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Kill your darlings
Why we changed our minds about dividend investing
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Daniel Kahneman won the Nobel Prize in Economics in 2002 - but Kahneman never had any background in economics. He was a psychologist. The ideas in his research were so fundamental and powerful that they just could not go unnoticed. One such idea was the anchoring bias.
You might have had this experience: A salesman quotes you a price of $100 for something, and you get it at a bargain for $80. On the way home, you realize “Wait a minute, this is probably worth $20 at most.” The anchoring bias sets an expectation in your mind based on the initial price, and all your subsequent reasoning is adapted to that. The first piece of information is powerful - even if it isn’t the most useful. There is a tendency to shape all your thinking around what you already know.
When it comes to investing, this can have a dangerous effect. Someone who starts their investing journey reading “The Intelligent Investor” might have an irrational attachment to PE ratios. If you listened to Peter Lynch, you might be tempted to invest in your own company. It’s necessary to question your beliefs once in a while. Beginner writers are usually advised to “kill their darlings”, to let their favorite ideas go for the greater good of the story.
That’s what we did with Dividend Investing.
Revisiting Dividend Investing
Dividend Investing is a polarizing topic, especially for something that’s considered a medium of safe returns. Strong supporters argue that a consistent dividend policy can align the interests of the company and its investors and signal confidence in the case of a mature company.
This is a personally appealing narrative to us as we believe that aligned incentives are necessary for long-term growth. That’s why we wanted to revisit our assumptions. In our previous article on Dividend Investing, we analyzed the returns of companies that pay dividends and grow dividends year over year.
It looked like companies that paid dividends had superior performance compared to the ones that didn’t, and that companies with a dividend growth policy did even better. But there was a caveat - Chasing yield alone was a dangerous move as it could compromise on the fundamentals. Also, 80% of the companies in the S&P 500 already pay a dividend. So how could we be sure that excess returns were due to dividends and not other factors?
One option is to focus exclusively on companies that combine dividends with good financials. The S&P 500 Dividend Aristocrats Index tracks S&P 500 companies with minimum liquidity requirements that have a 25+ year record of growing dividends. A number of ETFs track this index, and there is data to show that the index beats the S&P 500 by about 0.74% annually since 1990. The short-term returns of the S&P 500 in a 3 to 5-year period are greater, but the Dividend Aristocrats give better results over a longer term of 10 to 20 years.
About 1.73% of the difference is explained by selection effects, and -0.96% of the returns are explained by allocation effects. The problem is that there are 60+ companies on the Dividend Aristocrats list every year and it’s still unclear whether the performance is due to their dividend policy or their fundamentals. Do the Dividend Aristocrats do well because of dividend stocks or despite them?
Isolating the variables
To put this to the test, we picked the top 10 stocks by yield and the top 10 by year-on-year yield growth from the Dividend Aristocrats list every year, and compared their returns with the S&P500 over the last 30 years.1
The results were surprising. High-yielding stocks performed very poorly. Stocks that increased their yield by a high margin had inconsistent returns but seemed to perform better in the long run. Filtering for high yield and high yield growth has worse returns than the Dividend Aristocrats ETF (and these are financially strong companies). This shows that the performance of the Dividend Aristocrats index as a whole might be due to a number of reasons:
The companies are in the S&P 500, have high liquidity requirements, and plain old diversification could be responsible for the returns.
High exposure to value and profitability factors is correlated with better returns.2 In other words, companies that were financially healthy paid dividends, but identifying good companies based on dividend payouts is not possible.
A few outliers in the Dividend Aristocrats are responsible for the good performance of the index, but those outliers cannot be identified using high yield or high yield growth as a metric.
Despite that, investing in the Dividend Aristocrats ETF might be an attractive proposition: If companies that had a long track record of paying consistent dividends performed better in aggregate than the S&P 500, it would be worth it regardless of the reason. There’s another reason to avoid dividend stocks though…
The tax consequences for all taxpaying shareholders are inferior – usually far inferior – to those under the sell-off program. Under the dividend program, all of the cash received by shareholders each year is taxed whereas the sell-off program results in tax on only the gain portion of the cash receipts.
- Warren Buffett on dividends, Berkshire Hathaway annual report 2012
First of all, dividends are objectively more tax-inefficient as they are taxed at Federal income tax rates that are always higher than capital gains taxes.3 There’s another hidden reason why you should avoid dividend payments.
A company can either return money to its shareholders in the form of dividends or reinvest it in the business. Since value cannot be created out of thin air by just paying out dividends, the stock price of the company has to fall by the amount that the company is paying you in dividends in the long run. If you are paid $1000 in dividends, you are losing out on $1000 worth of stock value appreciation. In effect, the company is liquidating your capital gain and handing it to you as cash. If it had not done so, you could have sold the shares yourself, or waited for it to compound.
The problem is that the tax you pay in both scenarios is vastly different: If you receive $1000 in dividends, you would pay a tax on the entire amount of $1000. If you sell $1000 worth of stock yourself, you would have to pay a tax only on the proportional gain in the value of your stock. If the stock had gone up only 10% since you bought it, then the $1000 you receive on sale is a return on $910 of investment. You would have to pay a tax on only the $90 gains - less than 1/10th than with dividends!4 The difference would be sizeable in the long term because capital gains taxes are much lower than income tax.
There is a catch here: With dividend stocks, the ownership percentage in the company doesn’t reduce when you receive dividends, but you would have to liquidate some of your stock in the other case. The difference is that the amount of invested money that is working for you is the same in both cases while the share percentage is a symbolic number. Depending on whether you need the psychological comfort of regular cash payments and an untouched share percentage, as opposed to more control over when and how you choose to cash in on your gains, you can choose one over the other.
Humans are pattern-finding machines. In his article, “The financial world is a Rorschach test”, Rohit Krishnan describes how it’s possible to find a pattern in any series of numbers. That doesn’t mean all patterns are random - It’s a reminder that correlation is not the same as causation.
Dividend-paying companies have traditionally been financially mature and profitable, and manage their reputation by using dividends as a signaling tool. Attributing their strong returns to their dividend-paying power can mislead us into looking at the wrong decision metric. This might be even more relevant now, given that we are shifting into an era of growth companies and stock buybacks are becoming the preferred mode of returning capital to shareholders.
The next time you look at a potential investment based on a hypothesis that is convincing to you, dig one level deeper. Kill your darlings. It might give you a different perspective that you had missed.
Do you think dividend investing has an advantage that was not mentioned? Let us know in the comments below.
More interesting reads:
The myth of the secret genius: In an era where abnormal success is synonymous with genius, this article explores why we should re-examine the reasons people achieve extraordinary success and separate the outcomes from the reasons.
Repetition economics: How our ancestors made the decision whether to fight a mammoth when they were out hunting alone has a surprising connection to the way we make investing decisions. A little math involved, but totally worth it.
Market Sentiment will be on a break next week. We have something big coming up for the New Year… Stay tuned. Wish you all a Merry Christmas!
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Disclaimer: We are not financial advisors. Please do your own research before investing.
Caveat: A few companies in the list were delisted, and if they would have made the top 10, their returns would be omitted. But since an average is taken, the deviation would be less.
This video by Ben Felix gives an excellent explanation of why high returns from dividend-paying companies in the past don’t mean that dividends are the reason for the success of the companies.
Unless you fall into a lower tax bracket due to your income slab, in which case dividends would be the more tax-efficient option.