Scandalous accounting methods, massive corporate failures, and increased global economic and political instability over the past four years have produced one of the most volatile market environments many investors have ever experienced. The resulting greater risk built into the average investment has left many investors seeking methods to shore up returns while minimizing risk. We believe that a strategy focused on selective investment in dividend-paying stocks may offer just such a perfect blend of maximum return for a given level of risk.
Indeed, a recent study by the Investment Company Institute (see figure 1 on page 101) suggests that a good portion of the investing public has shifted to a lower-risk investing mindset. Wanting a lower-risk portfolio is one thing, but constructing a lower-risk investing strategy can prove to be a markedly complex endeavor. Historical evidence suggests, however, that an investment strategy focused squarely on dividend-paying stocks can offer market-beating returns at below-market risk.
The difficulty in building a lower-risk portfolio begins with the definition of risk. That’s because distinct groups of investors view risk in different ways. For example, our experiences corroborate the findings in the Investment Company Institute study and suggest the average investor would be more than happy to perform as well as the market when it is rising but would throw heaps of scorn at the manager who did not guard against inevitable portfolio declines–even if his overall performance beats the market. Therefore, “risk” to the average investor means simply the potential for loss.
Among most professional market observers, however, the definition of risk is much more complex and is measured most often in terms of the potential upside as well as the downside of a stock. This group quantifies risk using a value known as beta, which measures the manner in which the returns of a specific security generally move in relation to those of the overall market. So beta measures the historical volatility of a security’s returns in relation to a specific market index. A beta of greater than 1 means the security generally overshot the market when the latter was going up. A beta of less than 1 means the security saw a smaller decline than did a falling market. In sum, the risk of an investment in a particular security is most often measured by the volatility of the security’s returns over time relative to a market proxy.
Lower Risk, Higher Returns
Referring back to Figure 1 at right, most investors opt for average returns in exchange for average volatility. That is, they look for stocks that experience price changes of a magnitude equal to those of the market. But what if they could invest in stocks that offer lower-than-market levels of risk while generating market-matching, even market-beating, returns?
It may be surprising for many investors to learn that in the past 15 years, the largest dividend-paying stocks posted superior returns relative to both the market and to their non-dividend-paying peers. But they offered lower levels of risk.
How can this be? Over the past 15 years, we found that large-capitalization dividend-paying stocks generated returns that were less volatile than their non-paying peers. That is, the beta on their returns over the study timeframe was 0.88, versus 1.57 for non-dividend payers. Dividend stocks therefore were less risky investments over the study timeframe. As surprising as it seems, though, the dividend payers achieved an average annualized total return (capital appreciation plus reinvested dividend income) of 13.4%. That exceeds the 11.7% obtained by their riskier non-paying peers. These results are featured in Figure 2 below.
It would be reasonable to assume the higher-beta, non-dividend payers would outperform the dividend payers. In fact, that was the case before the bursting of the bubble–the excessive growth in U.S. markets starting in late 1998 and ending in March 2000. Figure 2 illustrates that the largest non-dividend stocks began in mid-1999 to significantly outperform the dividend payers. At that point, the higher risk the investors supported began to really pay off. Turning to the “Large-Cap Risk/Return” portion of Figure 2 at bottom left, the 100 largest non-dividend payers returned an average of 27.7% per year in the 10 1&Mac218;4 years before April 2000, outpacing the dividend payers’ 20.7% per year. Returns for the dividend payers still proved relatively less volatile, however, showing a beta of 0.94 versus the non-payers’ 1.41.
Nonetheless, when the market turned south in 2000, lower volatility worked in favor of the dividend payers (see Figure 3 on following page). Large-cap dividend payers as a group lost 1% annually in the four and one-third years since the end of March 2000, and the Wilshire 5000 lost 6.5% per year in that timeframe. But the non-dividend payers lost 18.2% annually. That’s just slightly less than the abysmal performance of the tech-heavy Nasdaq composite index, which has lost 18.5% per year since then. Once again, the dividend payers were less volatile in their performance, turning in a beta of 0.78 versus 1.81 for the non-dividend payers.
For Mid Caps, a Different Story
We extended our analysis to mid-cap stocks, for which we found a slightly different story in terms of overall returns, but one that still demonstrated a penchant for strong returns at sharply lower levels of volatility. These findings are detailed in Figure 4 on page 102.
It would be unwise to assume that dividend-paying stocks will continue to outperform the market and their more volatile peers while showing lower volatility, as the higher volatility experienced by the non-dividend payers should result in higher returns in the long run. In fact, current S&P 500 members that paid dividends in 2003 returned on average 34.1% last year, versus 62.7% for those that paid no dividend. But the former currently maintain an average beta of 0.8, versus 1.7 for the non-payers. That is an important feature in the context of returns for each group this year. In the seven months ended July 2004, S&P 500 dividend payers rose 3.9%, while non-payers lost 3.7%.
Therein lies the crux of the dividend investment story. It is their history of offering lower volatility and a proven stream of income–both of which can offer vital protection in a declining market–that arguably makes them so attractive.
Why Less Volatile?
