Interesting article and though I don't agree with his view, he makes many good points and I'm sure many would feel it's a good approach to follow.
Debunking Dividend Myths: Part 1
This post is the first in a series exploring common myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.
Dividend Myth #1: Companies that pay dividends are inherently better investments than those that don’t.
Many investors take it for granted that dividend-paying companies are superior to those that do not pay a yield. But this idea has been the subject of debate for decades, and many academics believe that it is irrational.
Let’s start with something everyone can agree on. Equity returns have two components: capital gains (price increases) and dividends. Add them together and you have the total return for a stock. Ignoring taxes and transactions costs, a stock that pays no dividend but increases in price by 6% provides precisely the same return as one whose share price rises 4% and pays a 2% dividend.
Dividends lead to a drop in share price
What many investors don’t grasp is the direct relationship between share prices and cash dividends. If a company’s stock is trading at $20 and it pays a $1 dividend, its share price (in theory, anyway) should fall to $19 on the ex-dividend date. This price drop will not be penny for penny, and it may even be washed out by the normal fluctuations in the daily markets. But there is always a trade-off. After all, when a company that pays out, say, $10 million in dividends, it must be worth $10 million less. The failure to understand this point is the reason so many investors think of dividends as “free money.”
In 1961, Merton Miller and Frank Modigliani published a landmark paper that became the basis for what is now known as the dividend irrelevance theory. They argued that whether or not a company pays dividends should not matter to shareholders, because it does not affect their overall returns. Dividend policy simply determines whether investors end up with a share valued at $20, or a share worth $19 plus $1 in cash.
Not everyone accepts the Miller-Modigliani model. Two other economists, Myron Gordon and John Lintner published a counter argument that has come to be called the bird-in-the-hand theory. Their idea was that shareholders cannot be sure that a company will spend its capital wisely, so a dollar paid in dividends is preferable to one kept as retained earnings. This may be true, but investors who advocate DRIP programs cannot logically subscribe to this theory: if they truly believed it, they would not reinvest their cash dividends in new shares.
The illusion of income v. capital
Why do shareholders believe so strongly that a $1 dividend is preferable to a $1 capital gain? Meir Statman looked at this question in a 1984 article called Explaining Investor Preference for Cash Dividends, coauthored by Hersh Sheffrin. He also reviews the idea in his new book, What Investors Really Want, pointing out that receiving $1,000 in dividends is no different from selling $1,000 worth of stock to create a “homemade dividend.”
Even when this idea is explained to people, most refuse to accept it. Statman suggests that it comes down to a cognitive bias called mental accounting. Investors categorize $1,000 in dividends as income that they will happily spend, but the idea of selling $1,000 worth of stock is “dipping into capital,” which causes them great anxiety. This idea is deeply ingrained in many investors, but it is an illusion, because a company that pays a dividend to shareholders is depleting its own capital.
Other sources of shareholder return
There are other compelling arguments against the inherent superiority of dividend-paying stocks:
· Many companies that pay no dividends use their free cash to repurchase stock. These buybacks increase the value of the remaining shares, which benefits all shareholders. There is no logical reason to prefer dividends over stock repurchases when the net benefit to investors is the same. (Indeed, share repurchases have no tax consequences, while dividend payouts do.)
· Profitable companies that have not reached maturity can often earn much higher return on equity by reinvesting their earnings in growing businesses. Many highly profitable companies (especially in technology and mining) do not pay dividends because they can put that cash to much more productive use. These companies will typically begin paying dividends later in their life cycle, when those growth opportunities disappear.
· It has long been known that the over the long term, small-cap stocks have dramatically outperformed large-caps (with correspondingly more risk). The small-cap premium was more than 3% during the past 80 years. Most small companies do not pay any yield, so investors who select only dividend-paying stocks are ignoring the segment of the equity market that has enjoyed the highest long-term returns.
Investors who use broad-based index funds accept that equity returns come from profitable businesses, some of which pay cash dividends, and some of which put their earnings to work in other equally rewarding ways. In the end, as Meir Statman writes, “a dollar labeled dividends is as green as a dollar labeled capital, so rational investors are indifferent between the two.”
Dividend Myth #2: Dividend investors are successful because they select excellent companies and buy them when they are attractively priced.
