The case for loving dividend stocks

Vishal Teckchandani’s recent Livewire article 'The case for hating dividend stocks' sparked plenty of debate - and rightly so.

He made some fair observations - Australian investors do have a pronounced home bias toward high-yielding, franked dividend stocks - banks and miners dominate. Chasing yield can lead to concentration risk. 

And yes, the obsession with franked dividends sometimes comes at the expense of capital growth or global diversification - one of the key reasons we offer a global shares income fund and advocate for a blend of Australian a global strategies within broader income portfolios.

But a closer and more clear-eyed look at the long-term global evidence completely dismantles the ‘case for hating dividends’

Dividend stocks chart crime

It’s important to look at all the data, instead of just cherry picking data that fits your argument. By all the data, we mean as much as possible, rather than looking at just the last 10-15 years which may be dominated by a particular style of investing.

For the chart below, we took all the data from our universe of global developed listed companies (over 10,000 companies) over nearly 30 years. 

You clearly see dividend payers outperform non-payers. That outperformance is over 6% pa, on average.  

Berkshire Hathaway clearly bucks that trend, but it is an outlier, not proof that zero yield stocks outperform.

Below, we did the same analysis at the country level, and the results stack up everywhere.

Non-dividend payers underperform on average.

Interestingly, in the US the gap between payers and non-payers is the smallest amongst major developed markets. 

This is likely driven by tax, as the US tax system discourages dividends, with many companies buying back stock instead.

Trust the data on dividend stocks

As for Vishal’s second contention “(t)he income you thought you could trust”, we largely agree with the thrust of his argument.

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We have always said that the key to successful equity income investing is avoiding dividend traps, or as Vishal terms them “yield traps”.

But we do question his table comparing total returns versus yields. First, it only looks at the last decade of data, a decade where growth stocks (think NASDAQ) dominated returns.

And second, it cherry picks the returns of just a few indices. 

When we consider the returns of all stocks within our developed investment universe, including Australia, over more than 25 years, we find the opposite effect. We find a monotonically increasing relationship between dividend yields and total returns.

However, we do caution against buying extremely high yielders. When we rerun our analysis on the Australian ASX300 universe we find extremely high yielding dividend stocks tend to perform fairly poorly.

We believe this is due to quite a few dividend traps in the high-yield bucket in Australia.

Not tax-effective? Just ask a retiree.

Vishal’s third contention, “are Australians dividends really tax-effective?”, implies the tax benefits of dividends stocks don't stack up.  

We agree with some of his arguments but not all.

We certainly agree that one needs to consider their own circumstances and those circumstances may change over time. Clearly, if you move overseas your tax situation changes dramatically.

But generally, for the vast majority of Australians, franking credits are valuable. The following chart looks at the after-tax value of different forms of return in the hands of various investors based on their tax rate.

A dollar of fully franked dividends is more valuable than any other form of income for all taxpayers, other than the very highest individual rate where long term capital gains are marginally more tax efficient (assuming the current 50% discount remains after the upcoming Federal Budget).

 

No need to hate dividend stocks

All our experience and detailed research suggests that, on average, companies that pay dividends have higher returns than those that don’t. And the higher the dividends, the better the returns.

One reason for this is that dividends can be a proxy for earnings. 

Companies need to make to a profit in order to pay a dividend, and the more profits the more dividends.

Of course, retaining earnings to reinvest in the business is good, but only when companies make good investments. Sadly, many companies don’t invest wisely. In fact, some of our red flags aim to identify companies which over-invest.

Long live dividends!

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