At times I have invested in “dividend stocks” and used dividend investing strategies in my portfolio. Dividend stocks are stocks of companies that pay dividends, and usually higher than average dividend yield (the average dividend yield of S&P 500 companies is 2%). I have had both successes and some failures in selecting stocks this way.
There are many different types of dividend investing approaches to evaluating and selecting dividend stocks, but I won’t dicuss those here. I’m going to focus on whether dividend investing is a good strategy or not.
I have often wondered whether the overall strategy of dividend investing was a good strategy. What might I be missing by focusing on dividend stocks? Do other strategies outperform dividend investing?
Do dividend stocks outperform?
Stocks provide value to investors in two ways:
- Capital gains / stock price appreciation – increase in the price of a stock
- Dividends – cash payments to investors
The total return of a stock is the annualized rate of return of both the price appreciation and dividends.
When considering total returns and not just dividends, how do dividend stocks compare to other stocks? Do low or no dividend stocks have better total returns than dividend stocks? Or do dividend stocks outperform when compared on a total return basis?
Dividend stocks vs. no dividend stock total returns
Using historical U.S. stock returns data going back to the 1920s, we can analyze and compare the total returns of portfolios of dividend stocks vs. no dividend stocks.
From the period of 1928 to 2018, dividend paying stocks outperformed no dividend stocks in 71 of the 91 years. Dividend paying stocks returned 10.4% annually while no dividend stocks returned 8.7%.
This may seem conclusive, but let’s look at how these portfolios performed over time. Dividend stocks outperformed no dividend stocks in every year from 1928 to 1973. Between the years of 1974 and 2000, no dividend stocks occasionally outperformed dividend stocks, but only in 3 of the 21 years so dividend stocks continued to outperform no dividend stocks.
However, in 2001 things changed and no dividend stocks began to consistently outperform dividend stocks. No dividend stocks have outperformed dividend stocks every year from 2001 to 2018, with the exception of 2018.
Let’s also compare different types of dividend paying stocks, as not all stocks that pay dividends are created equal.
High / Med / Low dividend stocks vs. no dividend stocks total returns
We can split dividend stocks into three portfolios:
- Low dividend paying stocks (bottom 30%)
- Medium dividend paying stocks (mid 40%)
- High dividend paying stocks (top 30%)
We can then compare the performance of these three groups of dividend paying stocks’ performance against no dividend paying stocks and each other.
No dividend stock performance
Over the same time period all dividend paying stocks generally outperformed no dividend stocks until around the 1980s. During the late 1980s and 1990s no dividend stocks began to perform relatively better, placing 2nd or 3rd in every year out of the 4 portfolios. In the 2000s no dividend stocks began performing better than both high and low dividend stocks, and trading places with medium dividend stocks for the top performance spot each year until 2018 when it fell to 3rd best.
High dividend paying stock performance
High dividend paying stocks outperformed all other portfolios from 1928 to 1974. After 1974, high dividend stocks began to perform progressively worse compared to the other portfolios, falling all the way to the worst performing portfolio in 2008.
Medium dividend paying stocks
Medium dividend paying stocks have been a very consistent performer, ranking 1st or 2nd in all years but one (2016). They performed second best from 1928 until the late 1970s when they began outperforming the other portfolios. Since 2000 they have gone back and forth with no dividend stocks as the top performing portfolio.
Low dividend paying stocks
Low dividend paying stocks have generally underperformed the other portfolios, ranking 3rd or 4th in all but 2 of the 91 years. Only recently, in 2016 and 2018, has this portfolio broken into the top 2 spots.
Interpretation of dividend stock analysis
The analysis indicates mixed results. Generally dividend stocks outperformed for most of the past century until the last twenty or so years. What changed in the last twenty years and will this trend continue?
I think we’re seeing a few different fundamental shifts in the stock market during the period of analysis. From the 1920s until around 1980 we saw the traditional blue chip companies, paying high dividends, outperform the market.
This began to change in the 1980s. I believe this is due to a couple factors including the increase of globalization and associated economic changes and disruptions and the legalization of stock buybacks. Stock buybacks were legalized in 1982, prior to that the SEC considered them a form of stock manipulation. With this change, companies could now distribute capital to investors in an alternate way than dividends.
Things changed again in the early 2000s. This time I believe the changes were driven by the innovation of the internet and associated tech growth stocks outperforming the markets. Tech growth startups and stocks usually don’t pay dividends as they are focused on reinvesting any profits back into the company and growing as quickly as possible. I also think we really saw the impact of the dramatic increase in the use of stock buybacks by companies (see graphic).
Stock buybacks have been on the rise since the early 2000s, with a brief interruption during the financial crisis. This coincides with the period of outperformance by no divdend stocks.
Tax benefits of stock buybacks
The popularity of stock buybacks has increased dramatically in the last 15 years or so. This is partially due to the fact that buybacks are a more tax efficient way to return capital to shareholders than dividends. Unless held in a tax advantaged account, investors must pay taxes on dividends received, however investors do not pay taxes on stock price appreciation from buybacks until they sell the stock, putting investors in control of when taxes are paid.
How much did no dividend stocks outperform in the 2000s?
As we know, dividend stocks underperformed no dividend stocks since the early 2000s. But by how much, and does it really matter?
Over the 2002 to 2018 time period, dividend stocks returned 10.0% annually and no dividend stocks returned 12.4%. So no dividend stocks outperformed by 2.4% annually, not huge, but a notable difference in returns. Additionally, the no dividend stock outperformance in 2003 and 2009 (post stock market corrections) really enabled the overall outperformance during this period (see chart above).
Conclusions: What does this mean for investors?
Investing in dividend stocks is a popular strategy. Being able to analyze a stock with a dividend yield is certainly an advantage as companies are usually very serious about maintaining and increasing their dividends over time. Reducing or eliminating a dividend is a show of bad faith to investors and is only done when absolutely necessary. Many companies have had to reduce or eliminate dividends during the COVID-19 crisis to conserve cash.
Buybacks are different. Companies periodically announce buyback plans but do not consistently meet or aim to increase the levels of buyback over time so buybacks are harder to assess in terms of impact on expected total returns.
However, it would be an oversight to invest solely based on dividends and dividend yields while not considering the implications of buybacks as they have become such an important factor in investing. Similarly many growth stocks are able to effectively reinvest their cash flow resulting in even more growth, which is why they do not pay dividends (or pay low dividends).
Any dividend investing strategy should use total return as the measure of success and consider the impacts of other factors like buybacks and growth stocks.
Analysis is based on Fama/French source data of value weighted portfolios formed on dividend yields.
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