Many investors prefer cash dividends, especially those who use a cash flow approach to expenses. From the perspective of classical financial theory, this behavior is an anomaly. In their 1961 paper, Dividend policy, growth and stock valuation, Merton Miller and Franco Modigliani famously proved that dividend policy should be irrelevant to stock returns. As they explained, at least before frictions such as trading costs and taxes, investors should be indifferent between $1 in the form of a dividend (causing the stock price to fall by $1) and $1 received from selling the stock . This approach should be worth it if you don't believe that $1 is not worth $1. This theorem has not been challenged since, at least in the academic community.

This is why no asset pricing model includes dividends as an explanatory factor in the cross section of stock returns. Key models include market beta, size, value, momentum, profitability and investment, but not dividends. Quality (betting against beta) is another factor that has been shown to have a premium that has been persistent, pervasive, robust, and actionable. Characteristics of quality companies are low earnings volatility, high margins, high asset turnover, low financial leverage, low operating leverage, and low stock-specific risk.

Despite not being found to be an explanatory factor, a large, passionate and vocal investor community strongly favors dividend-paying stocks, in part because they consider dividends to be income when they are not. Simply put, income increases your net worth while dividends do not (since the value of the company declines with the amount of the dividend). Rather than being income (except for tax purposes), they are simply a way for companies to return investors' capital (versus a stock purchase). For taxable investors, it is an inefficient way to return capital as taxes must be paid on the dividend.

With that said, the fact is that high dividend stocks and dividend growth stocks have outperformed the overall market. This fact helps explain the preference. However, the reason that dividends are not in any asset pricing model is that research has found that it is not dividends that matter in explaining returns, but other characteristics of dividend payers. For example, stocks that pay high dividends tend to be value stocks, but using price-to-dividend yields the weakest value premium—price to other metrics such as earnings, cash flow, and sales all produce stronger value premiums. high.

The latest research

To investigate whether dividends are themselves economically informative or merely provide a signal, Yin Chen and Roni Israelov, authors of the study “Income Illusions: Challenging the High-Yield Stock Story”, published in March 2024 ABoUT of the Journal of Asset Management, divided stocks in their eligible universe into high-dividend and low-dividend groups (50% of stocks in each group) according to their average dividend yield over the past year and analyzed the impact of dividends in investment returns under two different settings. In the first setting, they compared the performance of two other groups and tested whether the high-dividend group has historically outperformed the low-dividend group. In the second setting, they applied a dividend-based portfolio adjustment to some long-only factor portfolios to test the hypothesis that investors may benefit from restricting their selection of factor winners to high-dividend groups. . Specifically, they penalized the target weight of low-dividend stocks in the portfolio, regardless of their factor scores. If low-dividend stocks predict lower future returns in the factor portfolio, they should expect stronger performance in new construction.

They analyzed market beta, size, value, profitability, investment (Ken French data library), and momentum and quality (AQR data library). Their sample covered the period January 1964 to December 2021, with data from CRSP, and included 1,500 major US stocks. Here is a summary of their key findings:

The high dividend portfolio dominated in both return and risk. It achieved an average annual return of 13.8% with a volatility of 15.6%. In comparison, the low dividend portfolio realized lower returns (11.8%) with much higher volatility (21.9%). The higher return and lower volatility resulted in a 3.6% change in the compound annual growth rate. The high-dividend portfolio also had smaller draws during market corrections. Despite the best performance of high-dividend stocks in the full sample, investing in a long-term portfolio lost close to 1% per year between 2003 and 2021—the last 19 years of the sample. The most positive returns came from the average 20-year period from 1983 to 2002.

Dividend spread is negatively related to market beta (−0.53) and size factors (−0.48), suggesting that high-dividend portfolios contain larger stocks with smaller market betas than in the low dividend portfolio. The spread was also positively correlated with value (0.68), profitability (0.51), bets versus beta factor (quality) (0.44) and investment factors (0.60). There was also a small negative correlation with momentum (-0.07). Thus, non-dividend stocks tend to be growth stocks with lower profitability and more aggressive investments – stocks with these characteristics underperform the market.

Consistent with financial theory and prior research, while the high-dividend group delivered higher returns than the low-dividend group, the outperformance was entirely explained by a number of common quantitative factors—after controlling for value, quality, and hedging factors. , the excess return of the high dividend over the low dividend turned negative. Compared to the single factor CAPM, the dividend spread portfolio produced a statistically significant alpha of 4.8% (perhaps explaining its popularity). Against the three-factor Fama-French model, alpha was still an impressive 2.4% and explanatory power almost tripled as ru squared increased from 0.28 to 0.76. The inclusion of momentum had virtually no impact. Including profitability, the ru square increases to 0.84 and alpha decreases to a statistically insignificant 0.48%. Including all five Fama-French factors further increased r-squared to 0.86 while returning alpha to a statistically insignificant negative 0.60%. And, including bets against the beta factor further reduced alpha to a statistically significant -1.44%.

The skewing of the long-only factor portfolio towards high-dividend stocks had, in general, a negative effect on performance—regression results showed that dividend outperformance was more than fully explained by a number of well-known factors and investors could have avoided them. negative excess returns if they had held a combination of these factors instead of investing in the long-term dividend-based portfolio. For factors inherently related to dividend yield, the additional adjustment had little impact on gross performance, but resulted in lower net returns due to the tax burden on dividend income (in taxable accounts). The dividend filter was too restrictive for the momentum factor, which is fundamentally unrelated to the dividend yield. This caused a major reduction in enforcement efficiency and, therefore, return on investment.

Considering the negative tax effect, dividend-favored portfolios are even less desirable in terms of compound return.

Their findings led Chen and Israelov to conclude: “Our analysis suggests that investors seeking to achieve alpha should invest directly in a combination of these factors rather than holding high-dividend stocks.” They added: “All things considered, the dividend yield is simply a poor proxy for a multi-factor strategy based on value, quality and protection. Our analysis shows that active investors should not limit their portfolios based on dividend yields.

Chen and Israelov's findings are consistent with my research. My February 3, 2023 Alpha Architect article, “Should investors be indifferent to the impact of dividends on stock returns?” showed that over the period January 1979 to October 2022, the US stock dividend premium has had a negative alpha to both the Fama–French five-factor model and the Fama–French five-factor model with momentum.

Investor Takeaway

Even without considering the negative tax implications of dividend-paying stocks (versus a stock that provides all of its returns in the form of capital gains), investors are better served by directly targeting factor exposures in their portfolio than by using a dividend screen, which significantly reduces the investable universe, since only about 60% of stocks pay dividends. Thus, the screening of dividend investors excludes about 40% of the eligible universe by number and about 20% of the total market capitalization. All else equal (such as factor exposures), by definition, a less diversified portfolio is less efficient.

Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.
For informational and educational purposes and should not be construed as specific investment, accounting, legal or tax advice. Some information is based on data from third parties and may become outdated or otherwise replaced without notice. Third-party information is believed to be reliable, but its accuracy and completeness cannot be guaranteed. The opinions expressed herein are their own and may not accurately reflect those of Buckingham Strategic Wealth, LLC or Buckingham Strategic Partners, LLC, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article. LSR-23-617