|Summary: In the hunt for yield, many Australian investors have been chasing the high dividend returns offered by the big banks and Telstra. Those stocks have performed well, but it would be wrong to expect the total return outperformance from high-yield stocks to continue. The longer-term evidence shows that high-yield companies don’t outperform the market.|
|Key take-out: Set your own dividend policy. Retirees should agree a prudent safe withdrawal limit of funds to take out of their whole portfolio from both income and capital growth, and avoid letting dividend and interest income dictate what sort of lifestyle they should enjoy.|
|Key beneficiaries: General investors. Category: Investment portfolio construction.|
Low interest rates have sent investors on an Easter egg hunt for yield in the sharemarket.
Many investors have preferentially filled their portfolios with higher-yield stocks at the expense of lower-yielding stocks. Some companies are even altering their dividend policies to pay out more profits, rather than investing in growing their business. This has been done to attract investor demand and pump up their share price, and perhaps executive share options.
Would you believe, none of this should matter to you as an income seeking investor? And, possibly, those late in the hunt for yield may be better off now investing in lower-dividend paying companies and “making their own dividends”. Let me explain.
Dividend policy irrelevance
In 1961, Nobel Prize winning finance professors Franco Modigliani and Merton Miller suggested that how much dividends a company chose to pay out from its profits made no difference to its share price. Companies are simply valued on the earnings they create, regardless of whether their capital is financed by equity or debt. Whether they choose to pay out profits or not, and how much (i.e. it’s dividend policy) doesn’t matter.
Since money has no memory of how it arrived into the hands of an investor, it can come via dividend or capital sold without portfolio effect. As the well-known financial economist Ken French put it: “Investors should be indifferent to how they raise cash, whether through dividends and interest, or through the sale of shares—a method Merton Miller called homemade dividends.”
According to theory, retiree investors who need funds (note, I didn’t use the word “income”) to live off can obtain that not just from dividends but also from selling a small amount of share capital. If the company doesn’t pay a lot or any dividends, then a few shares can be sold. Younger accumulator investors don’t need dividends. In summary, there are always mismatches between individuals and a company’s dividend policies and you can do something about it.
Setting up your own policy
Accordingly, each investor should set their own spending policy (see How much is enough?) and overwrite the dividend policy of the companies they invest in. For instance, an accumulating investor invested in the Commonwealth Bank who doesn’t need income could enrol in the bank’s dividend reinvestment plan or manually buy back shares with the 6% dividend yield. On the other hand, a retiree could sell down 4% of their shares in CSL to top up its measly 2% dividend yield. Coincidentally, both shares returned just under 20% for the last 12 months counting both dividend income and capital growth.
Some talk about the “dividend illusion”, which makes investors feel that dividends are “free” money and don’t come at a capital cost. Hence their attraction. Generally speaking, however, if a $10 stock pays out a $0.50 dividend we would expect the price of that stock to fall to $9.50. This, then, isn’t free money; it’s a cash asset of the firm that is no longer owned by the shareholders and hence the company is worth less by this amount. Admittedly, in practice, studies will show slight differences that can be explained by various factors including overseas investors not fully valuing franking credits.
It may surprise Warren Buffett fans, but his popular investment holding company Berkshire Hathaway doesn’t pay a dividend. Loyal long-term investors needing funds for living have to sell small amounts of shares to fund living, if need be. The company is focused on retaining profits and reinvesting them to grow the business and share price. In his reasoning (beginning on page 18 of his 2012 shareholder letter) Warren Buffett says that many of his shareholders can sort out their own income needs and he believes he can better reinvest profits to grow them further.
A consequence in Australia of focusing on high dividend stocks is a resulting industry concentration risk in banks, in most portfolios. While the outlook for continued profits is reasonable, a property or a financial crisis could see investors give back their extra income in a higher-than-average price decline. In the US market, for instance, focusing on dividend paying stocks cuts you off from 60% of companies that don’t even pay a dividend and pushes you more into low beta defensive stocks and utilities. By the way, the US tax system used to favour share buybacks instead of dividend income, so the differences aren’t as stark as it sounds.
