It has long been known that many investors have a preference for cash dividends. From the perspective of classical financial theory, this behavior is an anomaly. In their 1961 paper, “Dividend Policy, Growth, and the Valuation of Shares,” Merton Miller and Franco Modigliani famously established that dividend policy should be irrelevant to stock returns.
As they explained it, at least before frictions like trading costs and taxes, investors should be indifferent to $1 in the form of a dividend (causing the stock price to drop by $1) and $1 received by selling shares. This must be true, unless you believe that $1 isn’t worth $1. This theorem has not been challenged since.
Moreover, the historical evidence supports this theory—stocks with the same exposure to common factors (such as size, value, momentum and profitability/quality) have the same returns whether or not they pay a dividend. Yet many investors ignore this information and express a preference for dividend-paying stocks.
One popular dividend strategy is to invest in the “dividend aristocrats.” For example, the S&P 500 Dividend Aristocrats measures the performance of S&P 500 companies that have increased dividends every year for the last 25 consecutive years. And there is an ETF based on that index, the ProShares S&P 500 Dividend Aristocrats ETF (NOBL).
In the Indexology blog of Jan. 9, 2019, Dividend Growth Strategies and Downside Protection, S&P’s Phillip Brzenk, senior director, global research & design, examined the performance of dividend growth strategies, specifically focusing on their performance during periods of negative market performance.
He found: “Since year-end 1989, there have been six calendar years of negative performance for the S&P 500—and in all six years, the S&P 500 Dividend Aristocrats outperformed the equity benchmark by an average of 13.28%. In fact, the S&P 500 Dividend Aristocrats produced a positive total return in three of those years.”
Examining the performance on a monthly basis, he found: “The S&P 500 Dividend Aristocrats outperformed the S&P 500 53% of the time, by an average of 0.16%. When isolated to down markets, the S&P 500 Dividend Aristocrats outperformed over 70% of the time and by an average of 1.13%. In up markets, the S&P 500 Dividend Aristocrats underperformed 56% of the time, but at a lower average magnitude (-0.34%). This shows that the S&P 500 Dividend Aristocrats has delivered downside protection in months when the S&P 500 lost ground.”
Of course, markets tend to be up more than they are down, so an advantage in down markets doesn’t necessarily translate into an advantage overall.
Brzenk also found that “The lower the return of the S&P 500, the better the relative performance was for the S&P 500 Dividend Aristocrats. We see the batting average was typically better for the more negative months than the less negative months. Additionally, we observe that the average excess return over the S&P 500 was higher in the most negative months. Since 1989, the S&P 500 has lost 5% or more in 31 out of 348 months (~9% of the time). In these months, the average excess return for the S&P 500 Dividend Aristocrats was 2.46%, with a hit rate of 81%. The median excess return was of similar magnitude (2.32%); therefore, the results were not skewed by only a few months—rather, there was consistent outperformance.”
Digging Into Dividend Growth
The evidence seems in conflict with financial theory that says dividends don’t matter, which raises the question of whether a focus on dividend growth adds value, especially in down markets: Is there something unique about companies with growing dividends? Or can the returns of the stocks with growing dividends be explained by exposure to common factors that have been found to explain the vast majority of equity returns—market beta, size, value, momentum and quality. In other words, do companies with the same exposure to these factors have the same performance whether or not they have growing dividends, or even pay dividends at all?
To answer the question, I’ll examine the performance of the two largest dividend-growth ETFs, with a total of more than $38 billion in assets, demonstrating that investors believe the strategy adds value. I used the regression tool available at Portfolio Visualizer.
The table below shows the loadings (how much exposure the funds have to each factor) as well as the funds’ annual alpha.