When dividends matter (Hint: Mostly not at all)

Today I read an article in one of the major German Newspapers, Frankfurter Allgemeine, about the merits of investing in stocks.

I know that the year is still young, but this article (in German) might be easily the worst article of the year on stock investing.

They offer 3 “compelling” reasons why stocks are attractive:

– dividends are increasing
– stocks are still below all time high if you look at a pure price index (the old FAZ index)
– the dividend yield according to them is 2,9% and higher than 10 year Bunds (0,5%) or BBB bonds (1,5%)

They even recommend to buy stocks just before the dividend payment to collect the dividend and then sell. They finally show a calendar with all dividend dates of the major German stocks in order for the readers to be prepared.


Technicalities:

For some reason, the author doesn’t seem to know the existence of an “Ex-dividend” adjustment for stocks. I guess this guy also buys bonds the day before they pay the coupon or so. Including taxes and execution costs, I am pretty sure this kind of “dividend hopping” has negative expected value.

Anchoring bias

Secondly, it is interesting that you see such a nice example of an “anchoring bias” in a major newspaper. For investing in stocks it doesn’t matter if the stocks trade at an all time high or all time low. All that matters is if stocks are valued adequately in relation to their intrinsic value which in turn is determined by future profits and cash flows. With a “strategy” like that one mentioned, you will miss most bull markets and happily buy into bear markets. Congratulations !!!

Where is the problem with dividend yields ?

Well, before I further insult the writer of this article, the problem is that many people seem starting to think that somehow dividends are like “coupons”. This is clearly the side effect of the current low-interest rate environment.

There are also many statistics which point out that over a very long period of time, dividends have been a significant part of stock market returns.

However just buying stocks with high dividend yields is actually a loosing strategy as Dreman, O’Shaugnessey and others have shown. For me, the problem is two fold:

1. High current dividend yield stocks are often value traps

When companies get in fundamental trouble, they often try to preserve their “sacred” dividend until the bitter end. For some reason, canceling a dividend is been seen as the ultimate ratio before the real troubles begin. So it is quite common, especially in capital-intensive industries that struggling companies keep up their dividend despite an eroding business, as it could be seen with E.on, RWE or the banks. Sometimes you even see companies paying dividends and issuing dilutive shares at the same time just to keep up the illusion of a constant, “coupon like” dividend like Santander just recently.

Those long term returns mentioned above are actually much more the result of high growth, low dividend yield stocks which over a long-term grow so much that after 20 years or more, the dividend in relation to the original purchase price is then huge.

Especially these days, dividend yield is a very imperfect measure for shareholder returns anyway. Including share buy backs and looking at total shareholder return is the much superior strategy as for instance Mebane Faber has shown in his book.

2. Psychology: Yield hogs get slaughtered

A “yield hog” is someone who only looks at coupons or yields and not on total returns. If you buy a bond and the issuer does not go bankrupt, you get the coupon and the principal back. If you buy a stock, you might get your dividends (or not), but you never get your principal back. In contrast to a bond, you have to sell the stock to someone else in order to get your principal back. However there is clearly no guarantee that you will your principal back as “mr. market” might disagree on the value he wants to give you.

Psychologically, “Yield hogs” often cannot stand draw downs on the stock price and then get “slaughtered” when the panic sell in a bear market (often after doubling up on the way down). In some areas like insurance or pension funds, where you need to show a current yield, this “yield hog mentality” is basically baked into the business model and can be observed cycle by cycle.

So when do dividends add or indicate value ?

In my opinion, the only case where dividend yields are important if you invest in “deep value” cheap non-growing companies with a lot of cash flow and questionable capital allocation skills or dangerous environments. In such cases, having a paybacks via high dividends lowers the “risk duration” of an investment significantly.

In my portfolio for instance, Installux, Romgaz and Electrica are such candidates where I would not invest if they would just accumulate earnings. but be careful: i ti snot the dividend which makes them good investment but the undervalued nature of the stock. Admiral for instance, a company I really admire, would do much better fo its shareholders if they would buy back stock instead of paying 6-7% dividends. The long term compounded return would be much better without the tax on the dividend income.

As always, Warren Buffett has summarized it nicely several times why dividends are actually stupid for good companies.

Quick summary:

Investing in stocks because of the dividend yield is an extremely stupid way to invest. Either you will end up holding a lot of value traps and/or you will lose your nerves in the inevitable downturns.

Dividends should only been considered in context with the underlying business model and in combination with the capital allocation (reinvestment, share buy backs, debt levels), but never ever as a stand-alone investment criteria.

Dividends ARE NOT COUPONS and stocks are not “yield replacements” for bonds !!

20 comments

  • Pingback: Dividenden sind schlecht für das Portfolio - Gier ist gutGier ist gut

  • http://www.handelsblatt.com/my/finanzen/anlagestrategie/trends/anlagestratege-asoka-woehrmann-die-dividendenrendite-ist-der-zinsschein-der-zukunft/11315542.html

    Subscription needed, but the headline speaks volumes. Not only journalists get it wrong, also “strategists” fall for it. Not going to end well.

  • I always got the impression that “Dogs of the Dow” or “Dogs of the XYZ-Index” happened to create an extra-return for stock-holders. Have all these studies and has all that literature been revised? As it seems, I missed something.

    • a lot of this stuff didn’twork anymore after 2007/2008 when banks were the cheapest P/B and didvidend yield stocks. If you exclude banks, then some of the stuff still works but excluding banksis the best example fr data mining. It is no wonder that Dreman for instance never managed to actually run a successful fund.

