High-dividend stocks may bring only low returns

Investors can put their money into a balanced portfolio based on sound principles, including a proper assessment of growth and valuation

PUBLISHED : Monday, 10 June, 2013, 12:00am
UPDATED : Monday, 10 June, 2013, 4:03am

Investing in high-dividend stocks is more of a fad than a real investment proposition. Before digging into why, let me briefly recap what the cheerleaders have been saying.

For starters, with interest rates near zero and some dividend yields significantly above government bond yields, it is commonly accepted that high-dividend stocks are a better place to park one's cash than money markets or government bonds. Another common argument is that a significant portion of stock returns for the past 100 years has come from dividends. Furthermore, high-dividend stocks are often associated with defensive sectors like utilities and consumer staples such as purveyors of toilet paper and soap. As we seem to be lurching from one crisis to the next, defensive sectors have resonated with investors and this might be a better argument than any in favour of high-dividend stocks.

Now that we've heard the main arguments, let's see if there are any weak spots in this investment proposition.

For starters, I encourage all investors to read Berkshire Hathaway's 2012 annual report (pages 19-21) explaining why the company linked to investor extraordinaire Warren Buffett does not pay dividends. There is a bit of maths involved and a few inconsistencies but it's a great primer on why some companies are better off not paying dividends. Put basically, in these situations investors can realise more value from selling a bit of their holdings each year instead of receiving dividend cheques. Avoiding such companies because they do not pay dividends is nonsense.

Meanwhile, there is a whole swath of companies experiencing high growth that do not pay dividends because they need cash to fund expansion. And the mother of all arguments against the high dividend camp is simply that strategies that select stocks solely from a basket of high-dividend-paying stocks does not consider their valuation relative to their low-dividend-paying peers. If all of the stocks in this universe are overvalued, then what? Instead, by selecting from a universe of dividend and non-dividend-paying stocks, investors can take comfort that their investment process is grounded in sound investment principles, including a proper assessment of growth and valuation.

Unfortunately, just as investors have piled into high-dividend stocks simply because their dividend yields are higher than money market rates, these same investors will likely start dumping dividend-yielding stocks as soon as they believe interest rates will begin rising. In fact, if the last week or so is any guide, investors have already started reducing their holdings on the expectation that the US Federal Reserve will soon begin scaling back quantitative easing. In other words, rather than selling these stocks simultaneously with rising rates, investors have already started selling them solely in anticipation of rising rates. Investors should not buy into such a narrow approach to stock selection, yet the recent adverse movement tells me that losses will motivate investors to move out of this strategy in a way that my advice never will.

Robert Jones is head of FCL Advisory, which advises family offices and wealthy individuals