Two UK equity fund sectors dominate in this country. Top of the list, unsurprisingly, is the broadest category, UK all companies (worth £133 billion). Second is the perennially popular UK equity income category at £67 billion1. It is that sector that interests me. Why are we a nation of dividend-seeking investors?
Part of the appeal of the sector probably lies in the higher yield offered by equity income funds in comparison to cash. But the equity income story is so seductive that it also appeals to many people investing for growth. In the billboard sales pitch, investors are offered the most “reliable” and “stable” companies in the market, all-weather portfolios of companies that have rewarded shareholders with a strong, growing share of profits. The implication is that you can enhance your return and reduce risk at the same time. Who wouldn’t want that?
But how many investors in the sector consider where their return comes from? What are equity income investors really getting for their money?
DO DIVIDENDS REALLY DRIVE RETURNS?
The first thing to consider is how much high-yield and low-priced stocks (sometimes known as value stocks) have in common. Both measures are sensitive to price. So, all else being equal, if a stock’s price is low, its dividend yield and book-to-market ratio will be high, and the two measures will move in lockstep. In other words, when you buy a high-yield stock, there is a good chance you are buying a value stock.
This theory is illustrated by a simple exercise we conducted in the office. We constructed a hypothetical portfolio of the highest-yielding 25% of FTSE 100 stocks and tested those stocks against our value criteria. Sixty-five per cent of our portfolio fell into our deepest value bucket. We did the same for the FTSE 350, and the result was virtually the same (60%). You can see the results of these tests in the charts below2.
Our experiment might be simple, but it should be sufficient to answer the question of whether the good performance of a high-yield stock is down to its dividend or something else—perhaps, the stock’s relatively low price.
EQUITY INCOME SACRIFICES DIVERSIFICATION
The next consideration is that investing in dividend payers alone means sacrificing a large part of the market. From 1991 to 2012, only 61% of stocks paid dividends, so if you only held dividend payers, you missed out on 39% of stocks3.
As you seek a higher yield, the concentration of stocks increases. The FTSE 100 income portfolio we created above would pay around 5% yield, but would include just 25 stocks and completely exclude small cap companies, which have a higher expected return.
DIVIDEND PAYERS PERFORM NO BETTER THAN THE MARKET
We know from our hypothetical portfolios that specifically targeting high-yield stocks can increase expected returns because of increased exposure to low-priced stocks and the value premium.
But a lot of dividend-paying stocks are not high yield. How do they perform in comparison to stocks that do not pay a dividend at all? In other words, is a dividend a source of return outside the highest yielders?
Our study found that dividend payers do not perform better than nonpayers or the market. Dividend payers, nonpayers and the market all produced a compound average annual return of between 7.4% and 7.6%.
The idea of investing in companies that pay a regular dividend is attractive to many investors, especially when certain practitioners of the equity income strategy have a long track record of good performance. But looking deeper at dividend payers reveals a more complex relationship between equity yield and investors’ chances of enjoying a successful investment experience.
As seductive as the arguments for equity income might seem, investors should remember that the source of excess return from high yield is most likely not the dividend itself, that diversification suffers and, overall, that dividends do not pay.