Dividends--A Better Approach to Value?

Morningstar

Low interest rates have encouraged investors to accept greater risk in pursuit of higher yields to make up for lost income. While greater risk tends to accompany higher-yielding assets, a naive strategy of targeting stocks with high dividend yields to generate income would have historically outperformed the broad market, with lower volatility. But this return premium isn't unique to dividend-paying stocks. It's no secret that cheap stocks have historically outperformed their more expensive counterparts over the long run, a phenomenon known as the value effect. Dividend investing is essentially a repackaged value strategy. However, it may offer investors a lower-risk way to harness the value premium than traditional value strategies that rely on a broader range of metrics to identify cheap stocks.

The following chart illustrates the performance of stock portfolios sorted by dividend yield, book value/price, and price/earnings from August 1953 through July 2013. In each case, the cheaper categories outpaced their more expensive counterparts. These results are broadly consistent over time and in foreign markets. Efficient-market hypothesis advocates argue that this return gap represents compensation for risk, which is plausible. Relative to their more expensive counterparts, value stocks tend to be less profitable, face dim growth prospects, and may remain out of favor for years.

However, it's hard to argue that stocks with high dividend yields are riskier than their lower-yielding counterparts. As the table below illustrates, they have historically been less volatile and have generally held up better during market downturns. Dividend payments help cushion volatility because investors immediately benefit from these payments, while there is more uncertainty about the value of money reinvested in the business. Managers do not typically commit to dividend payments unless they are confident they will be able to honor them over a full business cycle. That's because the market punishes companies that cut their dividends. As a result of this constraint, high-dividend-paying stocks tend to generate more-stable cash flows than their lower-yielding counterparts. Consequently, a dividend-focused approach to stock investing may offer investors a relatively low-risk way to harness the value premium.

While they have been more volatile than high-dividend-paying stocks, stocks that look cheap based on earnings/price and book/price don't look much riskier than their more-expensive counterparts based on traditional risk metrics, as shown below. This has led some researchers to argue that the value premium arises because investors extrapolate past growth too far into the future. These collective errors can push prices away from fair values, causing slow-growth value stocks to become undervalued and faster-growing stocks to become overvalued.

Something more may be at work with stocks sporting high dividend yields. Maintaining, and ideally growing, dividend payments limits managers' ability to engage in value-destructive empire-building. Managers are constantly under pressure to feed Wall Street's appetite for growth. It doesn't help that executive compensation is positively correlated with firm size. With large cash reserves on hand, a management team may be tempted to expand through investments in risky projects and acquisitions, even when doing so is not in shareholders' best interest. Dividend payments enforce a certain amount of discipline, reducing firms' access to easy money and creating a higher hurdle to undertake new projects. This can benefit shareholders, who may have better investment opportunities.

Because it is costly for firms to cut their dividend payments, managers may also use dividend payments to signal their confidence in their firms' business prospects, especially when they raise these payments. In a paper published in 2006, "Dividend Payout and Future Earnings Growth," researchers found that stocks with higher dividend payout ratios also experienced faster earnings growth. While this analysis only included dividend-paying stocks, it suggests that dividend payout policy is indicative of the strength of a firm's business.

But if high-dividend-paying stocks benefit from these factors in addition to the behavioral bias underlying the broader value effect, it's fair to ask why they haven't quite kept pace with the value portfolios formed on the basis of book value and earnings. On average, stocks in the high-yield portfolio tend to be larger than their counterparts in the value portfolios formed on book value and earnings. The value effect has historically been the largest among small-cap stocks, which may partially explain the performance gap. Income-sensitive investors may also help keep high-dividend-yielding stocks from becoming as undervalued as stocks that look cheap relative to their book value or earnings because they immediately benefit from dividend payments. In contrast, book value and reinvested earnings are less tangible sources of value. Finally, investors may demand less compensation for holding high-dividend-yielding stocks because of their lower volatility.

However, high-yielding stocks have historically been more sensitive to interest rates than other value stocks. That's because these companies tend to have more stable cash flow and may experience less growth during economic expansions (typically when interest rates rise) to offset the negative impact of rising rates. But their stable cash flow also works to their advantage when rates fall.

Taxes can also create a slightly greater drag on their performance because dividends are taxed when they are distributed, while investors have an option to defer capital gains taxes until they sell a security. But because most traditional value funds have above-average dividend yields, strategies that focus on dividend yield aren't at a significant tax disadvantage. For example, Vanguard High Dividend Yield Index ETF (VYM) and Vanguard Value ETF's (VTV) holdings are currently yielding 3.3% and 2.6% on average, respectively. Assuming these funds offered the same total return, the dividend fund would lag by 0.1% each year after taxes for an investor--assuming a 15% tax rate on qualified dividends.

Key take-aways:

Dividend strategies make an implicit bet on value. They may offer a smaller return premium than traditional value strategies and are slightly less tax-efficient.Rising interest rates may also put a bigger dent in their performance. However, high-dividend-yielding stocks tend to be less volatile than other value stocks over a full business cycle, which can more than offset these drawbacks.

Investment Options
Selecting individual stocks based solely on their dividend yield can be a dangerous game. Unusually high yields may portend future dividend cuts and are often a signal of distress. But a broadly diversified portfolio of high-yielding stocks can offer a relatively low-risk way to take advantage of the value premium. One of the largest dividend strategy funds, iShares Select Dividend (DVY), targets the 100 highest-yielding stocks that pass several screens. In order to qualify, each stock must have paid dividends in each of the past five years and grown its dividends over that time. As an additional precaution, qualifying stocks must have a five-year average dividend/earnings-per-share ratio of 60% or less. These screens allow the fund to weight its holdings by dividend yield (subject to a 10% cap) without loading up on distressed companies. However, it overweights mid-cap stocks and carries a relatively rich expense ratio of 0.40%.

VYM is cheaper (0.10% expense ratio). It targets the highest-yielding half of U.S. dividend-paying stocks and weights its holdings by market capitalization. This approach allows mature, quality companies to anchor the portfolio. In contrast, WisdomTree LargeCap Dividend (DLN) (0.28% expense ratio) weights its holdings by the dollar value of dividends each stock is expected to payout over the next year. Because larger firms tend to pay out more money in absolute terms, this approach balances dividend yield against market capitalization. It also causes the fund to increase its exposure to stocks that become cheaper relative to their dividends and to trim positions in stocks that become more expensive on the portfolio rebalancing dates. While they largely exploit the same effect, these funds have each experienced less volatility than comparable value funds over the past several years.

Alex Bryan does not own shares in any of the securities mentioned above.


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