Tuesday, December 22, 2015
Dividend-paying stocks are attractive in a world of near-zero interest on bond investments. However, only picking the highest payers is too simple an approach and may risk ending with a dangerously unbalanced portfolio, in our view. And it might not even deliver what it was supposed to do in the first place.
Here’s a thought that may be familiar to all those investors that have seen the income from their bond investments melt away in recent years: “Interest rates are so low, I think I will buy some really high-yielding stocks to polish up my investment income”. This makes sense at first glance. High dividend yields tend to be perceived as a reliable attribute of stocks with strong or at least above-average expected future total returns. Unfortunately, there is little empirical evidence that back up these assumptions since the beginning of the 1990s.
In our view, dividend yields alone do not work as a primary stock selection tool. The chart below illustrates various investment scenarios, demonstrating the performance of global portfolios comprising the highest and the lowest-yielding stocks respectively, as well as that of the MSCI World index (gross dividends reinvested). One conclusion is that higher-yielding stocks tend to outperform portfolios with lower-yielding stocks on average since the beginning of the 1990s. This outcome, however, might be random: the highest-yielding portfolio sharply underperformed in the 1990s, then outperformed during the rally before the financial crisis. Overall, it barely managed to deliver an added value relative to the MSCI World Index after 25 years. This means that for investors there is no sustainable outperformance to be had from high-dividend stocks. Interestingly, the assumption that dividend stocks are more defensive during sell-offs is a myth: As the chart below shows, during the 2008 equity market crash these dropped significantly more than the overall market.
But what about the aforementioned dangers lurking among stocks with high dividend yields? We have identified two: First, companies with very high dividend yields sometimes lack the earnings power to sustain the pay-out level. Think about commodities and energy-related stocks: Appealing dividend yields are now melting away on the back of falling earnings due to lower oil and commodities prices. On top of that, investors have suffered sharp declines in these stocks. One case in point is global miner Anglo American: It has announced to suspend its dividend payments for this year and 2016 for the first time since 2009. Second, purely focusing on dividend yield means that investors are likely to trade in sensible diversification for the privilege of higher income. It can create portfolios that are strongly skewed towards certain sectors, in particular energy, utilities and telecoms.
As a consequence, investors who are keen on receiving dividend income need to focus first on the sustainability of a company’s business model and the relative valuation of its industry, instead of zooming in directly on a required dividend yield level. It may mean ignoring the top dividend earners and go for slightly lower-yielding stocks that have long-term visibility on their earnings. In other words, old-fashioned fundamental company research is essential to build a portfolio that suits one’s needs, in our view. Just picking stocks from a ranking table, we believe, is akin to driving while only looking in the rear-view mirror.