We often encounter potential new clients who are managing their own investments (aka ‘DIY investors’), many of whom adopt a strategy of seeking companies that pay high dividends.
The view is that such payouts offer some form of ‘guaranteed return’. But this is misguided - ‘chasing yield’ is, in our view, one of the most widely observed cognitive errors in investing.
Why do companies pay dividends?
First, we consider why companies pay dividends in the first place.
When a company is profitable, it has several choices as to what to do with those profits. For example, it could:
- Invest them back into the business to drive future growth,
- Pay down debt,
- Acquire another company,
- Buy back its shares,
- Pay eligible shareholders a cash dividend.
Each of these strategies has its own merits (and drawbacks) so we immediately observe that tilting towards high dividend stocks (aka. ‘dividend investing’) and away from those companies that favour the reinvestment of profits; debt repayment, etc. is a ‘big call’, one that likely hinders portfolio diversification and potentially long-term return potential too.
Put another way, you’re fishing in a much smaller pond by only seeking out companies that offer an attractive dividend yield.
A ‘zero-sum game’
But where we observe investors ‘drinking the Kool-Aid’ is in the belief that a dividend represents an additional amount (i.e. return) being added to your investment account.
We’ll commonly hear statements such as “it’s offering a guaranteed return of 5% a year”, referring to a stock with a 5% dividend yield.
This is a common misconception. A dividend is not created out of thin air, rather, when a company pays a dividend, it is essentially giving you back some of your investment.
A dividend represents a slice of the company’s value being removed and distributed to shareholders. But the knock-on effect is that the company now has less money as a result. It’s therefore worth less and it’s share price will adjust accordingly – typically falling by the amount of the dividend that’s being paid.
Consider the following example:
- Say your favourite share is trading at £100 and you own 100 shares, hence a total investment value of £10,000,
- At the start of the next month, the company pays a cash dividend of £5 a share (an appealing 5% yield some would argue),
- You will therefore receive £500 in your back pocket,
- However, once the dividend is paid (or more precisely, once the stock trades ‘ex-dividend’), the share price will adjust to reflect the recent distribution, typically falling in line with the dividend amount,
- As such, you’ll still own 100 shares, but these will now be worth approx. £9,500, plus the £500 given to you in cash, hence total wealth of £10,000.
…a zero sum-game
That is, mathematically, you’re in the same position.
By way of an analogy, consider the delicious chocolate cake pictured at the top of this blog – this reflects your shareholding in a company. Initially, the whole cake is yours; the dividend is the slice that’s transferred to your plate; what’s left is a cake that’s reduced by the size of the slice.
The slice hasn’t magically appeared – it’s just part of the original cake that’s being handed over to you.
Disclaimer: When investing, your capital is at risk. The value of your investment (and any income from them) can go down as well as up, and you may get back less than you invested, particularly where investing for a short timeframe (we normally recommend a horizon of at least 5 years). Neither simulated nor actual past performance is a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
Sometimes good, sometimes bad
We’re not saying a high dividend yield is necessarily a ‘bad’ thing and should be avoided at all costs – roughly 75% of US companies in the S&P 500 index pay a regular dividend for example. But it’s certainly not always ‘good’ either.
Consider the following contradicting arguments:
‘Good value’ vs ‘value trap’
Some would argue that a high dividend yield is a good proxy for ‘value’, i.e. buying something that is trading at a low relative price (the denominator in the dividend yield calculation) and should therefore provide enhanced returns once the stock recovers.
That is a fair argument, albeit we must be careful with cause and effect here – value should be considered in its own right and dividend yield is just one, fairly limited, measure of this. One would argue that P/E (price vs earnings), P/B (price vs book value) and FCF (free cash flow) yields offer better proxies for a company’s ‘value’.
Moreover, focussing too heavily on dividend yield can present risk of falling into a ‘value trap’ – investing in stocks that have an unsustainably high dividend yield because their prospects aren’t great. For example, a stock might be yielding 10% a year, but if it is wildly overvalued, that dividend will provide little comfort when the share price falls off a cliff.
It's therefore crucial to view dividend yield in the context of other value measures and a company’s prospects in general.
A signal of strength or a signal of saturation
One of the most reasonable arguments for investing in companies that offer a decent dividend yield is that this signals strength. After all, only profitable and cash-generating companies can afford to pay a dividend.
However, the challenge to this is that such companies might also be nearing a point of ‘saturation’, so bereft of ideas for future growth that they’re opting to pay out any profits as dividends, rather than reinvest.
Furthermore, small, high growth companies are rarely in the position to pay dividends – they’re more likely to reinvest any profits. But excluding such companies from a portfolio not only limits diversification (and therefore increases portfolio volatility) but also potentially reduces long-term return potential too – small companies are inherently more risky and should therefore reward investors with greater long-term returns.
Conclusion
We see no evidence to support the strategy of tilting a portfolio towards high-dividend-paying stocks.
Whilst we acknowledge that a high dividend can signal strength in terms of profitability and cashflow, and can also be a proxy for value (i.e. stocks trading at a low relative price), there are reasonable counterarguments to both points.
Instead, we favour low-cost, globally diversified portfolios, that mostly track the market but with a modest skew towards smaller companies, cheaper companies, and profitable companies.
Disclaimer: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and it does not contain all the information which an investor may require to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of any articles.
