Swedroe: Rethinking Dividend Strategies

May 08, 2014

Is getting cash flow from dividend-focused equity strategies as attractive as it seems?

During bear markets, the dividends thrown off by companies provide the cash flow required, while a total-return approach requires one to sell shares to provide the cash flow—a clear advantage of dividend-focused strategies that those who favor them are quick to point out. This blog addresses that issue specifically.

We’ll begin our discussion by pointing out that any strategy that focuses its screen on dividends is likely to result in a portfolio that pays higher dividends than a strategy that doesn’t. This is true of any strategy based on a single metric. For example, until recently, the small value fund of Dimensional Fund Advisors (DFSVX) used a single screen of price-to-book (P/B) ratio (it recently added a profitability screen).

On the other hand, Bridgeway’s small value fund (BOSVX) uses four different screens, of which P/B was just one. (Full disclosure: My firm Buckingham recommends Dimensional and Bridgeway in constructing client portfolios.)

While Bridgeway’s funds typically had lower prices relative to earnings, sales and cash flow, the P/B ratios were typically almost identical, or they even slightly favored DFSVX. Thus, from the perspective of the other value metrics, or from the perspective of a combined measure, BOSVX was “more value-y” than DFSVX, and would have higher expected returns. However, if you only looked at the P/B metric, you wouldn’t find that difference. In fact, as I mentioned, at times it favored DFSVX.

Similarly, a dividend strategy such as an investment in the SPDR S&P Dividend ETF (SDY | A-66)—it seeks to closely match the returns and risk of the so-called High Yield Dividend Aristocrats, which Morningstar classifies as a large value fund—is going to have a higher dividend yield than a similar large value fund such as DFA’s DFLVX. SDY has a dividend yield of about 2.7 percent, while DFLVX’s dividend yield is only about 1.7 percent. However, in terms of the other value metrics, DFLVX is much more “valuey,” with much lower P/E, P/B and P/CF ratios.

What you also observe is that there really isn’t that great a difference in yields between the two value strategies—about 1 percentage point. In other words, not screening for dividends doesn’t mean you only buy the stocks of nondividend payers, it means you don’t avoid them as a dividend strategy does. You will also buy the stocks of dividend payers if they meet your other buying criteria.

In this case, if you needed to generate 2.7 percent cash flow from your portfolio, SDY would provide the full 2.7 percent. If you owned only DFLVX you would have to sell just 1 percent of the value of your shares.

However, as I have pointed out, the prices of the stocks of SDY are now lower by the 2.7 percent dividend SDY paid out, while the stocks of DFLVX are lower by just 1.7 percent. Thus, while you will have fewer shares of DFLVX, because the dividend was smaller, its price will be relatively higher, offsetting the reduction in share ownership. Your expected returns will be the same whether DFLVX paid out 2.7 percent in dividends or it paid out its 1.7 percent dividend and you sold 1 percent of value of your shares.

The other problem typically cited is that it’s one thing to sell shares during bull markets, but when you sell in bear markets, you’re selling at the worst time. There are two problems with this line of thinking.

The first is that dividends are the equivalent of a “disinvestment” in a company in the same way as is a self-made dividend (via the sale of shares). The second is an even more important one: Those who rely on a total-return approach don’t need to hold all their investments in equities.

They typically also own bonds, just as do some investors using dividend strategies. They also adhere to an asset allocation plan that requires them to rebalance on a regular basis. During the accumulation phase, rebalancing is typically done by buying the assets that had underperformed, of if need be, to sell some of the outperformers. In other words, you wouldn’t sell stocks during a bear market; in fact, you’d be a buyer.


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