Monday, 17 August 2015

The Dividend Fallacy

The dividend fallacy usually goes something like this:

“Reinvested dividends make up the bulk of long-term equity returns. Therefore you should invest in high yield shares.”

For obvious reasons the fallacy is most prevalent amongst those private investors or fund managers who practice high yield or income investing.

Let’s see where this argument goes wrong:

Fallacy 1 - Reinvested dividends make up the bulk of long-term equity returns.

This usually comes from studies comparing the market returns with and without re-invested dividends. E.g.

“One hundred pounds invested in equities at the end of 1899 would be worth just £168 in real terms without the reinvestment of dividend income, but with reinvestment the portfolio would have grown to £24,184.” Barclays Equity Gilt Study 2013

Of course these are not comparing like with like. In the first case you would have had the dividends in your pocket to spend or invest in other assets. In fact if you had another asset class that produced superior long term returns to equities and re-invested your dividends there you would have more money than £24,184. The reason that the comparison is so striking is that equities have been pretty much the best performing asset class to re-invest into (at least in most western countries.)

When you breakdown the Barclays return figures together with their cost of living index into compound annual growth rates they look something like this:

Real Return with Reinvested Dividends                                  5.0%    (A)
Inflation Average                                                                      3 .9%   (B)
Nominal return with Reinvested Dividends                              8.9%    (A) + (B)
Real Capital Return                                                                 0.5%    (C)
Nominal Capital Return without Re-invested Dividends         4.4%    (B) + (C)
From which you deduce the Average Dividend Yield was      4.5%.   (A) – (C)

People then erroneously compare the dividend yield to the real capital return and conclude that re-invested dividends are the major source of return. This comparison artificially separates out the components of compound growth and arbitrarily to applies the compound inflation to the compound capital gains. The re-invested dividends are done so at the nominal price of the index at the time so are subsequently compounded at the nominal rate not the real rate. Simply reversing the logic and applying the inflation to income would show that reinvesting dividends in a market without capital growth would lead to very low real returns and therefore capital gains were the driver of the bulk of returns.

The truth is that both dividends and capital gains are roughly equal in their contribution to equity returns at 4.4% for capital and 4.5% for income. The real return an investor receives is then reduced by inflation that has averaged 3.9% since 1899. This should hardly come as a surprise since the dividend payout ratio has been close to an average of 50% during the last century.

Fallacy 2 - Therefore you should invest in high yield shares.

The second fallacy is assuming that the impact of re-invested dividends on the returns of the whole market says anything about the performance of high vs. low yield shares within that market. To make statements about the relative performance of subsets of the equity markets you need empirical evidence.

In ‘Contrarian Investment Strategies’ David Dremen did these studies for the largest 1500 companies in the US Compustat database from 1970 to 1996 and the results are as follows:

The market total return was 15.1% CAGR over that period. So you can see that sorting by dividend yield does provide out-performance but it is the weakest of the metrics studied. If you want to implement a simple factor based strategy then you are better off using one of the others.

Dividends Redeemed

So you may be thinking that I don’t like dividends. Far from it. Used correctly I think dividends can have an important part to play in one’s investment strategy:

  • Paying a dividend enforces capital discipline on management. Since management know the impact that a dividend cut will have on their share price (and therefore the value of their options) then they really need to make sure the business earns the cash to pay it. They are less incentivised to pursue vanity acquisitions or take unnecessary investment risks.

  • Dividends provide effective signalling of the true opinion of management. A management that provide a cautious outlook but a big dividend increase are usually practicing ‘under-promise & over-deliver’. A management that talk up the company results but hold the dividend could well be ‘travelling hopefully.’ 

Here’s an example of this signalling. In March 2009 a UK company called Interserve (LSE:IRV) issued their 2008 results with the following management commentary:

"2008 was another successful year for Interserve. Whilst the Group is not immune to the current economic challenges, with a solid UK position, continued opportunities in the Middle East, a record order book, strong visibility and a robust balance sheet we believe that the Group's operations are well placed to deliver another year of progress." 

Having traded around the £5 level in March 2008 the shares were trading at around £2 when these results were released and the failure of Lehman Brothers had rocked the financial markets and the Western economies were in a deep recession. Given the uncertainty in the markets and that they were trading at a historic yield of 8.1% no investor would have been disappointed if Interserve had preserved cash and held their final dividend. However they chose to back their cautiously optimistic statement by increasing their dividend by 4.9% giving an 8.5% yield. I took this as a strong signal that things were not as bad as the market feared. This proved to be correct as they continued to increase their dividend and led to substantial gains over the next few years.

  • Focussing on income and not capital value can instil a very long investment timeframe in investors. Having a longer investment horizon is one of the only true competitive advantages that private investors have so this can add significant value to one’s decision-making. Even within fund management, income funds can be a good choice for those who don’t have the time and skills to invest directly. The reason is that these funds are also likely to be long-term focussed, attract long-term investors and avoid high fees or closet index-tracking. I.e. they simply make fewer mistakes than the average fund manager.

So used correctly dividends can be an important part of an investor's tool-kit. They provide a measure of management quality, a strong indication of the true performance of the business and a check on our behavioural biases. But only if we leave behind the dogma that reinvested dividends make up the bulk of long-term equity returns and that this makes dividend strategies fundamentally superior to all others.

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