January 25, 2011
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Dividend-paying stocks are best known for their income generation on the one hand and their unfavorable tax treatment on the other. Beyond recognizing these well known features, however, many investors hold a false belief that dividend stocks underperform. High-dividend portfolios are often dismissed as inferior to their high-growth counterparts for several reasons:
- Fear that increasing dividend yield means lower portfolio returns.
- A view that dividend payments are an admission by management that they do not have good reinvestment opportunities.
- A belief that dividends are associated with the end of a company’s growth cycle.
- The inferior tax treatment of dividend income relative to capital gains.
The evidence refutes these beliefs. Research shows that the higher a stock portfolio’s dividend yield, the greater its return. And just as surprising, the higher the yield, the lower is portfolio volatility.
Building higher-yield portfolios is a straightforward way to improve returns while simultaneously reducing volatility, notwithstanding the conventional, undue focus on income and tax considerations. Investors and advisors should shed this limited view of dividends and let them play a more prominent role in their equity portfolios.
Dividend yield, returns and volatility
At the overall market level, a long line of research shows that higher cash payout and dividend yields lead to higher future market returns. (See, for example, Surprise! Higher Dividends = Higher Earnings Growth, by Rob Arnott and Cliff Asness, and On the Importance of Measuring Payout Yield, by Jacob Boudoukh, et al.) More specifically, this research reveals that dividend yield is a good predictor of future earnings growth, so a period of rising dividend yield bodes well for future market returns. This belies the common belief that executives increase dividend payout when investment and future growth opportunities are poor. Company management, by increasing dividend payout, is actually signaling higher future cash flows, which in turn foretell higher stock returns.
At the individual stock level, too, dividend payout and yield are predictive of future earnings growth and future returns. (See, for example, Do dividends signal information about future earnings?,by Khaled Hussainey.) Among other things, this body of research has found that dividend changes contain information about 1) future earnings that cannot be found in other market data, 2) company profitability, and 3) future positive earnings surprises. Other research has found that companies experiencing financial distress rely more heavily on dividends for communicating with investors.
The overall conclusion is that rising dividends signal improved company performance and, in turn, higher individual stock returns.
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