I’ve heard it said that the first requirement for a share investment is income return and then growth of capital. This implies that income return is a key driver of investment performance. Perhaps it explains why so many investors are so transfixed on income yield when choosing a share investment. While we don’t know conclusively why investors have a preference for dividends over capital growth, some of the reasons we’ve heard include: I want to be able to preserve my capital; higher income return means I can retain my capital exposure and don’t have to sell anything; high yield shares are safer; I want to maximise my franking credits; shares prices can fall but at least I can rely on the dividend income; and more recently it’s a low growth world, so yield is more important. Despite these preferences, we think it’s a little too simplistic to build a strategy based purely on income (dividend) yield. Ultimately, there’s a diversification cost from narrowing your investment opportunity set and we think some facts about dividend paying shares may shed some light for decision makers. The facts about dividend paying shares A recent research paper investigated the qualities of dividend paying (versus non-dividend paying) shares over time to ascertain their key differences. This analysis looked at the effect on a global basis, focusing on the shares from 23 developed markets over the 22 year period from January 1991 to December 2012. It found the following: 1)There was no material difference between the annualised compound return of dividend paying and non-dividend paying shares. Source: Dimensional Fund Advisors This was confirmed by a Vanguard study that revealed no material difference between the average (income + capital) return of high yielding versus low yielding shares over a 20 year period. 2)A global share portfolio constructed to provide a high dividend yield would have become more concentrated over time. In order to capture 50% of the global dividend payout in 2012, you would have invested in 31% fewer firms than you would have in 1991. This is a clear indication that a high yield strategy is likely to create a more concentrated portfolio exposure. In order to capture half of the global dividend pool that was paid in 2012 you would have had exposure to only 2.4% of all global firms. 3)Larger firms are more likely to pay dividends than smaller firms. This means a high yield strategy (unwittingly) forgoes the higher expected returns associated with investing in smaller companies. Source: Dimensional Fund Advisors 4)Globally, the weighted average book-to-market ratios of payers, nonpayers and the overall market were similar in 2012 (and over the 22 year period). This indicates no growth/value bias by undertaking a high yield approach. 5)There are cross-country variations (as shown in the table below). For example, 92% of Japanese shares paid dividends in 2012, but only 38% of Australian shares paid dividends. However, 85% of Australian large companies paid dividends, and they represented around 75% of the capitalisation of the Australian share market. A high yield strategy in Australia is likely to reflect a concentrated exposure to a small number of large company shares. Source: Dimensional Fund Advisors And when it comes to the payout ratio, Australian companies tend to return a lot to their shareholders, with an average payout ratio of 61% (second only to New Zealand at 73%). Source: Dimensional Fund Advisors Companies that offer stable and increasing dividends are an important component of any investment portfolio, but purchasing on this basis alone is likely to be misleading. Companies that distribute most of their earnings as dividends clearly believe the best use of the capital is to return it, rather than reinvest it within the company. That says something about management’s view of the future growth prospects of their company. Some companies appear to attract capital by designing attractive dividend policies. Metcash, for example, had a grossed up yield of over 11% last year. It had been paying out 80% of its earnings over previous years but then went to the public to raise $375 million of new capital. Seems like they’re collecting it to simply hand back to shareholders again. The fact is some companies borrow money to perpetuate their dividend policy. Telstra has been a notable example of this and it highlights the issues associated with relying on dividend yield as a reliable indicator of a company’s future. The franking credit argument seems a fairly valid one and peculiar to Australia, yet there’s more to this strategy than meets the eye. See our article on this subject. For those seeking cash flow, there are more effective ways to manage your wealth than by limiting yourself to high yield investments. See our article on this subject. And if you’re buying high yield shares because you think they’re cheaper, you should know there are better indicators than yield for identifying these “value” shares. A company’s book to market ratio is a more reliable and recognised measure than dividend yield. If this is your strategy, then diversification should be your best friend as the risk of failure for an individual “value” share is quite high. Capturing the Equity Risk Premium Buying a portfolio of high yield shares may quell your concerns about re-entering the share market, but its a riskier strategy than many appreciate. The costs with this approach, most notably the loss of diversification benefits, result in a sub-optimal investment exposure. The aim of investing in shares is to capture the equity risk premium (i.e. the return for taking on equity risk). This should be approached using a methodical strategy that considers all the risk elements within the equity universe. Simply buying a portfolio of high yielding shares is unlikely to meet this requirement.
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