Often, it is up to the market observer to draw tangential conclusions from actual observations. It is easy to look at empirical data–existence of dividends and stock returns–to see that the two are related. It is far more difficult, though, to figure out why. Indeed, dividends are a fine example of this conundrum. Why do stocks in companies that pay dividends generally offer less volatile returns?
It is our belief that most companies begin to pay dividends once they reach a level of business maturity where attractive investment opportunities are relatively less available, while cash flow generation is stable or growing more slowly than in the past. The payment of dividends thus conveys stability–or lower risk–within the enterprise. In fact, a recent study by University of Michigan Business School Professor Douglas Skinner, “What Do Dividends Tell Us About Earnings Quality?” found that the reported earnings of dividend-paying firms are more persistent in future periods. In other words, changes in reported earnings are permanent. This effect increases with both the size of the firm and the magnitude of the payout. We believe that investors are attracted to dividends on the strength of these merits. (Professor Skinner’s study is available for download at http://ssrn.com/abstract=484542.)
Another recent study, “Payout Policy in the 20th Century,” sheds light on the reasons why companies pay dividends and also offers further insight into the drivers of volatility in dividend stocks. The study, by Alon Brav, John Graham, and Campbell Harvey of Duke University and Roni Michaely of Cornell University, involved a survey of 384 mostly U.S.-based finance executives and an additional 23 in-depth interviews with executives regarding their dividend-payout policies. One of the key findings was that dividend-payout decisions are at least as important as decisions to invest in new projects. Further, about two-thirds of respondents said their firm would raise outside money before it would cut dividends. The question with the greatest affirmative response was whether managers actively try to avoid cutting dividends. Ninety-four percent of dividend payers either strongly or very strongly agreed that this was the case. As for initiating dividend payments, two core reasons rose to the top. First, companies will begin to pay dividends because institutional investors want them to. Second, companies will initiate dividend payments based on greater assuredness of a sustainable increase in earnings. Regarding investors’ views of dividends, four-fifths of respondents said they believe dividends convey information to investors and about two-fifths said dividends make a stock less risky. (The study is available at http://ssrn.com/abstract=571046.)
Coupled with the results from the Skinner study that suggest dividends are informative regarding the sustainability of earnings, these data imply that dividends can be used as a measure of stability. Together, these findings present a powerful rationale not only for investing in dividend-paying stocks but also for holding onto them over the long run. We believe investors intuitively or deductively agree with these observations, an attitude that contributes to the lower volatility offered by dividend stocks.
Source of Long-Term Gains
In addition to the results from our study and the other works cited earlier, investor preference for dividend-paying names can be attributed to another motivating factor. According to financial research firm Ibbotson Associates, dividends comprise a substantial portion of long-term gains. This fact perhaps serves as the most powerful impetus for investors to hold dividend-paying stocks. As shown in Figure 5, dividend income for large-cap companies generated 41% of their average annualized 10.4% return. That portion fell as company size decreased but remained an important contributor. Without dividends, then, investors could lose out on two-fifths of their long-term gain potential.
Notably, the fact that the portion of long-term returns comprised by dividends is so sizable can be attributed both to the greater stability of dividend payers and to the fact that dividend payments have increased over time. U.S. dividend payments in the aggregate increased 183% in real terms (647% nominally) from 1978 to 2000. That’s according to another study by Skinner and Professors Harry and Linda DeAngelo of the University of Southern California, “Are Dividends Disappearing? Dividend Concentration and the Consolidation of Earnings.” In fact, dividend payments have increased despite the overall decline of 49% in the number of firms paying dividends over the timeframe. That is because nearly all of the companies that stopped paying dividends had originally offered very small payouts and dividend payments increased substantially among the largest firms, reflecting a very large increase in their real earnings. (The study is available for download at http://ssrn.com/abstract=318562.)
An anecdote from Barron’s further supports the long-term ownership of dividend-paying stocks. Diversified manufacturer Leggett & Platt (NYSE: LEG), for example, raised its dividend in each of the past 33 years at an average compound annual growth rate of 15 %. When the company first paid dividends in 1971, it offered 36 cents per share. After seven stock splits, that one share has turned into 54 and the original dividend payment now equates to $34.40 per share. That’s 95 times the original payout and well in excess of the end-July 2004 stock price of $27.05.
Dividend stocks have historically offered lower volatility with potentially market-beating returns given the right selection strategy. Dividend income has also comprised a significant portion of long-term gains. Dividend gains may also receive more favorable tax treatment going forward. We believe that these characteristics make a compelling case for an investment strategy based on long-term holding (5-10 years) of a select group of dividend- paying stocks.
Mark Mowrey is a senior analyst at Al Frank Asset Management in Laguna Beach, California. His responsibilities at the firm include developing editorial content for The Prudent Speculator newsletter and investment analysis. He can be reached at [email protected]
John Buckingham is Al Frank’s president, chief portfolio manager, and director of research. He is also the manager of The Al Frank Fund and The Al Frank Dividend Value Fund as well as the editor of The Prudent Speculator. He can be reached at [email protected].