Monday, October 4, 2010

High dividend stocks: Do they beat the market?

I was browsing through the Wall Street Journal this weekend and came across this story about "high dividend" stocks:
http://bit.ly/b0MrBt
Briefly summarizing, the author argues that investing in five high dividend paying stocks is a better strategy for an investor than investing in an index fund, and that the "loss of diversification" is made up for by the higher returns generated on the dividend paying stocks.

It may be surprise you, but I don't disagree with the core of this strategy, which is not a new one. In fact, in what is known as the "Dow dogs" strategy, you invest in the five highest dividend yield stocks in the Dow 30. A more detailed sales pitch for this strategy can be found here:
http://www.dogsofthedow.com/
Over time, its proponents argue that the strategy would have paid off richly for investors.

To add even more ammunition to dividend seekers, studies over the last three decades have also shown that stocks in the top decline in dividend yield generate about 2-3% higher returns, after adjusting for risk, than the rest of the market. This newsletter nicely summarizes the evidence:
www.tweedy.com/resources/library_docs/papers/highdiv_research.pdf

So, is this a winning strategy? In my book, "Investment Fables", I have a chapter on this strategy which you can download by clicking below:
http://pages.stern.nyu.edu/~adamodar/pdfiles/invfables/ch2new.pdf
Briefly summarizing, I argue that as with all investment stories, there are caveats and these are the most significant ones for "dividend" heavy strategies:
1. Dividends are not legally binding: Unlike coupons on bonds, where failure to pay leads to default, companies can cut dividends without legal consequence. The fact that "dividends are sticky" and companies don't usually cut dividends does not take away from this point.
2. Higher tax liability: At least in the United States, for much of the last century, dividends have been taxed at a higher tax rate than capital gains. (Since 2003, the tax rates on the two have been the same, but that law is set to expire on December 31, 2010, returning us to the old tax laws).
3. May be "liquidating" dividends: When companies are in decline, they may pay large liquidating dividends, where assets are sold to fund the dividends. While these dividends are cash flows, they are not sustainable and will run out sooner rather than later.
4. Sector concentration: If you pick the highest dividend yield stocks across a market at any point in time, you may find yourself holding stocks in one or two sectors. In early 2008, for instance, you may have ended up with five banks in your portfolio. If there is a shock to that sector, your portfolio will collapse.
5. The market "knows" something you do not: Remember that the dividend yield for a stock shoots up almost always because the price drops, not because the dividend is increased. In other words, it is a sudden drop in the stock price that makes the stock look attractive. It is true that markets make mistakes, but it is also true that sometimes price drops of this magnitude occur because there is a serious problem looming on the horizon.

Here is how I would modify the strategy to protect myself against these three issues:
1. Look for companies with positive earnings, low debt burdens and high cash balances. They will be under less pressure to cut dividends.
2. Use this strategy for "tax protected" portions of your portfolio. Even in the US, investments made in pension plans are allowed to accumulate income, tax free. Even if you cannot pick individual stocks in your pension fund, you may be able to redirect the money to a high dividend yield mutual fund.
3. Steer away from companies with dividend payout ratios that exceed 80% and have negative revenue growth. That may help keep liquidating companies out of your portfolio.
4. Try for some sector diversification. In other words, classify companies at least broadly into sectors and look for the highest dividend yield stock in each sector, rather than across the whole market.
5. Check every news source that you can find for news stories or even rumors about the company. 

In short, buying high dividend yield stocks makes sense for a long-term, tax-advantaged investment. One point that I disagree on is that this strategy requires you to give up on diversification. I don't see why you cannot construct a reasonably diversified portfolio (of 30-40 stocks spread across sectors) of high dividend yield stocks.

10 comments:

doctorgeeta said...

I fully agree with u when u say, "5. The market "knows" something you do not: Remember that the dividend yield for a stock shoots up almost always because the price drops, not because the dividend is increased. In other words, it is a sudden drop in the stock price that makes the stock look attractive. It is true that markets make mistakes, but it is also true that sometimes price drops of this magnitude occur because there is a serious problem looming on the horizon."

doctorgeeta said...

I fully agree with u when u say, "5. The market "knows" something you do not: Remember that the dividend yield for a stock shoots up almost always because the price drops, not because the dividend is increased. In other words, it is a sudden drop in the stock price that makes the stock look attractive. It is true that markets make mistakes, but it is also true that sometimes price drops of this magnitude occur because there is a serious problem looming on the horizon."

funindra said...

"4. Try for some sector diversification. "

How relevant do u think the sector correlation comes into play while u diversify using sector diversification for example, most of them do believe that while the banks outperform the real estate companies underperform and vice-versa. I would be nice if u can throw some light on sector correlations.

Gaurav Mehta said...

Since while we are doing stock selection on 100's of stocks to get to a good portfolio, we obviously cant really value them all.

Although this has worked well for me, i just wanted to ask if this approach is good enough and where can i tweek a bit.

I look for companies in the Indian Market with

Growth> 20% CAGR Sales and EPS both

Increasing sales during the downturn

ROE > 18% hopefully sustainable though one can never be sure about this for a small or a mid cap

Debt - minimal or no debt

Growing Industry

Share Holder Pattern - decent percentage by Promotor 5%-15% by FII's (leaving room for them to buy more reflecting in increased share price.

Share Price must have positive movement in the last 1 year when the market was moving to see if there are any active investors.

Management - try to look for known names, new names if its a small relatively unknown subsidiary of a big company.

Finally Valuation PE - 5 to 10 & P/B < 1x to 2x.

This approach is very similar to intrinsic PE calculation taught by you although i don't really use the formula...

Am i going wrong somewhere in this approach? Although this has worked very well for me getting me a few multibaggers as well (last year was as it is not difficult to find them). Now that almost everything is fairly valued or starting to look overvalued do you think this approach will work... getting <10 PE with these parameters is going to be challenge going forward.

Vesna said...

Prof. Damodaran, there is something wrong with the link you provided to the Tweedy, Brown article: www.tweedy.com/resources/library_docs/.../highdiv_research.pdf

Aswath Damodaran said...

Responding to three comments:
First, the entire basis for diversification working is that the correlation is low across sectors and even negative for some.
Second, screening is a very effective device for finding companies that you want to take a closer look at (and value). I have an entire book, "Investment Fables", on screens.
Third, I think I fixed the link to the Tweedy Browne file.

Parag said...

High dividend stocks carry their own set of risks and rewards, and can be a rewarding investment if you do the proper groundwork before investing.
best dividend stocks

holidaymylove said...

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Richard Gere said...

High dividend stocks are commonly viewed as investments that provide regular income to the stock holder regardless whether the market is bullish or bearish.
high dividend stocks

Tyler Jackson said...

instance, you may have ended up with five banks in your portfolio. If there is a shock to that sector

invest in stocks