Every morning Larry takes a brisk walk with his beloved German shepherd and then enjoys a Dole banana and a cup of nonfat Yoplait. He eats organic lunches at The Angry Vegan, and three times a week he visits The House of Pain, where he lifts weights, swims or does a spinning class. Larry follows this routine for decades (he goes through a few German shepherds) and remains spry and active into old age. One day, Larry’s great-grandson asks him for the secret to keeping so healthy. “It’s all about making good choices,” the old man replies. “Start by choosing a breed of dog that is strong and long-lived. Then buy only recognized brand names for your breakfast foods. Finally, always patronize restaurants and fitness clubs that are well managed and highly profitable.”
When I hear dividend investors talk about their success, I think of Larry. Because like my fictional fitness buff, these investors often achieve their goals without appreciating why. They save regularly and put their money to work in the equity markets, which have delivered better long-term returns than any other investment. They avoid high-fee mutual funds, keep their trading costs low, and carefully manage their accounts to minimize taxes. They hold their stocks for the long run and show strict discipline by not panicking when markets tumble. These factors probably determine 95% of their fate. Yet when dividend investors reflect on their wealth, they’re inclined to say, “I owe it all to my ability to choose excellent companies with good yield, and to buying them when they were attractively priced.”
The real reason dividend investors succeed
The most important factors affecting investment success are boring. When was the last time you bragged to a friend about how few trades you made last year? Or regaled your family with stories of your preauthorized RRSP contribution? Try as I might, I just can’t seem to get my hockey buddies interested in asset-class correlation.
By contrast, the hunt for dividends is exciting. People genuinely enjoy analyzing businesses, building their stock portfolios one company at a time, feeling smart when their picks do well, monitoring the markets for buying opportunities and, perhaps most of all, getting those cheques in the mail. This is clear from the zeal of dividend investors, which isn’t matched by people using any other strategy. There are no blogs called “Think Bond Ladders” or “The Capital Gains Ninja.”
There’s nothing wrong with this — indeed, people who enjoy investing are more likely to be successful than those who find it a chore. Anyone who tells a dividend disciple that they should switch strategies has failed to understand that investing isn’t only about earning the highest possible return. As Meir Statman has argued, investing has genuine expressive and emotional benefits.
However, because many dividend investors devote so much time and enthusiasm to identifying great companies at good prices, they mistakenly believe that this is the essence of the strategy. On the contrary, I think that dividend investors achieve their financial goals because they do everything else right. Their wealth comes despite stock picking and market timing, not because of it.
Beating the market is still a loser’s game
Dividend investing is a successful and enjoyable strategy. The problem is that it’s often extolled as a way to beat the market. This is the dangerous part of the myth, and a claim that should be challenged.
The fact is, dividend investing is simply a form of active management. I’m not going to rehash the whole active-versus-passive debate here — many books have been devoted to the topic, and the matter has been settled by academics. Suffice it to say that likelihood of any investor beating the market over a lifetime is extremely low. It’s probably higher for dividend investors than it is for mutual fund managers, who have much greater costs to overcome, but it’s still a long shot.
There is no shortage of data showing that dividend-paying stocks outperformed the overall market during many periods in the past. The problem isn’t that these data are wrong, it’s simply that they are backward-looking and have no predictive value. Stocks that pay consistently high dividends over the next 20 years probably will outperform the market between now and 2031. The problem is no one has figured out how to identify those companies today.
Companies that have grown their dividends in the past are no secret to anyone, and screening for these stocks in no way guarantees outperformance. (Does anyone buying Fortis think that its widely known record of rising dividends isn’t baked into the price already?) Identifying undervalued stocks is far more difficult than many people admit. Surely amateur investors cannot truly believe that they have special talents in these areas when nine out of ten professionals cannot outpace their benchmarks.
Dividend junkies have a solid track record, and no one should suggest they abandon their strategy if it works for them. However, all investors should remain skeptical of anyone’s ability to consistently pick stocks and time their purchases. It’s always been a loser’s game. Instead, we would all do well to emulate the discipline, cost consciousness and other good habits of dividend investors. No matter what strategy you use, if you can get that part right, you’ll reach your financial goals.
Dividend Myth #3: Dividend-paying stocks are a substitute for bonds in an income-oriented portfolio.
