Slaughtering the High-Dividend Sacred Cow

Facts, as founding father John Adams put it, are stubborn things, but our minds are even more stubborn. Doubt isn’t always resolved in the face of facts for even the most enlightened among us, however credible and convincing those facts might be. One reason is that, due to the well-documented phenomenon of confirmation bias, we undervalue evidence that contradicts our beliefs and overvalue evidence that confirms them. We filter out inconvenient truths and arguments on the side opposite our own. As a result, our opinions solidify, and it becomes increasingly harder to disrupt established patterns of thinking.

This is especially true when it comes to investors who believe that dividend-based strategies are an efficient way to invest (even though the research suggests many investors don’t understand how dividends actually work). No matter the amount of evidence presented, or the logic supporting it, investors who believe in dividend strategies will ignore the facts and data.

At least for tax-advantaged investors, dividends are irrelevant: They are neither good nor bad in terms of forward-looking return expectations. Therefore, while there is no reason to exclude dividend-paying stocks, focusing solely on them leads to less diversified (less efficient) portfolios.

The individual investor’s preference for cash dividends has long been known. However, from the perspective of classical financial theory, this behavior is an anomaly.

In their 1961 paper, “Dividend Policy, Growth, and the Valuation of Shares,” Merton Miller and Franco Modigliani famously established that dividend policy should be irrelevant to stock returns. As they explained it, at least before frictions like trading costs and taxes, investors should be indifferent to $1 in the form of a dividend (causing the stock price to drop by $1) and $1 received by selling shares.

This theory has never been challenged, and for good reason – the historical evidence supports it. Stocks with the same exposure to common factors (such as size, value, momentum and profitability/quality) have the same returns whether they pay a dividend or not. Yet, many investors ignore this information and express a preference for dividend-paying stocks.

Even worse is that high-dividend strategies – which, as opposed to growth-in-dividend strategies, are basically value strategies – have provided the smallest value premium compared to standalone value strategies based on metrics such as price-to-book value, earnings, cash flow, sales and EBITDA.

Among the more commonly cited explanations for investors’ preference for dividends is that they offer a safe hedge against the large fluctuations in price that stocks experience. Another is that investors don’t have to sell any stock to generate cash flow. But these explanations ignore the fact that the dividend is offset by a fall in the stock price, and is thus a virtual substitute for (or equivalent to) the sale of stock in the same amount as the dividend. It’s what can be called the fallacy of the free dividend – the only free lunch in investing is diversification, not dividends. Further explanations are provided by behavioral finance professors Hersh Shefrin and Meir Statman, which I have discussed in detail elsewhere.

On an after-tax basis, the composite value strategy far outperformed the high-dividend strategy. For example, even in the no-taxes environment, equal-weighed value strategies both including and excluding the highest dividend payers outperformed the equal-weighted high-dividend strategy by more than 3 percentage points, 13.9% versus 17.4% and 17.2%. And when taxes are introduced, the performance gap becomes much larger. To repeat, while the impact of turnover isn’t considered, passive value strategies have relatively low turnover and investors can use ETFs or tax-managed value mutual funds, which seek to maximize after-tax returns by eliminating the realization of unnecessary short-term gains. Perhaps the most interesting finding is that a value approach that avoids the highest-dividend stocks has the highest after-tax returns for high-tax-bracket investors.

As Faber noted in his article, while many investors, including retirees, value the psychological benefits of those quarterly dividend checks, they are losing sight of the cost one pays for those benefits. He writes: “The ‘bird in the hand,’ so to speak, is costing about three or four in the bush.”

Summary

I don’t hate dividends. In fact, just as screening for them results in less diversified (and less efficient) portfolios, screening them out entirely would also result in less diversified portfolios because about 40% of U.S. stocks and 60% of international stocks pay dividends. Screening them out might also lead to less exposure to factors with premiums (such as profitability and quality, as well as value).

There are no logical, economic reasons for preferring dividends – none, just some purely psychological or behavioral ones. The knowledge of why such biases lead to less efficient investment results should help overcome the psychological hurdles.