Incidentally, the tax system in Australia doesn’t favour income or capital growth either way to guide your decision. Tax-free pension investors, for instance, pay no tax on capital gains, and through dividend imputation they pay no tax on corporate profits. Non-super taxed investors enjoy tax breaks on both capital growth and dividends – paying tax on a discounted 50% of gains provided assets are sold after 12 months while also getting a refund of tax already paid by companies they own through franking.
Yes, transaction costs are relevant, however these days with discount brokerage fees around 0.1% the cost of making your own dividends is minor. It’s important to keep a portfolio in balance in any regard, so arguably most investors should be trimming outperforming shares at least annually anyway.
Do dividend paying stocks outperform?
Paying a regular and growing stream of dividends is a good sign of a company’s health. However, it is no guarantee that the company is fairly priced and will outperform. Nor is it true that a company that chooses to reinvest profits or has little is necessarily overpriced and will underperform. Indeed, in today’s market it is quite possible high dividend paying companies are overbought and overpriced and poised to underperform. Last year, when warning readers about dividend fever, I showed readers a chart illustrating that the top dividend paying companies in the US market, for instance, are trading at a 50-year price high.
The following charts show the total returns from investing in the local and US sharemarkets broadly, compared with the returns investing in high dividend paying stocks. Total returns, of course, count income and capital growth, which is relevant to the homemade dividend maker. Shown are returns from popular Vanguard index funds you can invest in. Data for Australia is for 14 years and in the US eight years, which is when the high-yield funds were introduced into the respective markets. Note, to help you see when high-yield outperformed, or not, and for how long, the typical growth of invested dollar charts are accompanied by rolling return charts. The latter, more sophisticatedly, refresh every 36 months, forgetting about past performance periods a later investor would have missed. As an aside, professional fund managers should show rolling returns more often as they highlight how often short-lived is outperformance.
These charts show that over the last 14 years in Australia, high dividend stocks outperformed the broader market for just two of them. Prior to the GFC, they even underperformed the market for about a year and a half when everyone fell in love with low-yielding mining stocks.
In the more industry sector diversified US stockmarket, you can see that over the last seven years the returns from high dividend stocks were no different than the broader market for six of those years. Only those investors around in 2011-12 for 12 months were rewarded for especially investing in high-yielding stocks.
By the numbers, Australian investors in high dividend paying shares enjoyed an annualised total return of 8.6% compared to 8% since 2000. Since 2006 in the US, high-yield stocks returned 6.2% vs 5.4%.
The respective standard deviations of 13% and 13%, and 16.6% and 16.2% don’t support the view that the returns from high dividend stocks are more reliable given their steadier and higher income. You can see that both portfolios fell similarly during the GFC – which also means the price of lower-yielding stocks fell slightly less (equal to the amount of yield differential).
While it is true that past investors in high-yield companies listed in the local and overseas sharemarkets enjoyed a period of outperformance, I believe this was to do with a historically unique demand for high-yield shares. In 2012, for instance, $22 billion flowed into US high-income stock ETFs while, at that same time, $25 billion of funds left the broader market and all other ETF funds. With this sort of investor interest it becomes a self-reinforcing phenomena that high-yielding stocks outperform.
Time to make your own dividends from low-yielding stocks?
I think it would be wrong to expect the total return outperformance from high-yield stocks to continue. It is even more likely that, when bond yields rise, the relatively appreciated price of high dividend stocks could reverse. There is little in finance theory to say that companies that pay out a higher share of profits should fundamentally outperform those who don’t.
My suggestion for new investors or investors with fresh money is to be careful chasing high dividend paying stocks at this time. Instead, make your own dividends by investing in companies not necessarily in this glamour group, which includes the banks and Telstra.
Retirees should agree a prudent safe withdrawal limit of funds to take out of their whole portfolio from both income and capital growth, and avoid letting dividend and interest income dictate what sort of lifestyle they should enjoy. In short, set your own dividend policy and enjoy your own homemade dividends.
This should be a relief to those investors who have run out of high dividend shares to buy and would otherwise take on a risky concentration risk in them.
Dr Doug Turek is principal advisor of family wealth advisory and money management firm Professional Wealth (www.professionalwealth.com.au).