It’s awfully hard to get excited about fixed-income investments these days. During most periods in the past, bonds and GICs paid interest rates significantly higher than the average stock dividend. But not today: five-year GICs are now pulling down about 3%, while 10-year federal bonds are earning less than 3.5%. The dividend yield of the S&P/TSX Composite Index is about a point lower than that, but it’s easy enough to build a stock portfolio that pays 4% or more.
No wonder I frequently hear from investors who have ditched fixed-income investments altogether in favour of dividend-paying stocks. Indeed, some popular dividend gurus advocate throwing fixed income to the dogs altogether, no matter what market conditions happen to be. “I don’t understand why people switch to bonds in retirement,” writes Tom Connolly of the popular Dividend Growth website. “Have you ever known a bond to increase its interest rate?” Lowell Miller, author of The Single Best Investment: Creating Wealth with Dividend Growth, opens his book with a whole chapter devoted to bond bashing: “Let me put it bluntly: bonds are a bad investment.”
Both of these authors argue that stocks with a track record of growing dividends can provide an income that rises every year, even if the stocks themselves fall in value. Bonds, meanwhile, pay a fixed coupon until their maturity date. “In 2008, our dividend income rose in spite of the turmoil by 9.9%,” Connolly wrote in 2009. “Did your income rise by 10% last year?”
It’s true that dividend-growth stocks can provide a steadily rising income for investors in retirement. But any investor contemplating an all-equity portfolio should make absolutely certain they understand what they’re doing.
Dividend stocks are not “bonds with growth”
Connolly scoffs that bonds do not raise their interest rates, but that’s never been the reason for including them in a portfolio. Investors buy bonds because the interest income is guaranteed. (Unless the issuer goes bankrupt, of course, but this is a negligible risk with government bonds, and an extremely small one with investment-grade corporate bonds.) One might ask Connolly, “Have you ever known a stock to reduce its dividend?” Of course, this happens frequently, even with blue chip companies. Remember, a company is not legally bound to pay dividends, but it must never reduce the coupon on its bonds.
The other consideration is the risk of capital loss. Bonds fall in value when interest rates rise, but stocks can suffer declines that are far more gut-wrenching. A portfolio of dividend-paying stocks might well have seen its income go up by 10% in 2008, but it likely lost 30% to 40% of its overall value before the market bottomed.
Consider that in dollar terms: imagine a retired investor with a $1-million portfolio generating $40,000 a year in dividends in 2008. Assume (generously) that every company she owns raised its dividend by 10% that year, bumping up her income by $4,000. Meanwhile, the portfolio’s value would have dropped by as much as $400,000. If you can stomach a loss like that in retirement, then an all-stock portfolio is perfectly appropriate for you. But few people can. Derek Foster couldn’t do it, and he was under 40 when he sold everything in a panic. Ask any financial advisor how clients in their 60s and 70s handled the crash of 2008–09, and how much solace they took in the fact that most of their stocks continued to pay dividends.
A more balanced approach
There is an alternative for investors who want rising income in retirement. It’s based on the highly influential research of William Bengen, first published in 1994 and updated many times since then. Bengen determined that investors with a portfolio of 50% stocks and 50% bonds can safely withdraw 4% in the first year, followed by inflation-adjusted withdrawals each succeeding year. For example, our investor with $1 million can take out $40,000 in year one. If inflation is at 3%, she can raise her withdrawal to $41,200 in year two, and $42,436 in year three.
Bengen ran his simulations using decades of historical returns and inflation scenarios, and found he that a portfolio drawn down using this “4% rule” has an extremely high likelihood lasting throughout retirement. Upping the stock portion to 75% allowed retirees to raise their withdrawal rate even further, so long as they could accept the additional risk. Bengen’s research revolutionized retirement planning and is widely followed by financial professionals.
The point is that it’s not necessary to rely solely on dividend-paying stocks to provide a cash flow that keeps pace with inflation. Keeping 25% to 50% of a portfolio in bonds will dramatically reduce a portfolio’s volatility and still provide retirees with the rising income they desire.
Dividend Myth #4: You can beat the market with common sense: just focus on blue-chip companies with a competitive advantage and a history of paying dividends.
