Swedroe: No Refuge In Dividend Stocks

Despite the fact that traditional financial theory has long held that dividend policy should be irrelevant to stock returns, one of the biggest trends to occur in recent years has been a rush to invest in dividend-paying stocks. The heightened interest in these assets has been fueled both by media hype and the current regime of interest rates, which are well below historical averages.

The low yields generally available on safe bonds during the past six years have led many once-conservative investors to shift their allocations from safe bonds to much more risky dividend-paying stocks. This has been especially true for those who take an income, or cash flow, approach to investing, as opposed to the total return approach, which I believe is the right one.

The interest in dividends also arises from the belief that dividend-paying stocks are better investments. The SPDR S&P Dividend ETF (SDY | A-76) has $13.75 billion in assets under management, and the Vanguard High Dividend Yield ETF (VYM | A-95)  has $11.3 billion. Together, that’s almost $25 billion invested just in these two dividend strategies.

Given the interest in these funds, and the extremely rapid growth in their assets under management, I thought it worthwhile to review the recent performance of the dividend and nondividend-paying stocks with the S&P 500.

Performance

Over the first four months of 2015, the average return to its 420 dividend-paying stocks was 1.55 percent. The average return to the nonpayers was 7.45 percent. Over the last 12 months, the gap was even wider. The dividend payers returned 12.85 percent and the nonpayers returned 20.64 percent.   

How did the strategy involving dividend-paying stocks work in 2014? The 423 dividend-paying stocks within the index last year (equal-weighting them) returned 14.0 percent. The 79 nondividend payers returned 14.4 percent, an outperformance of 0.4 percentage points. And in 2013, dividend-paying stocks within the index (again, equal-weighting them) returned 40.7 percent. That’s compared with 46.3 percent for the nonpayers.

It’s also important for investors to understand that the popularity of a strategy correlates negatively with future expected returns. In short, the popularity of dividend-paying strategies has altered their very nature. Dividend-paying strategies historically have been value strategies.

Yet Morningstar data shows that, as of April 29, 2015, the price-to-earnings (P/E) ratio of SDY was 19.6, higher than the P/E ratio of 18.1 for the SPDR S&P 500 ETF (SPY | A-98). The price-to-book ratio for SDY is also higher, at 2.6, compared with SPY, which is at 2.4. Higher price-to-earnings ratios and book value forecast lower future returns.

A Potentially Expensive Lesson

There’s an anomaly at work here. Many investors seem concerned about the high current valuations of the market. Yet many of those same investors have been rushing to buy stocks with even lower expected returns (almost certainly without knowing this is the case).

In summary, 2008 should have taught investors that dividend-paying stocks aren’t a viable alternative to safe bonds. Unfortunately, far too many investors failed to learn that lesson, one that could prove to be very expensive when the next bear market arrives. The problem is compounded by the fact that the popularity of dividend strategies has led to valuations now above those of the overall market. Forewarned is forearmed.

As another point of interest, I thought it worth mentioning that despite all the concerns/forecasts about how badly the market’s historically high profit margins were going to get hit, the first-quarter profit margin for the stocks in the S&P 500 Index was 9.75 percent. While that’s down a bit from the record margin of 10.10 percent for the third quarter of 2014, it’s up from the 8.98 percent reported for the fourth quarter.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.