The High Dividend Strategy: Pros and Cons
Let's start with the bottom line about investing in high dividend stocks: It works, but there are significant wrinkles. A while back, I did a 20-year study of investing in high dividend stocks. The approach was straightforward. I began with the S&P 500 universe and divided it into 10 groups of 50 stocks each.
The groups were arranged by dividend yield, highest to lowest, at the beginning of each of the years. I then tracked the total returns (dividends plus capital appreciation) of these groups for the full period.
The results were illuminating. The highest total returns were from the group with the highest dividend yields. The returns then descended in perfect order down to the group with the lowest dividend yields. What's more, the aggregate return from the group with the highest returns was greater than that of the Standard & Poor's 500 and its volatility over the period was lower.
That did not mean all stocks in the group of highest yielders did well. Quite the contrary. The main reason for these impressive returns was surprisingly strong performance from a few stocks that did far better than they were expected to. The majority of the stocks in the top group did not do well, but the average return was increased dramatically by a handful of huge winners. In contrast, the group of stocks with the lowest dividend yield was the poorest performer because there were a few losers with very bad results.
The high dividend yielders, as a group, had their best showings during the weakest market years. That's not surprising since it's well known that generous dividends tend to buffer price erosion when the market hits air pockets. One more thing: The average performance of each of the highest yielding stocks was only so-so. It was only as a group that they stood out.
At the same time, I did a similar study of companies using price-earnings multiples instead of dividend yields. As might be expected, those with the lowest multiples turned in the best returns, actually a bit better than those of the highest dividend yielders. But there was a greater variation in returns from year to year and the returns from lowest to highest did not decrease in perfect order.
With both groups, unusually high and low returns from the outliers were what caused the average returns to end up where they were.
Since each group consisted of 50 stocks, efforts to come close to replicating the results of these studies would require holding approximately that many stocks or investing in an exchange-traded fund with a similar approach. Keep in mind, too, that the study covered two decades, so even though the numbers work over that long a period it's entirely possible, if not likely, that there will be short periods in between when the returns lag the overall market.
No strategy works all the time, but for those who are patient this one seems to be well worth considering. Even so, investors need to be wary of obvious areas of concern. For example, utilities often come up as possibilities when investors are looking for high dividends. With the prospect of higher interest rates ahead, however, that may be a yellow flag before considering same.
High dividend yielding stocks offer a worthwhile opportunity, but careful consideration is essential before pulling the trigger to buy. Especially important is the need to buy a sizable group, not just a few.
N. Russell Wayne, CFP®
Sound Asset Management Inc.
Weston, CT 06883
Any questions? Please contact me at email@example.com