I recently attended an investment show where one of the speakers (a well-known Canadian author) explained that his strategy was just common sense. It went something like this: “Think about the products and services you use every day. We all use toothpaste, cellphones, debit cards, oil and gas. So all you need to do is identify the best companies in these sectors: they should have strong brand recognition and a competitive advantage. Buy stocks in these companies, and then sit back and watch those dividends roll in.”
Peter Lynch was the pioneer of “buy what you know,” and here in Canada, Derek Foster has taken up the torch. I touched on this kind of folksy investing wisdom in a previous post back in November, after The Globe and Mail profiled an investor who explained his strategy this way: “I basically sat down and thought, what is absolutely essential to our society, and who provides those essentials?” In his view, it came down to pipelines, banks and railroads, and he chose his stocks accordingly.
Why do these strategies make more sense than simply buying a broad-market index fund? There’s a common-sense answer for that, too: “Buying an index fund is foolish, because you get the bad companies as well as the good ones.”
It’s easy to see why this approach to stock selection is so appealing. It’s intuitive, easy to understand, and empowering. And it makes no sense if your aim is to beat the market.
The problem here is not the premise of the argument—it’s the conclusion. Clearly blue-chip, dividend-paying companies like the big banks, telecoms, major retailers and energy producers are profitable businesses. But this information has zero value to an investor trying to outperform the broad market, for the simple reason that everybody knows this.
Information is not insight
Financial author Larry Swedroe likes to compare stock picking with sports betting. When the first-place New England Patriots play the woeful Denver Broncos, it doesn’t take a genius to identify the favourite. So if you bet on the Patriots, they have to win by, say, 10 points or you lose the wager. Based on all available information — the teams’ records, injured players, home-field advantage — skilled bookmakers establish a point spread that makes the odds of winning the same no matter which side of the bet you take. In other words, knowing that New England is a better team is worthless information.
You can see the parallel with stocks. The “bookmakers” are the analysts who pore over every detail about public companies and trade millions of shares a day. They all know which ones have solid sales, a competitive advantage, a low price-to-earnings ratio and a record of dividend increases, and this knowledge is reflected in the (higher) price of those stocks. Companies and sectors that are struggling are just as easy to identify, and their (lower) stock prices reflect this, too.
In the end, buying Royal Bank or Telus rather than one of their competitors is like betting on the Patriots to beat the Broncos. You’re probably right about which company will succeed in the marketplace. But unless you can consistently cover the spread, you won’t earn higher returns.
The wisdom of the crowds
Common sense is a rare and precious asset, but it has no value when it comes to choosing stocks that will outperform a broad-based index. In an efficient market, every stock’s price already reflects the collective common sense of hundreds of thousands of informed investors. Once you accept this — and it’s clear that many people do not — then it’s wise to abandon the idea of selecting individual companies and simply embrace the market as a whole.
You can put your faith in your own unique ability to outsmart the market, or you can buy a slice of the entire world’s economy for less than 30 basis points. The right choice would seem to be common sense.
Dividend Myth #5: It’s easy to build a well diversified portfolio of Canadian dividend stocks.
One of the most appealing aspects of dividend investing is the tax advantage: dividends from Canadian companies are eligible for a significant tax credit. This credit does not apply to US or international stocks, however—indeed, foreign dividends are taxed as regular income and are subject to withholding taxes. That’s why many dividend-focused investors hold only Canadian stocks in their portfolios.
Income from Canadian dividends is an important part of most retirement plans. But if you’re staking your whole future on a small number of domestic stocks, you should be aware that your investment strategy may be a lot riskier than you think.
Understanding risk
First, a little financial theory. All equity investors face systematic risk, which is simply the risk associated with the market as a whole. Systematic risk cannot be diversified away: even people who own index funds with thousands of stocks are not immune to a market crash.
A second type of risk is called is unsystematic risk: it applies only to investors who hold individual stocks. For example, a company’s share price will fall if it declares lower-than-expected earnings, but such an announcement will have virtually no effect on the broad market.
The important point is that investors are rewarded for taking systematic risk: it is the reason stocks have the highest long-term returns of any asset class. However, investors are not compensated for taking unsystematic risk. Holding a small number of stocks in a portfolio offers the possibility of dramatically beating the market, but this potential is outweighed by the much higher downside risk.
That’s why investors should try to eliminate unsystematic risk altogether. They can do this by diversifying their holdings across many stocks, so that no single company can torpedo their portfolio.
