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 !!
value and opportunity 