Digging Deep On Dividend Defense

March 11, 2019

[Join us for our “Has Volatility Met Its Match: A Case for Dividend Growth Investing,” webinar on Tuesday, March 19 at 2:00 p.m. ET.]

 

With apologies for that alliteration, I’ve been thinking a lot about return expectations lately.

ETF.com Live! Has been full of questions about gold, derivative strategies, quality, sector rotation—all signs that folks are feeling nervous. Perhaps it’s the return of volatility last fall. Perhaps it’s the seemingly endless trade war and deficit discussions. Maybe it’s a coming election.

But regardless of why you might be looking for an alternative to “just put it all in the S&P” strategies in your portfolio, it’s worth considering at a really fundamental level why we’re all investing in the first place.

Simple Investments

In many ways, fixed-income securities are (contrary to what the math would suggest) the easiest investments to understand.

I had a savings account when I was 7 years old, and fundamentally it worked the same way as any junk bond I’d buy now: I give my money to someone (my local bank, or an wildcatter floating garbage paper to fund a well) and they, in return, promise to give me back more money based on certain terms.

If the bank (or the wildcatter) goes under, you get in line to get some of your money back along with the guy who rented them the buildings, but for the most part, defaults are rare, and we assume those promises are good.

The value of the bond might change a bit over time, but if you hang onto it until it comes due, you get your money back, and collected some sort of return along the way (either in the payment at the end, in the case of a zero-coupon bond, or in interest paid out along the way).

But stocks are just different. When you buy shares in a company, they aren’t promising you much of anything. You’re an investor, not a creditor. And that means you’re engaging in the entrepreneurial risk of that venture just as much as if you were the founder of the company. So how is that actually supposed to turn into positive returns?

Foolish Considerations

The most basic way is some version of the “greater fool” theory. If you buy a company’s shares for $100, and it then proceeds to “do well” by whatever metric Wall St. believes is important, the expectation is that other investors—greater fools—will pay more in the future than the $100 you paid. While this price appreciation is fundamental to why we invest, it’s also the most problematic part of the process.

The vast majority of financial hand-wringing goes into determining what the “right price” is for assets. Sometimes companies are really simple, and they make widgets in a factory that they sell to widget buyers, and it’s all about growth, margins and market positioning.

Increasingly, however, asset prices are driven by nontraditional metrics. Consider the innovative ways The Street comes up with to value companies that lose money: eyeballs, patent applications, market penetration, brand value.

Actually Making Money

Then then there’s the old-fashioned idea of actually just paying back your investors.

That’s what dividends do. When a company makes a bunch of cash, it has a lot of choices about what to do with it. If it’s still growing and building, it might hoard the cash to reinvest in the business or make acquisitions. Or it might choose to buy its own stock—definitely the flavor of the month these past few years. That has the effect of limiting the supply of shares available, thus putting upward pressure on the stock price. And last, most old-fashioned of all, is to simply pay a dividend.

There’s no real magic in dividends. They’re a way of rewarding your shareholders from free cash flow. But there’s also a mystique about dividends. I remember when I was a child, my grandfather, who was a stockbroker, had a near cultlike devotion to the dividend stocks that made up his portfolio (and subsequently funded his retirement). Yet some of the largest, richest companies in the S&P 500—Facebook, Alphabet, Amazon—choose not to pay dividends even when they can.

Should You Care?

In short: probably. Despite the reluctance of some high-fliers to hoard their cash (or buy back their stock), there’s an overwhelming amount of evidence that the propensity for a company to pay dividends is an important consideration when evaluating the long-term quality of a firm.

In 2007, Eugene Fama and Ken French took a look at the components of return since the 1960s and, unsurprisingly, found that dividends were an enormously important contributor to your returns—especially the more large-cap and the more value-oriented you were:

 

Source: Fama, Eugene F. and French, Kenneth R., The Anatomy of Value and Growth Stock Returns (August 2007). CRSP Working Paper. Available at SSRN: https://ssrn.com/abstract=806664 or http://dx.doi.org/10.2139/ssrn.806664

The chart above looks at growth, neutral and value portfolios of small and big stocks, and pretty inescapably shows that the more “large cap value” you are, the more important dividends are.

But perhaps even more importantly, the research is continuing to show that if you want a strong indicator of your portfolio returns, it’s very hard to do much better than dividend yield. A paper from Andrew Ang and Jun Liu in 2005 did the heavy lifting on this, and produced (on top of 50 pages of analysis) one chart that pretty much sums it up:

 

Source: Ang, Andrew and Liu, Jun, Risk, Return and Dividends (Nov. 29, 2005). Available at SSRN.

 

Digging Even Deeper?

If it’s inarguable that dividends are important, there’s a legitimate follow-up question: So what? Depending on how you want to slice and dice, I count over 150 funds that make some sort of claim to be focused on dividends. So how the heck, in this age of buybacks, are we to make sense of the options?

If you want to continue the conversation, please join me, Aye Soe, managing director of global research and design for S&P Do Jones Indices; and Kieran Kirwan, director of investment strategy for ProShares, for a deeper dive on how to approach the dividend decision. We’ll get started at 2 p.m. ET on Tuesday, March 19, and CE credits are available, as always.

We’ll look at how dividend screening can create high-quality portfolios for today’s more volatile markets. Come loaded with questions. I know I will. You can register here.

Contact Dave Nadig at [email protected]

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