How many stocks do you need?
So how many stocks do you need in your portfolio to eliminate single-company risk? A commonly held belief is that 15 to 30 stocks are enough, so long as they are spread across several sectors. However, recent research suggest that number should be much higher.
An analysis in The Journal of Investing in 2000 found that “even 60-stock portfolios achieve less than 90% of full diversification.” A 2008 paper from Dimensional Fund Advisors argued that a 50-stock portfolio would need to beat the market by 10 basis points per month to reward the investor for the additional risk.
In his review of the research on diversification, William Bernstein puts it this way: “To be blunt, if you think that you can do an adequate job of minimizing portfolio risk with 15 or 30 stocks, then you are imperiling your financial future and the future of those who depend on you.”
A narrow slice of a narrow slice
Even if you could properly diversify a portfolio with 30 holdings, there’s still the matter of spreading these across all sectors of the economy. And if you’re picking only from a menu of Canadian dividend-paying stocks, that is virtually impossible.
The makeup of the Claymore and iShares dividend ETFs bear this out. Claymore’s CDZ includes companies that have raised their dividends for at least five years: there are fewer than 40 of these, and about 30% are in the energy sector. Its iShares competitor, XDV, includes the 30 highest yielding stocks in the country, and it’s 52% financial services companies. The broad Canadian market is already poorly diversified, and focusing on dividend stocks just compounds the problem.
Canadians who select individual stocks rather than using ETFs have more freedom, but they can’t avoid sector concentration altogether. They can pick a few telecoms, utilities, REITs, and a railroad or two. But the technology, health care and consumer retail sectors (which make up about 45% of the S&P 500) are all but absent from the mix.
No one cares about diversification when their concentrated bets are working well. But what happens if Canadian banks suffer a crisis like US banks did in 2008–09? We dodged that bullet, but do we really think our financial institutions are immune from something similar? What happens when oil prices fall, as they have many times in the past? Or if foreign competition changes the Canadian telecom space?
Why expose your whole portfolio to idiosyncratic risks like this, when you’re not likely to be rewarded for doing so?
Seeking diversification abroad
It’s not just dividend investors who face risks from Canada’s small, narrowly focused stock market. Even Couch Potatoes who hold the entire S&P/TSX Composite have 70% of their money in three sectors (financials, energy, and materials). That’s why all Canadian investors should give serious thought to addressing their home bias.
If you have a significant portion of your investments in Canadian dividend stocks in a taxable account, consider taking a broader view with your RRSP. A diversified mix of index funds or ETFs (bonds, US and international stocks, and other asset classes) can dramatically reduce the risk of your overall portfolio. Canada is a wonderful place to invest, but there’s a big world out there beyond banks and energy.
Dividend Myth #6: Investors who follow a dividend growth strategy will eventually beat the market on yield alone.
I was hoping to wrap up this series on dividend myths after Part 5, but I bumped into another fundamental misunderstanding that I just couldn’t ignore. It’s proclaimed on Tom Connolly’s website DividendGrowth.ca, and I’ve heard it cited several times by other investors. According to Connolly: “With dividend growth investing, after a few years (maybe a decade) of dividend growth, you can beat the market with yield alone.”
This would be a very compelling argument in favour of a dividend growth strategy — if only it were true. Unfortunately, it’s just terrible math. Here’s an example of the logic that investors use to arrive at this spurious conclusion:
· In 2000, I bought 1,000 shares in Phil’s Nails for $20 each. The stock’s yield was 4%, or $0.80 per share.
· Over the next ten years, Phil’s Nails increased its dividend by 5% every year, so by 2010 it had grown to $1.30 per share.
· Since my original cost was $20 and I’m now receiving $1.30 per share in dividends, my yield on cost is 6.5% ($1.30 / $20).
· Therefore, I earned 6.5% in 2010 on dividends alone.
The first three statements here are fine, but everything falls apart in the last point. The investor here has assumed that his yield on cost and his annual return are the same. They’re not.
Investment returns are expressed in annual terms, while yield on cost is a completely different measurement that doesn’t consider how long an investment has been held. If you confuse the two, you will quickly fall into the trap of believing that your investments are doing better than they really are. You might even think you’re beating the market.
