Over the past few years an increasing number of investors have been chasing a trade that at first glance seems perfectly harmless but over the long term will likely work out to be hugely damaging to portfolio performance.
I’m calling this trend income chasing as it involves investors quite literally chasing income at any cost. I’m not talking about buying bonds with artificially low yields, real estate or investing in alternative assets; I’m talking about equities.
A big mistake
With most developed central banks keeping interest rates at ultralow levels, investors have been left with few choices but to buy equities as a substitute for traditional savings products. This in itself isn’t the biggest problem; the most significant development is the fact that company managements have been all too happy to meet investors’ demands for more and more income. In several cases, higher dividend payouts have come at the expense of growth capex.
Since 2004 shareholder compensation as a percentage of capex has fluctuated between 39% the first quarter of 2010 and a record high of 88% during 2007, according to research from credit ratings agency Moody’s published in November. At the end of the second quarter, the ratio was 75%. During the last five years, the average annualized growth of shareholder compensation is 10.8% compared to growth of 6% for nonfinancial corporate capital spending.
Dividends are supposed to be paid out from profits after a company has run out of opportunities for capital expenditure or in other words, gone ex-growth. Now it looks as if companies are putting off growth in favor of dividends. For businesses trying to maintain a progressive dividend policy, this can only last so long. If earnings are struggling to grow due to a lack of capital investment, but dividends continue to push higher, it is only a matter of time before the inevitable happens and the payout is cut.
If or when a company, which was formerly considered to be a dividend champion, cuts its payout the resulting declines can be significant. In this scenario it does not make sense to chase a stock for the extra yield if further down the line when the payout is eventually cut you end up losing more in capital than has been received via dividends. There is clear evidence to show that for capital preservation and optimal long-term returns investors should be buying those dividend stocks that pay out a low percentage of earnings to investors.
Chasing yield
Tweedy Browne’s booklet “The High Dividend Yield Return Advantage: An Examination of Empirical Data Associating Investment in High Dividend Yield Securities with Attractive Returns Over Long Measurement Periods” is a dividend investing bible. If you are looking for evidence as to how dividends can improve your investment returns, the book is almost certain to convince you that dividends are the most important part of investing. The booklet is a collection of studies praising a dividend-focused investment strategy.
One of these studies comes from an equity research paper titled "High Yield, Low Payout" by Credit Suisse analysts Pankaj N. Patel, Souheang Yao and Heath Barefoot. The team ran a simulation of a dividend strategy from January 1980 to June 2006, limiting its universe to stocks within the Standard & Poor's 500. It created equal-weighted decile baskets based on dividend yields as of each month end.
The study showed that by far the most profitable investment strategy for dividend investors is to buy those dividend stocks with a low payout ratio but high dividend yield, which is not all that surprising. However, what’s really surprising is that the study showed those stocks with low yields and low payout ratios outperformed virtually all of the rest of the test universe. The results are shown in the charts below. As you can see, when it comes to yield, bigger is not always better:
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