Dividend stocks aren't fail-safe
Dividend investing has many sterling qualities but protection against
downturns is not one of them. With few exceptions, dividend stocks
fall just as hard as other stocks when the market crashes.
Yet despite that failing, you should still own dividend stocks. Let me
explain why, with the help of Dartmouth professor Kenneth French.
His data show that U.S. stocks with high dividend yields have
outperformed the market over the long term.
In one study Prof. French sorted dividend-paying stocks by yield into
five groups plus a sixth group that tracks non-dividend payers. He
looked at the returns an investor would have reaped if he or she had
bought each group, held them for a year, sold them, and repeated the
process over and over.
The long-term returns are shown in this accompanying bar graph.
[larger version]
The group of stocks with the highest yields gained an average annual
return of 10.9 per cent and bested the market by 1.6 percentage points
a year from the summer of 1927 to the end of 2011.
However, the highest yielding stocks didn't produce the best
returns. It was the second highest yielding group that fared best,
with average annual returns of 11.8 per cent.
What's behind this quirk? Extremely high yields are usually a sign of
distress rather than strength. Should a company run into trouble, its
share price often tumbles, pushing its yield into the stratosphere
- until management cuts the dividend to save money. It's a sequence
that Yellow Media shareholders recently learned about the hard way.
On the other hand, buying stocks that don't pay dividends is also
risky. In Prof. French's study, they underperformed the market by a
percentage point a year.
The moral here: It pays to be a yield hog but not a greedy one.
It also pays to keep your expectations in check during tough
times. Returning to Prof. French's data, we can track the performance
of the second highest yielding group during bear markets. Declines
from prior peak levels are shown in the accompanying graph along with
the declines of the market as a whole.
[larger version]
You can see that the experience of dividend stocks is quite similar to
that of the market in down times. They didn't save investors during
the grand daddy of crashes in 1929. Nor did they help investors much
when they were licking their wounds in 2009. Dividends are not
sure-fire bear repellants.
Mind you, they helped a bit on a few occasions. They cushioned the
downturn of 1974 and dividend investors largely avoided both the
growth, and the burst of, the Internet bubble more than a decade ago.
Overall, the notion that dividends protect investors during downturns
is less than convincing. But they have provided a nice return
advantage over the long term. So while both dividend investors and
index investors might cry into their beer during bear markets, at
least dividend investors can afford more expensive hooch.
First published in the Globe and Mail, April 21 2012.
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