I think I’ve made it pretty clear that dividend investing is the basis of my investment strategy. Why is that? Well, to summarize; dividends provide higher returns (see this post ), dividends enhance returns during bear markets (see this post ), dividends account for most of world wide stock market returns (see this post ), and of course for retirees they generate income to live on irrespective of market prices. Today I want to drive the point home again about the power of dividends and explore some reasons why they are so powerful.
I came across a recent study that looked at the performance of the S&P500 across different types of dividend stocks and non-dividend stocks. You can find the study here . Lets take a look at the results of the study before we start the discussion. The study looked at annual returns from 1973 through September of 2010 of equal-weighted portfolios of the S&P500 stocks broken out by non-dividend paying stocks, dividend stocks with growing dividends, dividend stocks with no change in dividends, and those stocks that cut their dividends. There chart below shows the data.
Dividend stocks with growing dividends outperform non payers by 7.45% per year! Even dividend stocks that don’t grow their dividends outperform non-payers by 3.9% per year. Also, note that this out performance is way more than enough to overcome the tax disadvantages of owning dividend stocks in taxable accounts. How about risk, as measured by annualized volatility?
Pretty impressive. Not only do you get better performance but that performance comes with lower volatility, the modern finance measure of risk. There you have it – more data that supports that dividend payers are superior investments. As to the reasons for this out performance the study suggests that investing in dividends stocks is contrarian in nature because most investors believe that;
- rising dividend yields mean lower portfolio returns
- that the paying of dividends is an indication by management that they have no good investment opportunities
- a belief that dividends signal an end to a company’s growth
- the negative tax treatment of dividends means lower returns
There is nothing better I like than taking advantage of incorrect conventional wisdom. What I really liked about this study was the break out by types of dividend stocks, and it shows that the highest returns are to stocks that are increasing their dividends. The author then points to yet another fact that goes against conventional wisdom, “The overall conclusion is that rising dividends signal improved company performance and, in turn, higher individual stock returns.” In other words, dividends and in particular rising dividends are a forward indicator of improving company performance! And that is nothing if not extremely powerful.
In closing, this study proves yet again that dividend investing is a superior way to invest. In particular it points to a focus on investing in dividend stocks with growing dividends as the best dividend strategy. And it shows that sometimes you can have your cake and it eat it too – higher returns with lower risk.
Postscript: I haven’t found an investment product, fund or ETF, that implements such a strategy. It would be a very easy strategy to run in an ETF. It would also be very cheap to run. Maybe if I ever decide I want to work again I’ll take this on.
11 thoughts on “ The power of dividends ”
You stated “Postscript: I haven’t found an investment product, fund or ETF, that implements such a strategy.” May I suggest that you take a look at the Thornburg Investment Income Builder mutual fund. Despite what looks like heavy loads one can buy this fund through certain fund supermarkets (e.g. Fidelity) without the load and without the onerous stated minimum initial purchase amount. I use TIBIX.
Mark, thanks for the comment. Thornburg is one of the better fund houses out there. TBIX is a blended income fund, i.e. it holds both US stocks, foreign stocks, and bonds. And a pretty good one it is. What I was referring to in my postscript specifically is an ETF that would generate the results for dividend growing stocks that the study detailed. It would thus use the following strategy; take the S&P500 stocks and create an equal weighted portfolio that invests only in those stocks that increased their dividend in the last year. Then at the end of the year, re-balance the portfolio and do it again.
For others that are interested, Thornburg has a brochure for the Income Builder fund ( http://www.thornburginvestments.com/literature/fund_literature/TH1731_DividendStory.pdf ) that makes many of the same points as the study I linked to made. Enjoy. Hat tip to Mark for pointing me to Thornburg.
Paul, unless I am misunderstanding something, the Vanguard Dividend Appreciation ETF VIG is based on the strategy you discussed. Also, it has a low expense ratio. Have you looked at VIG? An aside, while I am attracted to the idea of investing in stocks with an increasing dividend, I have thus far not invested in VIG due to the its low, though presumably growing, dividend.
Hi J. VIG comes closer than most other ETFs to what I’m talking about. VIG replicates the Mergent Dividend Achievers Select Index which consists of stocks that have raised their dividends for at least 10 years. It also selects stocks across the market, not just the S&P500 and it is market cap weighted as well. They then do additional screening for liquidity and financial strength – but they don’t publish what those screens are. So, its not quite what I’m talking about, which is an equal weighted index of S&P500 stocks, that only looks at what happened to the dividend on year back.
As for VIG, I agree the yield is awfully low, about the same as the S&P500. If the ETF grows its dividend at a higher rate than the S&P500 then maybe its worth it. It only has about 5 quarters of history as an ETF. I’d like to see some more history or at least some more details of the index methodology before giving it a thumbs up or down.
I should probably do a post reviewing the various dividend ETFs out there.
Thanks for another enlightening post. I am a bit confused about something (what else is new!). Both your post and the article you referenced refer to dividends as being tax inefficient or having a negative tax treatment. My understanding is that qualified dividends are taxed at a flat rate of 15%, the same as long term capital gains. To me, 15% is not bad compared to ordinary income tax rates of up to 35%+. Can you explain why dividends are seen as bad from a tax point of view?
You’re not confused at all. You’re absolutely right about most dividends being taxed at the lower 15% rate. At least for a couple of more years anyway. But one of the arguments people use against dividend stocks is even the 15% rate is higher than the 0% you would pay on a stock that pays no dividends. So you are relying 100% on capital gains for the return on your investment which are only paid for at the time you sell. And while that is definitely an advantage the study shows that the extra return you get from dividends is more than enough to offset this.
Got it. Thanks Paul.
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