By Jack Forehand, CFA, CFP® (@practicalquant) —
Ok, I’ll admit that the title of this article is a little aggressive. That is especially true when you consider the fact that I don’t think investing in high yield stocks is a bad investment strategy. In fact, academic research shows that it is a reasonable one.
The problem with dividend investing isn’t that it doesn’t work. The problem is that investor enthusiasm for it significantly exceeds its actual value. When you look at each of the benefits that buying high yield stocks provides, you will typically find that there is a better way to accomplish that same thing using an alternative approach.
To better understand why that is, let’s look at some of the major arguments supporting high yield investing and why there might be a better way to accomplish each of them.
[1] High Yield Stocks Beat the Market
The argument that high yield stocks outperform the market is actually backed up by the long-term data. So if you stop there, you would think that the strategy is a sensible one to pursue.
But the most important question is not whether the strategy beats the market, it is why it does. And that question is the one that trips up the argument for buying high yielding stocks.
If you invert the calculation of dividend yield (dividend/price), you get price/dividend. If dividing price by a fundamental variable looks familiar, it is because it is what all of the major value metrics do. When you look at it that way it becomes clear that yield is really a value factor. And if it is a value factor, it would make sense to compare its excess return over time with the excess returns of the other available value factors. And that is where high yield investing ends up looking less attractive than many think. Most of the other value factors show better long-term performance than price/dividend.
Gregg Fisher looked at this idea in his 2013 paper “Dividend Investing: A Value Tilt in Disguise?”. He examined the excess returns of high yield stocks and found that value was a significant positive contributor. But once value was stripped out, yield had a negative contribution. So if you are looking to beat the market, investing in value stocks using other metrics is a superior approach to focusing on yield.
[2] Yield Requires a Dividend
Although investors love to focus on dividends, they are not the only way to return capital to investors. In many cases, they are not even the best way. From the perspective of an investor, a company buying back its stock has virtually the same benefit as it paying a dividend. And it also has an additional benefit in that it is more tax efficient since dividends are taxed when they are paid while buybacks just result in existing shareholders owning more of the company.
When you look at long-term returns, a strategy that uses shareholder yield (dividend yield + buyback yield) also outperforms a dividend yield only strategy by a substantial margin.
This chart from an OSAM research piece shows just how substantial that outperformance has been.
[3] Dividends Are Required to Fund Portfolio Withdrawals
Another reason investors love dividends is the fact that they are automatically deposited into their accounts. As a result, they can be used to fund withdrawals without having to sell securities.
But is selling securities really such a bad thing? With the technology available today, it is easy for an investor to setup an automatic synthetic dividend system that sells a small portion of their portfolio to meet expenses. And in some cases, that can be a more tax efficient approach since the assets that are sold can be controlled. For example, losing positions could be sold to generate taxable losses when the opportunity presents itself as opposed to the taxable gains generated by dividends. When you look at the total picture, synthetic dividends can do almost everything regular dividends can, and high yield stocks are not a necessary requirement to generate portfolio income.
The Reality of Dividend Investing
Investing in high yield stocks is not a bad strategy. If you look at the long-term data, there are far worse approaches you could use. But our goal in investing is not to produce a good portfolio. It is to produce the optimal portfolio to meet our goals. And when you break down the individual goals investors try to accomplish using dividend paying stocks, there usually is a better way to achieve each of them. When you dig beneath the surface, investing in high yield stocks just doesn’t live up to the hype.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.
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See the stocks part of the S&P 500 and have increased their dividends in each of the past 25 years.
