future projects,
fund the research and development
or fund that 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 as always, there's more to the story.
I'm Ben Felix, associate portfolio manager at PWL Capital.
In this episode of common sense investing,
I'm going to tell you why chasing dividends
might hurt you in the long run.
(upbeat music)
Before I start the episode,
I do want to let everyone know
that I've started a weekly podcast called
"The Rational Reminder."
It's a reality check on sensible investing
and financial decision making for Canadians
co-hosted by my PWL Capital colleague, Cameron Passmore.
If you enjoy my common sense investing videos,
I think that you will really like the podcast.
I've put links to "The Rational Reminder"
in the description below.
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 longterm.
I can't stress enough that picking dividend growers
should not be expected to beat the market over the longterm.
We can look to the SPIVA Canada year end 2017 report
for a sample of professional investors
who try to do exactly this.
For the 10 years ending December, 2017,
the S&P TSX Canadian Dividend Aristocrats Index
returned 8.01% per year on average.
There were 48 dividend mutual funds in Canada
at the start of that period.
And exactly zero of them managed to beat the index
over 10 years.
The average return of the funds was 4.9% per year
on average over the period.
Even if we add back an estimated 2.5% fee,
the funds were unable to match the dividend index.
Now here's where it gets tricky.
I just told you that dividend funds
can't beat the dividend index,
but 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 naive 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 naive
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 naive factor exposure
is a substantial lack of diversification
that is likely to do more harm than good over the longterm.
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 longterm 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.
I bet there will be a ton
of dividend investors watching this video
thinking that I'm crazy.
So please change my mind in the comments.
Thanks for watching.
My name is Ben Felix of PWL Capital,
and this is Common Sense Investing.
I'll be posting a new video every two weeks,
so subscribe and click the bell for updates.
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