Q&A with IFA: Dividends—Is Bigger Better?

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Question: Does an equity strategy focusing on stocks with above-average dividend yield offer an appealing risk/reward tradeoff? Have dividend-paying stocks outperformed non-dividend payers in the U.S.?

Note: The question above was taken from DFA’s Fama/French Forum. Here is the first paragraph of their two-paragraph response:

“Ranking stocks on dividend yield is just another way to separate value stocks from growth stocks using the ratio of a fundamental to price. We prefer to use other fundamentals, like book value or cash flow, in the numerator of the price ratio, for a simple reason: roughly 80% of all listed U.S. stocks and almost all small firms do not pay dividends.”

Whether your strategy is to invest in companies that currently have the highest dividend yields or companies that have a strong history of increasing their dividends, the bottom line is that you can expect to be paid for the risk you take and not for anything else. In this article, we thoroughly explored the “increasing dividend” strategy and found that over a 20-year period, it had about the same risk-adjusted return as the S&P 500 Index. Fama and French bring up the important point that filtering on dividends essentially confines you to a few industries such as utilities and consumer staples which at certain times can cause you to lag the overall market. The second paragraph of their response addresses the value-tilt (and higher expected return) that results from selecting only high-dividend stocks:

“Dividends were more common in the past, and like sorts of stocks on book-to-market equity or cash flow to price, sorts on dividend yield do identify a value premium (higher average returns for higher dividend yields) in international markets as well as the U.S. (Fama and French 1993, 1998). Sorts on book-to-market equity or cash flow to price seem to do a better job identifying value premiums, possibly because dividends are subject to more managerial discretion than other fundamentals.”

In addition to value risk, high-dividend stocks (especially utilities) also carry an element of term risk that we normally associate with bonds. We are not saying there is anything wrong with that, but investors in high-dividend stocks should not fool themselves into thinking that paying dividends makes them a safer investment than other stocks. In fact, an abnormally high dividend yield can signal underlying distress at a company and thus a high probability that the dividend will be reduced or eliminated altogether. As Fama and French note, there is absolutely no guarantee that a company will continue to pay dividends at the same level, much less continuously increase them.

Occasionally, we hear from individual investors or foundations that insist on never taking a withdrawal that requires securities to be sold. It’s almost like they are religiously adhering to the commandment of “Thou shalt not invade thy principal.” In this article, we showed how investors can benefit from taking a total return approach to investing and taking “homemade dividends” rather than requiring on the whims of “managerial discretion” noted by Fama and French above. The most important thing to remember is that there are no free lunches in investing (except for diversification), and nobody can reasonably expect to earn higher risk-adjusted returns merely for choosing dividend-paying stocks.