Dividend investors for approximately the last 15 years have been seen as the boy-scouts of the equity investing world: the play it safe crowd while the jocks, best represented this decade by the 26 year old i-banker wielding a MBA and a pocket full of hubris, got the glory and returns chasing the latest ten-bagger. However, research into returns of a dividend stock portfolio has shown that this perception is not reality; in fact, dividend stocks have returned greater than a broad based index over time.
With the markets being what it is even the jocks are turning into boy-scouts. The result is that the rush is on into dividend paying stocks. But is pursing the highest dividend yield stock (or income trust) necessarily the best thing? Nervous holders of bank stocks, now paying yields in excess 6%, would probably tell you no. Professor Kenneth French of Dartmouth’s business school would tend to agree.
French conducted a study by looking at what $100 invested in 1927 would yield if it investing in the highest quintile of dividend yielding stocks in the U.S. (a quintile is 20% so the highest quintile is the top 20%). The return on investment was $424,000 as of 2007 or 10.8% per annum.
He then took that same $100 and hypothetically invested it in stocks which paid yields in the next highest quintile. The return on investment was $806,000 or 11.7% per annum. The lowest yielding quintile (so the lowest paying dividend stocks) returned 8.8% per annum in the time studied.
The S & P 500 produced a 9.4% annualized return over the same time.
In other words, the highest and 2nd highest dividend yielding stocks beat the S & P 500 but chasing the highest dividend yields will not get you the best return based on historical analysis.
One reason why the 2nd highest quintile outperforms the highest is high yields may indicate a company is in trouble (since yield is a function of earnings per share/dividend per share, a high yield may indicate earnings erosion) or a company paying too much dividend may not have enough free cash to grow the business properly.
French’s then looked at 10 year blocks commencing 1928 (i.e. 1928-38, 38-48 etc.); for the 8 decade blocks, the highest quintile of dividend yieldig stocks outperformed the S & P 500 in 5 of 8 decades and the 2nd highest quintile outperformed the S & P 500 in 7 of 8 decades (although the highest quintile outperformed the 2nd highest quantile in the period of 1998-2008). Again, the 2nd highest dividend yield quantile is a steady outperfomer over time.
The implications appears to be that a race to 2nd (quantile) in the dividend yield race may be better off than merely scanning the highest yielding dividend stocks and buying them. French’s conclusions also seem to suggest that the dogs of the dow dividend investing strategy would not give one the best return over time (assuming the stocks in the dogs of the dow reside in the top quantile).
Here is French’s website.
January 27th, 2009 at 11:30 am
That’s a very interesting result – dividend yields do have some predictive power but you don’t want the companies that actually have a good reason for a high yield. In the long-term study was the result based on holding the same stocks for the whole period or changing regularly?
January 28th, 2009 at 1:50 am
From what I understand from the research, it was the top quantile so you could have the same stock move from quantile to quantile periodically.
January 29th, 2009 at 3:26 am
This is a pure gem, thanks. As someone who has been burnt twice by buying very high dividend stocks only to find the stock price or dividend to come crashing down in a short period of time – I can relate. I’ve recently added things like “Payout Ratio” to my analysis of income trusts to make sure it doesn’t exceed 75% so that the company is likely to have enough spare cashflow to pay the distributions and still grow the company.
January 29th, 2009 at 11:14 am
It may be based on switching every year then… that’s something that should be specified!
Another reason this could happen may simply be that there’s less attention. Buying high-yielding stocks is a well-known idea, which may cause the prices to be bid up and decrease the future returns. But if you go for the “second highest” yield there could be less competition. Of course if prices are bid up that lowers the yield so the effect would be a bit weaker.
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