Dividends for Yield, Stability and Outperformance

“Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.” – Charlie Munger

Academic research over the years has told us that investment risk is defined by standard deviation or volatility. The higher the volatility that an investment has, the greater the risk and therefore the greater the reward you can expect.

I think that looking at risk in the form of volatility is a mistake for individual investors. The quote at the top of the page by the great Charlie Munger more accurately describes the types of risks you should be worried about.

The complete loss of capital from investments gone bad or simply not earning a suitable return on your investments to achieve your stated goals should matter much more to you than the short term movements in your portfolio.

Actually the research on the volatility and risk/reward relationship of stocks has been challenged in the past few years.  Studies that now reveal that lower volatility stocks have historically outperformed higher volatility stocks, and with less risk (as defined by volatility).

These studies state that one of the reasons for this phenomenon is that higher volatility can lead to larger gains, but it can also lead to larger losses. And large losses can have a detrimental effect on your portfolio.

For example, an investment that loses 50% of its value needs to gain 100% just to break even. Obviously, the larger your losses, the larger your gains must be to play catch up.

DIVIDENDS
So why have the so-called lower volatility stocks outperformed over the years? Larger losses do play a role here, but more important than that is the fact that low volatility stocks tend to be higher quality companies that pay consistent dividends over time.

Dividend stocks allow you to take advantage of the wonders of compound interest by reinvesting your dividend income and continuing to build on those investments over time. The results can be tremendous in both the long-term and over periods of market disruption.

According to Tadas Viskanta in his book, Abnormal Returns, from 1900 to 2010, the U.S. stock market returned 9.4% per year with reinvested dividends; without dividends reinvested it returned 5.0%.

Take a look at this graph from Blackrock, which shows how dividend stocks have performed against the broader S&P 500 over the most recent investment cycles:

As you can see from this data, dividend stocks have performed well in both good times and bad. They protected you on the downside from 2000-2002 and actually outperformed during the recovery from 2003-2006. Dividends also kept pace during the roller coaster ride that was 2007-2012 and have massively outperformed in the entire thirteen year period.

One of the reasons for this outperformance is that companies that pay out dividends on a consistent basis tend to be higher quality companies. They can afford to pay dividends because they have the financial flexibility and recurring cash flow from operations to make these periodic payments.

We’ve seen many cases over the years of companies manipulating earnings numbers to meet or beat expectations through accounting tricks. It’s much harder to fudge your results when actual cash is being paid to shareholders on a regular basis.

Another reason that high quality stocks have historically done better is that most investors become enamored with high flying growth stocks that show potential for outsized gains. The expectations for these growth stocks gets too high and investors are disappointed when results aren’t met.

Many times these companies don’t have the cash flows available to pay out to shareholders because they are forced to reinvest in the business for future growth opportunities. Quality companies do this as well, but are more seasoned so they have the resources to invest in their core business and in their shareholders.

WILL DIVIDEND STOCKS CONTINUE TO OUTPERFORM?
In a low interest rate environment like we have experienced for the past five years or so dividend stocks will continue to be in high demand. Investors in search of yield are having a hard time finding it in the usual places (bonds, CDs, money market funds, etc.).

In fact, many stocks have much better yields than traditional government bonds. Another interesting stat from Blackrock:

409 S&P 500 companies were paying dividends as of April 30, 2013. And more than 60% of those had a yield higher than the 10-year Treasury. Taking a broader view over time, S&P 500 dividend increases have historically outpaced the rate of inflation by 1%-1.5%.

This factor has led to the continued outperformance of dividend stocks this year. They have been on a tear as of late and have been outperforming the broader market by 3-4% all year.

I stay away from short-term forecasts, so don’t take this as a recommendation to rush out and buy dividend stocks right this minute.  It’s impossible to predict short-term movements in the stock market so it is possible that these stocks could cool off for a while if investors get nervous and take some gains

No investment strategy can outperform over every market cycle forever. That’s why you need to think long-term with your investments because there will be times where quality stocks don’t perform as well as they have been lately. That’s just the nature of the markets.

But over the long-term, the baby boomer retirees will need to get income in one form or another. Bond yields are pitifully low and CD rates are almost non-existent. This should help keep dividend stocks in demand, even if there are periods of underperformance.

INVESTMENT OPTIONS
Your best strategy with dividend stocks is to take the long view and reinvest your dividends over time. That will allow you to reap the benefits of compound interest and can be thought of as a form of dollar cost averaging. Look for companies that have a consistent history of not only dividend payouts but also a history of increasing their dividend each year.

If you aren’t comfortable investing in individual dividend stocks you do have some options in the ETF space. Here are some popular dividend ETFs with the lowest expense ratios that you can use in your portfolio: VIG, SCHD, SDY and VYM.

Another way to gain more exposure to dividend stocks is shift your portfolio to more value oriented strategies. Value stocks are typically the more high quality, over-looked stocks that pay higher dividends than the overall market because they are more established companies.

The Vanguard Value ETF (VTV) currently yields a little over 2.5% while the S&P 500 yields around 2.0%.

As always, do you homework before investing and understand that dividend stocks can go down in price just like stocks that don’t payout dividends.

But if history is any indication, your risk should be lower by both academic standards such as volatility and by common sense measures like reduced risk for a complete loss of capital and the risk of inadequate returns.

Sources:
Low Volatility Stocks Consistently Outperform
New World Wisdom: Winning More by Losing Less
Digging Into Dividends
Abnormal Returns

Further Reading:
Dividend Stocks are Not a Bond Substitute

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