      • You mean, P/B is dead as well? How about P/E, P/S, P/CF, EV/EBIT etc? All these “valued” ratios should be dead, just due to the bank crisis some years ago?

        I can’t believe that. However I agree that Price/Dividend never was the strongest of those ratios.

        • EV/Anything seems to work best for now, but most likely because it doesn’t work for financials….

          As far as I know, you have read O’S different books, so you should be aware that P/E and P/B don’t really work well. P/S nevere really had anyway.

  • Hi mmi,

    something different: do you have some experience with EPC (Engineering, Procurement, Construction) companies? When I looked into this sector I found some companies with ridiculously low EV/EBIT ratios and often lots of cash (e.g. Metka, Monadelphous, Duro Felguera, you name it) but it seems to me that the whole sector is valued quite low. I understand that this is a project based business and in economical downturns projects will be cancelled and this sector will suffer severly (that’s maybe also a reason why these companies sit on a pile of cash). But this argument applies also for other industries which are not valued that low. Do I miss something here? What is your opinion on this industry?

    Walter

    • #Walter,
      with EPC companeis, there is one specialty to consider: A lot of the cash on those balance sheets is not “free cash” available for shareholders but prepayments which have to be spent on future work. So you should always look et EV/EBITs with and without prepayments to get a feeling how those compenaies are valued.

      The second point is that the P&L of those companies is often driven by “percent of completion” accounting. This can look good for a long time but then turn nasty if a project somehow fails at the end.

      mmi

  • I see this article as one of those things occuring in a low Bond yield era. Remember this has happened before and don’t be surprised if certain high market cap Stocks with good dividend yield will see a pronounced increase in the PE ratio up to 20 or 25, just because they pay good dividends.
    We may not like it as value investors and may opt not to participate, but there is a chance it will happen again.
    Covacoro

  • Not sure. Not sure. There is more about dividends than just payout.

    But you had a point mentioning that it is most important when companies are not growing!

    http://undervaluedjapan.blogspot.de/2014/03/value-investing-and-importance-of.html

  • I totally agree with your article! Just wanted to mention that in the past there was a strategy to make money with high-dividend stocks which worked like that: You select a group of stocks with relatively high dividends (> 5%) and buy each of them 6 – 9 months before the day of dividend payment. You then sell them within 4 weeks BEFORE dividend payment. This way you don’t have to pay taxes on the dividends but benefit from increases in stock prices. The strategy is based on the observation that small companies with very high dividends are often quite cyclical in their stock price over the year with highs around dividend payment and lows about 6 – 9 months before that. Of course this can go totally wrong in a bear market, but over a couple of years market effects level out and the underlying trend works. I know that in the 90s and first half of 2000s this strategy worked quite well. I have no data about the last years, however.

  • Admiral probably does not take into account foreign (= non-UK) tax matters. AFAIK, UK citizens even get a tax credit for dividends which are supposed to be already taxed at the company level. So UK investors might even do better with dividends compared to repurchases.

  • Don’t forget that you have to pay taxes on your dividends as well. That seriously hurts your compounding.
    It might be a viable strategy when you’re looking for an additional income stream during retirement but i wouldn’t recommend that either.

  • Thank you for this article. I don’t read good articles on dividends very often. And that’s not because I don’t want to…

    • You’re welcome. I was so agitated by that FAZ article so I had to let off some steam…

      • I wonder you totally ignored the end of the article: “Allerdings ist der Aktienkurs am Tag nach der Hauptversammlung in der Regel um die Dividende niedriger. Aus diesem Blickwinkel betrachtet, ist die Freude des Aktionärs dann getrübt.”
        It puts all the stuff above in that article quite in perspective indicating it was bullshit for the pure sake of playing for lines. 😉

        Regarding your comment: I agree that by catching for dividends you may easily enter some of the most obvious traps to delude problems in companies. But I do not share your fascinaton for share buybacks as I suspect them as beeing even more often used to manipulate share prices in the short time, eg to meet bonus payment barriers for management.
        I believe to remind more problems for companies by overpriced and overdimensioned share buybacks, leaving companies stripped of assets in a hard time, than by dividend payments, as the financial dimension of share buybacks is often bigger.
        Both methods have their huge merits but both can be abused to feign a wrong picture of quality and prosperity.

        • Hi Roger,

          I hope that I did not leave the mpression that I love stock buy backs in all cases. I am totally critical of stock buy backs financed by debt into a sky high share price. However if a company has limited investment opportunities and the stock price is below the intrinsic value, stock buy backs instead of dividends can add significantvalue to shareholders.

          mmi

        • Yeah, now I agree!
          A company with free money and stock price below intrinsic value should better repurchase own stocks than instead of dividends.

          But for companies with stock prices far above intrinsic value as we actually can find quite a lot, I am really septical about share buybacks. Here dividends should be the smarter option for giving money back to shareholder. (OK there is a window between where dividends are less attractive due to taxation of dividends and no taxation of share buybacks…).

          🙂

  • Very true. The news paper article reflects the current investment philosophy many so called “wealth management specalists” pursue. Many or their clients have retired and are looking for yearly returns to make a decent living. Since bonds offer a very low yield at the moment, they are flooding into high yield stocks which they consider as “bond surrogates” such as rents from real estate. So the stock prices rises for a long time until the final crash will come. Good time to buy then …

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