Bonds and bond funds pay regular dividends. Some stocks pay dividends and some don't, depending on how much of the company profits are reinvested in the business and how much are handed out to shareholders. Investors invest in dividend-paying stocks and the funds that invest in them for a couple of reasons: to provide current income (for retirees, for example), or to have the relative certainty of getting a dividend every year, which can be more reliable than the returns from growth in share prices. This blurb won't focus on bond investing, since we've talked about that quite a bit and because all bonds pay dividends. Instead, it will discuss dividend-paying stocks (and stock funds) and how they compare as an investment strategy.
Companies that pay regular dividends to their shareholders tend to fall in the value category of the stock market, but not always. They tend to have relatively low P/E ratios. They are usually in well-established industries, like food or appliances, so they are not trying to expand rapidly and therefore they can hand out some of their profits to shareholders. You can invest in dividend-paying stocks either directly through a broker or through a dividend stock mutual fund or ETF.
There is a sub-category of dividend-paying stocks called the "dividend aristocrats." These are companies that have reliably paid dividends and have increased the payout per share for at least 25 consecutive years. Among the S&P 500 (the largest 500 companies traded on the US stock exchanges), there are currently 54 companies that fall in this category. Interestingly, they include ten different business sectors and also include both growth and value companies. There are ETF options to invest specifically in the dividend aristocrats.
A long-term study of the US stock market (1928 to 2013) divided all the stocks listed on four exchanges into non-payers of dividends and quintiles of dividend-paying stocks (the 20% with the lowest dividend yield, the 20% with the next lowest yield, and so on). They found that over the long haul, companies paying more dividends tended to outperform, but the best performing group was the second-highest dividend quintile. The average annual performance of the fourth quintile was over 3% higher than the non-paying group, with much lower variability from year to year. This is significant enough to be worth factoring into your investment planning - it's a difference that even ranks up there with differences in management fees. If you want to read more about that study, check it out here.
The authors speculated about why it's the second-highest quintile that performs the best instead of the highest quintile. They suggested that it may be because some of the highest-yielding companies have unsustainable dividends, and may strive to keep their dividends high even while the company is failing. The second-highest quintile would include companies with more reliable dividend programs and better long-term business prospects.
The one concern I have about this approach is that this is theoretical and not based on real funds. Hindsight is always a great way to invest, but can you tell which companies are going to be in which quintile in advance? How does this work with real funds?
I found three dividend-oriented ETFs that I could compare against a plain jane ETF that invests in the S&P 500 index of large capitalization US stocks. Each of them had at least eight years of return history. One of them specializes in the dividend aristocrats, tracking the S&P High Yield Dividend Aristocrats Index, one of them tracks the NASDAQ US Dividend Achievers Select Index, and the third tracks the Dow Jones US Select Dividend Index.
All three of them had management expense ratios somewhat higher than the S&P 500 Index ETF I was comparing them to, though in one case it was only 0.1% instead of 0.07%. Two out of three of the funds outperformed the S&P 500 Index ETF by an average of about 0.6% per year and had lower variability from year to year. The third fund lagged the S&P 500 Index ETF by about 1.5% per year and had higher variability from year to year.
It seems to me that this brief analysis is promising but not conclusive. Based on the long-term outperformance of the stocks that had high dividend yields (chosen based on hindsight), and the fact that on average the ETFs based on this strategy seem to at least keep pace with the broader index, that two out of three of the ones I looked at outperformed and had less variability from year to year, there seems to be some merit to this strategy.
Although in general I approach investment styles with a pretty skeptical eye and like to remind people to stick to the basics and keep their costs low, this particular style seems to have some merit. It might be for you if you consider the following aspects:
Somewhat to my surprise, I find myself recommending a specific investment style. Particularly if you are in retirement, it seems to me a combination of bond investing (especially for Canadians, where bonds have historically performed well) and dividend-oriented stocks would provide steady income and good performance over time.
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