Dividends aren’t as important as they might appear. True, dividend payments can impose discipline on managers, making it harder for them to squander shareholders’ money on low-return pet projects. And yes, high-stocks have outpaced their lower-yielding counterparts over the long term, as shown in Exhibit 1. But there does not appear to be a causal relationship between dividends and returns.
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Instead, this performance pattern can be explained by high dividend payers’ tendency to trade at lower valuations and exhibit less sensitivity to the business cycle than less-generous dividend payers. These characteristics have historically been associated with more-attractive performance independent of dividend policy. So dividends don’t tell the whole story. Focusing too narrowly on them can lead to trouble.
Exhibit 2 shows the results of a regression analysis that attempts to explain the returns of six portfolios of stocks in the U.S. formed on dividend yield with the market risk premium, size, value, and profitability factors from the French Data Library. After controlling for these factors, the high-dividend portfolios didn’t perform better than the low-dividend-paying portfolios. But they were less volatile and exhibited lower sensitivity to the market risk premium (market beta). This inverse relationship between dividend yield and market sensitivity likely arises because the market often punishes firms that cut their dividends. So firms wouldn’t commit to high payments unless their managers were confident in their ability to honor them over a full market cycle. Managers of firms with more-stable cash flows (and lower market betas) are likely more comfortable paying higher dividends. Firms that don’t pay dividends tend to be less mature and have more-volatile cash flows.
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The positive relationship between high dividend yields and low valuations isn’t surprising. Mechanically, lower valuations translate into higher yields among dividend-paying stocks. Firms that pay out a larger share of their earnings as dividends tend to reinvest less to fuel future growth. Lower growth, on average, leads to lower valuations.
It may be intuitive to presume that stocks with higher dividend yields tend to be more profitable than those that have lower yields, but that's true only up to a point. Non-dividend-paying stocks exhibited lower sensitivity to the profitability factor than dividend payers, but the two highest-yielding portfolios had less exposure to that factor than their lower-yielding counterparts. That’s consistent with other portfolios that exhibit pronounced value tilts, as investors typically pay less for less-profitable firms. Investors who narrowly focus on yield may ultimately sacrifice profitability and increase risk.
Dangers of Yield Chasing
History is strewn with examples of high-dividend yielding stocks forced to cut their dividends amid deteriorating fundamentals, including Bank of America (BAC) during the financial crisis and ConocoPhillips (COP) in February 2016 after oil and gas prices dropped sharply. Firms with the highest dividend yields are the most likely to cut their dividends because they generally pay out a large share of their earnings as dividends, leaving a smaller buffer to sustain those payments if earnings fall. And their low valuations often reflect lackluster fundamentals. Even without a dividend cut, weak fundamentals can lead to underperformance and large drawdowns in tough environments.
It isn’t necessary to avoid the highest-yielding stocks altogether or apply demanding screens for quality to stay out of trouble. Rather, a broadly diversified, market-cap-weighted portfolio of high-dividend-paying stocks can mitigate the impact of the riskiest names.
Dividend Growth
While most broadly diversified dividend-income strategies are essentially value strategies with slightly lower-than-average market risk, dividend growth strategies are more quality-oriented and defensive. They tend to favor highly profitable firms with durable competitive advantages. Consistent dividend growth is usually a good sign. It suggests that the firm is growing profitably, more insulated from the business cycle than most, and that managers are confident in their firm’s prospects and committed to shareholder-friendly policies. But like dividend yield, past dividend growth does not tell the full story. It isn’t sustainable if it grows faster than (cash) earnings and doesn’t provide a good indication of how earnings will grow in the future. Even if it did, growth alone is not predictive of better stock performance, as growth expectations are usually reflected in stock prices. So, while dividend growth is a sensible strategy, it isn’t perfect.
Look Beyond Dividends
Dividend income and growth strategies both have merit, but dividends alone don’t drive stock returns, and focusing on them in isolation can increase risk. To keep risk in check, dividend income investors should look for strategies that are well-diversified, or that screen for quality, including profitability. Similarly, dividend growth portfolios can be good defensive strategies, but past dividend growth isn’t always sustainable. It is best to look for strategies that demand a record of consistent dividend growth and the potential to sustain that growth.
