Dividend Investing: Ignoring Half the Picture

Main takeaways

• Companies with stable cash flow generation and fewer reinvestment opportunities might return cash to shareholders in the form of dividends.

• While dividend investing is a way to earn stable income, the strategy must account for fees, taxes and be compared to factor performance.

• More importantly, dividend investing ignores buybacks, an important mechanism for returning cash to investors.

• Focusing on shareholder yield, rather than just a dividend yield, could be a more promising way to allocate capital.

A way to beat the market?

Investors are always looking for the optimal strategy to maximise their wealth. Dividend investing is a popular approach among retail investors and professionals. However, there’s a possibility that better alternatives exist for maximising returns. Before we delve into the potential issues with dividend investing, here’s a quick refresher on dividends.

Deciphering Dividends

When a company generates cash flows by providing a product or service, it can use the money for any of the following: pay outstanding debt, re-invest into its operations, acquire a target company or return it to shareholders. The two pathways that return money to shareholders are dividends and buyback. The most common form of dividend is a cash dividend, which is simply a distribution of cash from the company to its shareholders. 

The payment can be a one-time special dividend or a recurring quarterly payment. Recurring payments take place when the company consistently generates excess cash and has no reinvestment opportunities. The dividend yield is a measure that represents the annual dividend payments as a percentage of the company’s stock price. In other words, it tells you how much annual income is generated from dividends, per dollar invested in the stock: 

Dividend yield = Annual Dividends Per Share / Current Share Price

Alternatively, you can consider the dividend payout ratio, which tells you how much of a company’s earnings are paid out as dividends. For example, if earnings per share are $2 and the company pays out $1 as dividends, then their payout ratio is 50%.

Dividend payout ratio = Dividends Per Share / Earnings Per Share

Now that we have covered the basics of dividends, we can move onto dividend investing.

Dividend Investing

Dividend investing is a strategy that focuses on buying stocks that regularly pay dividends. Some firms focus on maintaining a steady and growing stream of payments, a practice called dividend smoothing. In spite of volatile earnings, there are corporations that refrain from cutting dividends (which can be a detriment to the company if it leads to excess debt or poor deployment of capital). For this reason, the practice has become attractive for those looking to generate stable income; typically people that are closer to retirement.

Corporations that consistently return money to shareholders tend to be more mature firms that have exhausted growth opportunities and don’t have high yielding reinvestment options. Even though not every firm can sustain dividends over long periods of time, there is a set of stocks that has managed to do so, the so-called dividend aristocrats. This is a set of 65 blue chips that are members of the S&P 500 and have grown dividends for the past 25 years. As such, they are large-cap, established enterprises like McDonalds and Johnson & Johnson.

There are low cost ETFs from the well known asset managers that provide an avenue for those interested in this type of investing. For example, the SPDR S&P Global Dividend Aristocrats UCITS ETF. Fidelity, Blackrock and Vanguard all offer alternatives. At surface level, dividend investing has performed well, over 60% of the gains made since the 60s until 2022 came from dividend reinvesting. Additionally, dividend growers have performed far better than non-payers. The chart below displays their performance and is often used to advertise dividend ETFs:

The dividend growers (green line) trump the non-dividend paying stocks (orange line). However, you know what they say about things that are too good to be true. So what’s the catch?

Risks and inefficiencies

To begin with, according to Meb Faber Research, the data is calculated with geometrically weighted indices, which suppress the presence of outliers. If arithmetically weighted indices are used, then the returns become much more mundane:

There are other issues with this strategy. As mentioned previously, corporations may be dead-set on maintaining dividends at a certain level, which could come at the expense of efficient capital allocation. There may be an opportunity cost to paying dividends, so the payout might destroy value. This is a potential risk to take into account.

Even worse, dividend investing ignores half the picture. Recall that there are two pathways for returning money to investors: buybacks and dividends. There are instances in which buybacks are more appropriate than dividends. For example, if the business can generate higher returns on equity than whatever the investor would redirect the dividends into. Other reasons include repurchasing undervalued shares, using buybacks to signal confidence and altering capital structure. Times during which the tax rate on dividends is higher than on capital gains (1971-2003 in the US for example) also make buybacks a better option. For more detailed insights on buybacks, check out this article.

Furthermore, rather than comparing dividend and non-dividend companies, it's more useful to compare dividend investing to factor investing (i.e. buying stocks with certain characteristics). Systematic value and momentum seem to offer more promising returns. For these reasons, it may come to no surprise that Warren Buffett, widely regarded as one of the best capital allocators of all time, has not paid any dividends. The Oracle is a strong proponent of conducting buybacks below intrinsic value, reinvesting the money operationally and acquiring other businesses for a bargain price. All this suggests that a value approach that considers both dividends and buybacks will lead to better returns.

Shareholder yield: a superior alternative?

If we consider both payout policy pathways, it’s also relevant to discuss the concept of buyback yield. The metric is similar to dividend yield and it measures the percentage of a company’s market cap that is returned to shareholders through repurchases:

Buyback yield = Net Value of Share Repurchases / Beginning Market Capitalisation

For example, if a corporation has a buyback yield of 7%, then 7% of its market cap was returned to shareholders in the form of share buybacks over the past year.

By combining dividend and buyback yield we can get shareholder yield. The mix appears to have performed better than dividend investing and S&P 500 (bottom) stocks as well as a wider universe of 3,000 securities (top), over a time period spanning 1982-2015.

Some ETFs centred around this strategy are the Cambria Shareholder Yield ETF: SYLD and Cambria Foreign Shareholder Yield ETF: FYLD (designed by Meb Faber). Keep in mind that historical performance is not an indication of future performance and both ETFs could underperform a market index or even a dividend ETF.

Overall, the comparison between dividend investing and shareholder yield illustrates that whenever an investing strategy is pitched, it's always important to consider the alternatives and whether or not the full picture is being told.

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