Many stock investors seek out high dividend paying companies. Over time, dividends have been an important component of long-term stock returns and many investors, particularly investors drawing off their portfolios, favor higher yielding companies because they view income paying investments as getting “paid while they wait”. The average dividend yield on the S&P 500 is around 4% going back to the late 1800s, but as you can see by the chart below, the dividend yield on large cap stocks has been in decline since the 50s and 60s, and with the big decline starting around the mid-1980s. Currently the dividend yield on the S&P 500 is hovering around 1.6%. I thought I’d use the trend of declining dividend yields to talk about a few things investors may want consider now and in the future relating to dividends.
The Decision of Dividends
It’s important to remember that dividends aren’t automatic payments that companies just pay out. Rather, the decision to pay a dividend is made by the Board of Directors and plays into a company’s capital allocation decisions. Some companies have a long tradition of paying dividends, and their investor base partially invests with them because of these consistent payments. Firms like AT&T and Exxon have long paid out dividends and there are a few dozen or so companies that have a 25-year track record of consistent dividend payments. These firms are often referred to as Dividend Aristocrats. There are other firms, like Berkshire Hathaway, that don’t pay a dividend. Buffett doesn’t favor the double taxation of dividends (the company pays tax on the net income and the investors pays tax on the dividend) and he would rather use the capital to buy income producing assets, including stocks of companies that pay dividends.
When a company closes its books at the end of the year or quarter with a profit, it can choose what to do with the net income remaining. It can retain those profits, adding to the cash on the balance sheet for future use and investment, it can pay down debt, it can buy back its own stock or it can pay a dividend.
Over the last few decades, dividends have fallen as share buybacks have increased.
The chart below, extracted from the S&P Global Report, “Examining Share Repurchasing and the S&P Buyback Indices in the U.S. Market”, shows the amount spent on share buybacks actually eclipsed dividends in the late 90s and hasn’t looked back since. From the report:
Since 1997, the total amount of buybacks has exceeded the cash dividends paid by U.S. firms (see Exhibit 1). The proportion of dividend-paying companies decreased to 43% in 2018 from 78% in 1980, while the proportion of companies with share buybacks increased to 53% from 28% during the same time period. The increased use of share repurchase is mainly driven by some key advantages of this method, including tax benefits and financial flexibility.
Source: Examining Share Repurchasing and the S&P Buyback Indices
Dividend Yield vs. Buybacks
Up until this point I probably I haven’t told you anything you don’t already know. But this is where things get interesting. What S&P also did in the paper is look at three different portfolios or indices to see if buybacks performed better from a long-term investment standpoint than dividends. They created an S&P 500 dividend yield portfolio, S&P 500 Buyback Index, S&P 500 Shareholder Yield portfolio and compared those to the S&P 500, and also to the S&P 500 equal weight indices. For simplicity’s sake, I’ve included only the 20-year annualized returns below through Dec. 31st, 2019.
- S&P 500 Dividend Yield Portfolio: 9.9%
- S&P 500 Buyback Index: 11.5%
- S&P 500 Shareholder Yield Portfolio: 12.1%
- S&P 500 Index: 6.1%
- S&P 500 Equal Weight Index: 9.3%
An investor who made an $1 million investment in the S&P 500 would have had $3.2M after those 20 years. A high dividend investor, however, would have done even better with $1M turning into $6.6M. But the real winner was the investor who used the shareholder method (dividend yield + net buyback yield + interest payment reduction yield), which would have produced a portfolio valued at over $9.2M. There wasn’t any material difference in the risk or variability of the portfolios– they were effectively the same when it came to the annual standard deviation of returns, and the S&P Dividend Portfolio actually had a higher max drawdown compared to the other two.
Hitting 4% with a Synthetic Dividend
For most investors living off their portfolio, a 4% withdrawal rate is approximately what advisors suggest should be used in order to avoid running out of money before the end of one’s expected life. In our example above, a 65-year-old retiring now with a 20+ year time horizon may be tempted to look at high income yielding stocks for the equity portion of the portfolio to help meet that 4% target, but that could mean a big difference in the total portfolio value over time, as we can see above. One idea is to use a synthetic dividend and opportunistically sell part of the stock portfolio in order to meet the income needs vs. loading up on higher yielding stocks that may not give the investor the best long-term return.
Ultimately the best portfolio for the investor is the one they can stick with over time. If that means high dividend payers for many that is fine. But it’s important to note that dividends continue to come down and companies continue to buyback their stock. Investors who see these trends and who can look past just dividend yield could be the ones rewarded the most over time.
There are a few resources on Validea and elsewhere that maybe helpful for those investors that want to look beyond just yield.
Validea’s Shareholder Yield strategy based on the writing and research of Meb Faber, founder of Cambria Investments.
Our Dividend Aristocrats screen showcases those stocks that have increased their dividends in each of the past 25 years. The NOBL ETF holds the Dividend Aristocrats in and ETF wrapper – view NOBL on our ETF Factor Report.
Validea’s Guru Stock Screener can be utilized to identify higher yield stocks that pass one or many of our guru models and you can add in dozens of additional fundamental filters to refine the list down to a manageable and actionable set of ideas.
Justin J. Carbonneau is VP at Validea & Partner at Validea Capital Management.
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