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The Fallacy of Dividend Stocks


I read a lot blogs from others in the financial independence, early retirement community who invest heavily in high yield dividend stocks. These investors often boast about the high returns they are getting in the form of passive dividend income which sounds great. However I was curious to see if this type of investing was actually the best in the long run. Below are my findings.

Why Dividend Stocks

The argument often made is that dividend stocks offer better value than growth stocks. A blog article I read recently from Money in the 20s even listed growth stocks as one of 5 assets which you should not invest in. The others being commodities (fair enough), real estate in major cities (?), penny stocks (definitely avoid) and bonds (low long term returns). It’s certainly true that some companies do a poor job at reinvesting their profits and would be better off paying them out as dividends or buying back the company’s shares (reducing the number of outstanding shares will increase the value of the remaining stock).

However many investors are duped into investing in some companies merely for the relatively high dividend yield without paying any attention to the growth or sustainability of the dividends. For those of you who studied finance or economics at university you might recall the Boston Consulting Group’s matrix which gives the 4 life stages of a company:

Basically in the beginning companies start as question marks. They typically have a high growth rate but a low market share. Many of these companies will fail. Those that succeed will hopefully become stars. Stars are large companies that have high growth and high market share in their industry. Eventually they become large and established and become cash cows. These are typical blue chip companies that pay out regular dividends. Finally these companies often go into decline, they are often in dying industries with little room for growth.

Dividend paying stocks tend to come from the cash cow and the dogs categories. Clearly cash cows are great at generating cash and dividend income. The dogs can offer a false sense of security by paying a large unsustainable dividend. Also stocks in this category will have low (or even negative) growth rates on their dividends.

Growth stocks on the other hand come from the question mark and stars categories. Typically in the beginning of a company’s life cycle they will not pay out dividends and instead reinvest this money into the company for further growth. In the beginning the returns on this reinvested capital can be very high. Clearly the danger with growth stocks are the high number of question marks in this group. These might not go out of business but they might not achieve the growth estimates analysts give them.

Why Growth Matters

To illustrate this lets compare two stocks. Stock A and Stock B. Stock A pays a dividend of 4% and has a growth rate of 2% a year. Stock B pays a dividend of 2% but grows at 10% a year. In year 1 the investor in Stock A will get a $40 dividend for a $1,000 investment. The investor in Stock B will receive just $20. In year 5 Stock A investor will get a $44 dividend and the Stock B investor a $32 dividend. By year 10 the Stock A investor is receiving almost $49 a year whereas the Stock B investor is now receiving almost $52 a year.

The guy who invested in Stock A is probably thinking so what? It’s taken the Stock B investor 10 years to get the same income as me, which is true. However income is not the only factor involved here. If the dividend yield has remained the same on these two stocks then Stock A would be worth $1,225 after 10 years ($49/4% yield). Stock B would now be worth $2,600 ($52/2% yield). This of course depends on the facts that Stock A and Stock B hit these targets and continue to pay their dividends.

Some Data

This is of course all theoretical. Let’s have a look at some data to see what actually has happened over the last 10 years using total return (dividends and capital growth) data from some low cost ETF from ishares (% as 10 year annualized returns; June 2007-June 2017, value of $1,000 initial investment in 2007):

Select Dividend: 6.29% $1,840

S&P500: 7.46% $2,053

S&P500 Growth: 9.01% $2,370

Russell2000 (Small Cap): 7.17% $1,999

Russell2000 Growth (Small Cap): 8.14% $2,187

As you can see the Select Dividend fund failed to even keep pace with the broad market (S&P500). The growth fund (defined by ishares as stocks with above average growth estimates for their industries) outperformed the general market by over 1.5% a year.

If we look at the small cap funds (Russell2000 index) we again see that the growth stocks outperformed the general market albeit by a smaller margin.

Is this just true in America?

Let’s look at the UK.

UK Dividend: 1.83% £1,199

FTSE100: 4.57% £1,563

FTSE250 (Mid Cap): 7.87% £2,133

Similar story again although more striking. The return on the UK Dividend ETF was a woeful 1.83% annualized. The broad-market, FTSE100, added over 2.5% a year to the returns and the mid cap (I used the mid cap fund as ishares do not have a growth version of the FTSE100. The mid caps by their nature contain smaller growing companies) even outperformed the broad market by over 3% a year.

The same rings true in Europe too:

EUROStoxx Dividend: -0.67% $935

EUROStoxx50: 0.81% $1,084

EUROStoxx Mid Cap: 3.23% $1,374

Here the return on the dividend fund is actually negative over 10 years. The current yield of over 4% might look tempting but these stocks look to be dogs.

Conclusion

It looks like over the last 10 years dividend stocks have been a poorer investment than growth stocks. However this does not mean they will continue to under perform going forward. We might be at a stage where growth stocks have been driven up in price too much and now offer little value. I suppose one way to examine this would be to look into changes in the PE ratios of Dividend and Growth stocks over time. If these appear out of sync then this could prove as a warning or opportunity going forward. Does anybody have this information: Historical PE ratios of Dividend and Growth Stock funds stretching back at least 10 years?

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