Increasing income does not mean increasing returns
Our shareholder in Phil’s Nails seems to believe that if his dividend grows every year, then his returns must also be increasing. Otherwise, how could he think he will someday “beat the market on yield alone”?
To see if that’s true, consider how the company’s stock price might have behaved over the last ten years. I have to make a few assumptions here, but the specifics are not important. The idea is to illustrate that dividend increases do not not translate into growing annual returns.
Phil’s Nails increases its dividend amount by 5% every year: from $0.80 in the first year to $0.84 in the second, and so on. But we cannot assume that the company’s dividend yield will also rise. For that to happen, the stock’s price would have to stay the same or fall every year — and it’s hard to imagine how any investor would see that as a positive thing. So let’s assume that the current yield remains constant at 4% for ten years, which is generous, but reasonable.
If the dividend amount increases by 5%, but the current yield stays constant, then the price of the stock would have to rise by 5% a year to make this possible. Here’s how the stock’s performance would look, assuming that the market moved in a straight line:
Share Dividend Current Yield
Year price amount Yield on cost
2000 $20.00 $0.80 4% 4.0%
2001 21.00 0.84 4% 4.2%
2002 22.05 0.88 4% 4.4%
2003 23.15 0.93 4% 4.6%
2004 24.31 0.97 4% 4.9%
2005 25.53 1.02 4% 5.1%
2006 26.80 1.07 4% 5.4%
2007 28.14 1.13 4% 5.6%
2008 29.55 1.18 4% 5.9%
2009 31.03 1.24 4% 6.2%
2010 32.58 1.30 4% 6.5%
So how have Phil’s shareholders fared? The investor who is focused only on the dividend will enthusiastically point out that his income has risen by 5% every year, and that he’s now earning a 6.5% yield on cost. But any way you slice it, the stock has returned 9% each and every year: a 5% price increase, plus a 4% dividend. The investor has done well, but he’s not likely to be beating the market, period, never mind “on yield alone.”
Why yield on cost is an illusion
Here’s a thought experiment. Imagine you bought 1,000 shares of MegaBank in 1990 when they were trading at $10. You’ve held them in your RRSP for 20 years, and the stock is now at $40, with an annual dividend of $1.60 per share. That means your yield on cost ($1.60 / $10) is a whopping 16%. One day your spouse accesses your account and sells all the shares. What would you do?
Your first reaction might be to shriek: “You just sold an investment that was yielding 16%! I’ll never be able to replace it!” But the correct course of action should be obvious: you should buy another 1,000 shares in MegaBank immediately.
Yes, you’ll be out two trading commissions and will lose a bit on the bid-ask spread — all told, you’ll be down perhaps $50. But otherwise, you’re back where you started, because your investment wasn’t yielding 16%, it was yielding 4%. You didn’t have a $10,000 investment yielding $1,600 — you never did. You had a $40,000 investment paying $1,600 in dividends. Your yield on cost is a historical relic that has no bearing on anything going forward.
I know this is hard for some investors to accept: read the comments under this Motley Fool article for some examples of the confusion. But if you take a deep breath and think about it, you’ll see that it must be true. If I buy MegaBank today, and you bought it 20 years ago, our yield on cost will be vastly different, but our annual returns will be exactly the same from now on. And if that’s the case, one of us can’t be beating the market while the other is not.
The power of compounding
There seems to be a stubborn belief that dividend growth stocks are fundamentally different from other equities. Dividend investors dwell on their “growing income” and “increasing yield on cost” as though these are unique to their strategy. But every other equity investor benefits from exactly the same concept. It’s called compounding.
Consider the most popular ETF in Canada, the iShares S&P/TSX 60 Index Fund (XIU), which holds the 60 largest companies in the country with no attempt to screen them for dividend growth.
In 2000, this ETF paid $0.15 per share in dividends. The distribution increased in eight of the last ten years (it fell by two cents in 2002 and five cents in 2009), and is now about $0.45 per share. Which means a boring old index investor who bought XIU in 2000 would now be collecting three times as much income as he did a decade ago, and his yield on cost would have tripled. That’s just how compounding works.
Some of the issues I’ve explored in this series come down to differences of opinion, but not this one. The idea that dividend growth stocks will eventually “beat the market on yield alone” is nonsense, pure and simple. If this is the basis for your investing strategy, then you’re guaranteed to be disappointed.