Markets

Why a High-Dividend Stock Strategy Isn't a Good Approach

By Larry Swedroe

Updated on: December 8, 2010 / 1:56 PM EST / MoneyWatch

I've seen a number of articles touting high-dividend stock strategies, which are poor substitutes for either a high-quality bond approach or diversified stock approach. My Buckingham Asset Management colleague Jared Kizer wrote the following to help you see why such approaches are likely not in your best interests.

While the financial media touts high-dividend stocks strategies as alternatives to other prudent investment strategies -- such as equity strategies or high-quality fixed income portfolios -- there are several issues you should consider. First, a high-dividend strategy is far riskier than a high-quality fixed income approach, so comparing the two is like comparing apples to oranges.

Second, a high-dividend strategy is essentially a value stock strategy, which involves buying companies that have low prices relative to earnings, book value, dividends or some other accounting metric. However, the high-dividend approach to a value stock strategy has historically had the lowest returns, and returns (meaning dividend payments plus capital appreciation) are ultimately what should matter.

The Risks of a High-Dividend Approach The table below illustrates the historical differences in risks between a high-dividend stock strategy and a high-quality fixed income approach for the period of 1952-2009. For the high-quality fixed income approach, we'll use the returns of five-year Treasury notes.

	High-Dividend*	Five-Year Treasury
Lowest Annual Return	-36.3%	-5.1%
Lowest Two-Year Total Return	-39.7%	-1.7%
Lowest Three-Year Total Return	-33.6%	1.6%
% of Years With Negative Returns	24%	14%
Annual Volatility	20.0%	6.4%

The increased risks of a high-dividend stock strategy compared with a high-quality fixed income approach are clear. For example, the lowest one-year return on the high-dividend strategy was -36.3 percent, which occurred in 2008. This compares with -5.1 percent for the five-year Treasury strategy. So by no means do high dividends insulate you from the overall risk in the equity markets. It's also worth noting that the volatility of the high-dividend strategy was more than three times higher than the volatility of the five-year Treasury strategy. In no way should a high-dividend equity approach be considered a replacement for a high-quality fixed income portfolio.

Comparing High-Dividend Strategies to Other Value Strategies In academia, there are four well-known approaches considered to be value stock strategies:

Buying companies with low stock prices relative to accounting book value
Buying companies with low stock prices relative to earnings
Buying companies with low stock prices relative to cash flow
Buying companies with low stock prices relative to dividends

These four strategies are all very highly correlated with each other. For example, the high-dividend strategy has a correlation of 0.90 or higher with the other three strategies. The problem, however, is the high-dividend approach has historically had both the worst returns and the worst risk-adjusted returns of the four strategies. The table below shows the historical performance of all four strategies in the U.S. over the period of 1952-2009. Note that the Sharpe ratio is the standard measure for risk-adjusted return. A higher Sharpe ratio indicates better returns relative to realized risk.

	Low Price-to-Book-Value Ratio*	Low Price-to-Earnings Ratio*	Low Price-to-Cash-Flow Ratio*	Low Price-to-Dividends Ratio*
Average Return	16.6%	18.4%	17.7%	13.7%
Volatility	22.4%	23.7%	21.6%	20.0%
Sharpe Ratio	0.51	0.56	0.58	0.44

Summary Nothing in the historical data suggests high-dividend strategies are an appropriate substitute for high-quality fixed income or are the best way to gain exposure to value stocks. A high-dividend approach has substantially more risk than a high-quality fixed income approach and substantially lower returns and risk-adjusted returns compared with other value strategies.

* Data courtesy of Ken French's Web site.
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Do Municipal Bonds Still Have a Place? How to Build a Bond Portfolio With TIPS, Should You Buy, Hold or Sell? Have You Been Misled by Returns Information? The Economy Isn't the Same as the Market
Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.

Larry Swedroe

Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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