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Dividends: Myths and Realities by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research July 25, 2008 Reprinted from the July 2008 issue of Schwab Investing Insights®, a monthly publication for Schwab clients. A recent spate of big-name companies that have cut their dividends—from Citigroup to Sprint—is a stark reminder of an unappreciated reality: Dividends are by no means a sure thing. What's more, contrary to conventional wisdom, our research finds that dividend-yielding stocks as a group have underperformed the market during recent years. And since they tend to cluster in certain sectors and style groups, getting overly enamored of them can introduce unexpected concentrations and unnecessary risk to your portfolio. But just because a company has cut its dividend doesn't mean its stock will underperform. In fact, our research finds that such stocks often outperform! Indeed, the rules of the game have changed so much in recent years that some of the most common strategies for picking dividend-paying stocks no longer appear to work very well. Understanding what's real—and what's not—is key. Basic dividend realities The first reason to pay attention to dividends rests on the simple understanding that a stock's total return is based upon price changes and dividends received. For a one-year period, Total Return % = Stock Price Change % + Dividend Yield %.1 All things being equal (which they seldom are), higher dividends mean higher returns. Indeed, about one-third of average U.S. stock total returns historically have come from dividends. Second, dividend yield is known at the time of purchase, while future price changes are highly uncertain. Of course, future dividends aren't guaranteed, but most firms aim for a stable dividend payout and typically cut dividends only when under severe financial stress. Third, dividends tend to grow over time, offering potential income growth and inflation protection that bonds cannot provide. Finally, dividend-yielding stocks tend to be less volatile than the average stock and have offered a nice cushion during bear markets. Myth No. 1: dividend-yielders outperform Back in the 1980s and 1990s, many academic studies found that dividend-paying stocks historically provided the best of all worlds—above-average total returns with below-average risk. The result: a flood of ETFs designed to capture the potential performance advantages of higher-yielding stocks. But in reality, Schwab research has found that dividend-paying stocks have generally underperformed non-dividend-payers over the past 18 years (see "Dividend-paying stocks have underperformed"). Among dividend-paying stocks, we found no material return or risk differences between stocks with high, medium or low dividend yields.
TIP: Schwab has found dividend-paying stocks to be much less volatile than non-dividend-payers, with very strong relative performance in down markets. Consider them a bear market cushion. Myth No. 2: a yield-focused portfolio is "safe" Relative to the overall market, the universe of dividend-payers is extremely concentrated in the financials sector and extremely underweighted in health care and information technology (see table below). While we don't know whether these sector bets will add to or detract from average returns over the next 18 years, we believe these weightings virtually ensure that dividend-paying stocks as a group will not tend to move closely with the overall stock market.
Mismatched return fluctuations through time are known as tracking error, a measure of portfolio risk caused by incomplete diversification. Most professional portfolio managers work hard to avoid such risk. Only one who was extremely bullish on financials and extremely bearish on health care and technology would structure a portfolio anything like the dividend-paying universe above. And such a manager would incur a huge risk of getting fired if wrong for long. Individual investors also should avoid tracking-error risk for psychological reasons. In my experience, the more an investor's portfolio performance deviates from the market (particularly on the downside), the more likely the investor is to become emotional, make undisciplined decisions, and even abandon a sound long-term strategy. Since a high-tracking -error portfolio is more likely to deviate from the market, it's more likely to trigger self-destructive behavior. Also, firms with stronger growth prospects tend to reinvest earnings rather than pay dividends, as evidenced by the paucity of dividend-payers in the high-growth health care and technology sectors. But this means that investors who only invest in dividend-paying stocks must be careful to avoid introducing a distinct anti-growth bias into their portfolios—another source of tracking-error risk. TIP: To manage this risk, Schwab suggests building stock portfolios with sector weightings that reflect the overall market. Myth No. 3: dividend hikes are always good and cuts are always bad One common argument against investing in higher-yielding stocks is that they tend to have low earnings-growth prospects and, as a result, are less likely to increase dividend payments in the future. While this may be true, don't jump to the conclusion that a stock with higher dividend growth will provide higher future returns, as this growth attribute may already be reflected in its stock price. In fact, we found that stocks that have raised their dividends in each of the past five years have underperformed all other dividend-paying stocks by almost 3% annually since 1990! This research finding should caution you against investing in recently introduced ETFs designed to track various dividend-growth indexes. Another argument against investing in higher-yielding stocks is that they may be more likely to cut dividends during periods when earnings are depressed. Even if that's true, don't jump to the conclusion that stocks with recent dividend cuts will underperform. In fact, we found that stocks that cut dividends in the prior year have outperformed all other dividend-paying stocks by about 2.5% annually since 1990 (albeit with higher volatility). Perhaps investors interpret dividend cuts as a signal that management is dealing with financial difficulties and that better times are forthcoming.  What you can do Since 1990, the Schwab Equity Ratings research methodology has been able to draw sharp performance distinctions among the universe of dividend-paying stocks (see "Schwab Equity Ratings Performance on Dividend-Paying Stocks, 1990–2008"). While these returns are hypothetical and likely to be lower in the future, they suggest that the ratings can be a powerful and time-saving research tool if you're seeking income and potential capital gains. We suggest the following basic portfolio strategy:
Important Disclosures Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S.-headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform, and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Schwab Equity Ratings are not personal recommendations for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio. Results from tests using Schwab Equity Ratings are based on use of historical model performance results that have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual investment performance or trading. No representation is being made that any investor will or is likely to achieve profits or losses similar to those shown. The results presented are for illustrative purposes only and should not and cannot be viewed as an indicator of future performance, as an indicator of the returns a Schwab client would have realized or will realize in relying on Schwab Equity Ratings, or as an indicator of how individual Schwab Equity Ratings are performing or will perform in the future. 1. Assuming no dividend changes in the year being evaluated. This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. (0708-4222) Return to Top |
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