Sunday 2 June 2013

Dividend Investing: Value or Income?

An insight about the DIY Income Investor strategy has been slowly dawning on me: that investing in high-yield dividend shares is actually a form of 'value' investing - in other words, buying out-of-favour shares that have good fundamentals at a good price (but in this case also high yields). This was highlighted by my recent rapid purchase-and-sale of Homeserve.

Well, here is some interesting analysis that seems to nail down that issue - and the conclusion is quite encouraging.

The research article is 'Dividend Investing: A Value Tilt in Disguise?' by Gregg Fisher in the Journal of Finance Planning. Although it is written for the US market, the conclusions are almost certainly applicable in other markets.

Fisher begins by noting the current popularity of dividend investing due to the low yields available elsewhere and the recent good performance of these dividend shares compared with the rest of the market. Indeed he underlines the wide acceptance of the notion that the high-dividend-yielding stocks outperform the market (quoting in particular the Tweedy, Browne Company LLC 2012 High Dividend Yield Advantage white paper).

However, he notes that there is also a school of thought that attributes good share price performance to high-value characteristics. The purpose of the study was to examine what really contributes to higher returns, in particular the relationship between dividend yield and value factors (using the 'industry standard' performance attribution framework developed by Barra in 2007).

US stock (share) returns represented by the Russell 3000 were analyzed over a 33-year period (1979-2012), separating out risk factors, such as value (specifically book value to price ratio), 'earnings yield' (the inverse of the price/earnings ratio), growth, momentum, and company size. A portfolio of 10% of the market  with the maximum exposure to the dividend yield factor was compared with the full market.

The headline result was outperformance of the high-yield dividend portfolio (by an annual average of 1.27%) compared with the wider market. However, when the factors explaining the returns were decomposed, it was determined that the dividend yield factor actually contributed negative 1.02 percentage points annualized to the excess return. In other words, the yield factor actually detracted from performance.

The analysis is fairly complex - and I encourage you to read the full paper - but the conclusion was that the results suggested that it was actually the value factor that is inherent in most high-dividend-yielding stocks that was responsible for the outperformance of these stocks over the period studied. In particular the key factors were:
  • 'earnings yield' (earnings per share to price per share) - the inverse of the p/e ratio - which was actually the biggest contributor to returns
  • book value to price ratio

So, it seems that by focusing on high-yield-dividend stocks, investors unwittingly tilted their portfolios to value stocks, as the dividend yield factor is closely linked (through the share price) to the value and earnings yield factors. However, its was the value factor, not the yield factor, that was responsible for the excess performance over the period studied. Finally, the dividend yield factor tilt also brought with it a high exposure to the earnings yield factor, which is a commonly used method for identifying value stocks and a strong contributor to positive returns.

The unanswered question was: why does the high-yield-dividend factor produce such a negative impact? The tentative answer of the study was that this is due to price movement momentum (i.e. 'falling knife' syndrome). My own take on this is that there is research that shows that the second decile of high-yielders tend to outperform the top decile  - in other words, avoid the very highest-yielding shares. I suspect that then you get the best of both 'value' and 'income' worlds.

My conclusions from this study are:
  • this is actually further confirmation that dividend investing works over the longer term (despite the 2007/8 debacle)
  • when looking at potential purchases, look for low p/e and price/book-value ratios (as well as other factors such as cash flow, debt, market position, etc)
  • avoid the highest yielding shares

I am not a financial adviser and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

1 comment:

  1. Thank you for an interesting article. Perhaps a pertinent warning that very high yield must be measured against company performance metrics, and trending dividend cover strength. As a new investor I've been caught by First Group; I was nieve to their debt which should have been a warning sign! We live and learn ...