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One of the most common requests for a Screening for Value article is for an income screen. It is not a surprise that income strategies are some of the most popular amongst value investors. The idea is that, by investing in companies that pay above-average dividends, investors can capture both the value premium from owning cheaply-rated stocks and generate a higher-than-average income.
Weak markets can make for difficult investment decisions, but the flip side is that some exceptional yields are now on offer from UK stocks. Of course, some companies may cut their dividends, but dividend payments are often surprisingly robust. One of the arguments that economist Robert Schiller makes for stock markets not being fully efficient is that prices are far more volatile than the future dividend stream proves to be. In highly volatile markets, the surety of knowing that regular dividend payments are arriving to provide spending power or be reinvested into cheaply-valued stocks is a salve. Investors are likely to have felt the soothing power of dividend income this year.
While higher inflation and political uncertainty haven’t provided the best investing backdrop, the current challenges are very different to where investors found themselves in March 2020. Back then, the level of uncertainty meant that companies were cutting dividend payments completely. In contrast, today, many companies are increasing their dividends and adding share buybacks as well. Despite this, valuations remain low, meaning that the yields on offer look highly attractive. So now could be the ideal time to invest for income. But do income investment strategies outperform?
Before looking at the data, it is worth dispelling a couple of income investing myths that crop up from time to time.
This myth usually comes from studies comparing the market returns with and without reinvested dividends. For example, the 2017 Barclays Equity Gilt Study says:
One hundred pounds invested in equities at the end of worth just £195 in real terms without the reinvestment of dividend income. With reinvestment, the portfolio would have grown to £32,050.
Of course, these are not comparing like-with-like. If an investor didn’t reinvest these dividends, they would have had the cash to spend or invest in other assets. In fact, if another asset class produced superior long-term returns to equities and dividends were reinvested there, then the total return would exceed that amount. The reason that the comparison is so striking is that equities have been pretty much the best-performing asset class to reinvest into (at least in most Western countries.)
At the root of this myth is the misapplication of compound growth mathematics. This typically involves breaking down the approximate nominal long-term stock market return of around 9% into an average dividend yield of 4.5% and a capital return of 4.5%, and then applying the 4% average inflation over the period to get a real capital annual return of just 0.5%. In this case, it appears that dividend yield contributes nine times that of capital returns to an investor.
However, applying the inflation adjustment only to the capital returns is an entirely arbitrary choice. The reinvestment of dividends is done so at the nominal price of the index at the time, so these are compounded at the nominal rate, not the real rate. Simply reversing the logic and applying the inflation to income would show that reinvesting dividends in a market without capital growth would lead to very low real returns, and therefore, capital gains were the driver of the bulk of returns.
The truth is that both dividends and capital gains are roughly equal in their contribution to equity returns over the long term. This should hardly come as a surprise since the dividend payout ratio has averaged around 50% during the last century.
Even if reinvested dividends did make up the bulk of stock market returns, it is still a logical fallacy to infer that this means the high-yield strategy must outperform. However, this myth is surprisingly persistent, particularly amongst fund managers with income funds to sell!
Dividend growth investing involves identifying companies where the absolute dividend yield may not be high, but the dividend payout is growing rapidly. The theory is that if you buy stocks where the dividend is increasing, then the share price will follow over time. This appears to be a logical way to invest, but it simply isn’t backed up by the data.
Meb Faber and Jack Vogel examined this strategy in detail and found that dividend growth investing generated lower returns than a strategy of simply investing in the highest-yielding stocks:
Dividend growth investing adds complexity and reduces performance, making no sense as a strategy.
In my earnings-based stock screen article, I discussed the various quant-based research over the years and highlighted the work of David Dremen and James O’Shaughnessy. Both writers also looked at dividend yield as a value factor. Here are the results of Dremen’s study:
Interestingly, the second quintile in this study outperforms the highest-yielding 20% of stocks. This suggests that the highest-yielding stocks may not always be the best place to invest. Dremen doesn’t investigate the root cause of this. Still, it is easy to see that investing in stocks based on the highest historical dividend yield may be finding companies with unsustainable, uncovered dividend payments and exposing investors to the wrong kind of mean reversion.
Even more worryingly, in Dremen’s studies, the best-performing quintile on income measures underperformed the best-performing quintile on Price/Earnings by some margin:
However, Dremen didn’t examine the volatility of these returns. A strategy that generates a slightly smaller return but is less volatile may be preferable to a higher-returning but more erratic portfolio. After all, the best strategy is the one that an investor can stick with and allows them to sleep well at night.
O’Shaughnessy considered the volatility of returns in his findings by including the Sharpe ratio in his results. The Sharpe ratio takes the excess return that a strategy generates and divides it by the volatility of those returns. Overall, he found very similar results to Dremen: a clear outperformance of high-yielding stocks versus the market. Unfortunately, the highest dividend yield stocks also proved to be slightly more volatile than the general market, giving a very similar Sharpe ratio. In this case, the best-performing decile was the third one.
Again, he found an underperformance versus other available value strategies, suggesting that high yield wasn’t the best way to capture excess returns from being a contrarian.
However, it is better news for income investors when only large companies are included. In this case, O’Shaughnessy found the Sharpe ratio of investing in the highest-yielding large companies was 0.52 compared to 0.46 for the whole market over the period studied. Perhaps more importantly, by focusing on only the largest of companies, the maximum drawdown was 30% compared to 47% for the general market and 57% for the highest-yielding decile of all stocks.
The bad news is that other value factors, such as Price to Sales or Cashflow, had better Sharpe Ratios in O’Shaughnessy’s study. These generated much better performance for investors who could cope with the extra volatility of these strategies.
Many investors forget that it is net returns that matter to their long-term wealth; those the investor receives after costs and paying taxes. In many jurisdictions, dividends are taxed at a higher rate than capital gains and with a smaller tax-free allowance. In addition, there is often a level of choice when an investor chooses to crystalise a capital gain, whereas the company determines the dividend timing. This means that many investors will receive a higher net return if a greater proportion of their returns come from capital gains and not dividends. This is especially true in the US, and for this reason, many US-listed companies have chosen to buy back shares rather than pay dividends.
For many UK investors, this is academic. More generous tax-free savings vehicles such as ISAs and SIPPs mean that there is no tax to pay on dividends or capital gains. In these cases, the net return will be equal. However, investors with assets outside of tax-sheltered accounts will need to consider these factors.
After all that, it may appear that income investing is a bad idea – it is likely to underperform other value strategies, may incur higher taxes, and attempts to improve the strategy with something like dividend growth are likely to reduce performance even further.
However, this misses the easy solution to this problem – investors can build a value strategy and simply turn on or off the income aspect by choosing to invest in a subset of these value stocks. For example, investors paying high income taxes can choose smaller companies with low to no dividend yields. Investors who value regular income in their tax-free accounts can choose value stocks with high dividend yields. Income investors may also want to prefer larger stocks over smaller ones.
These studies show that the value anomaly and the higher return to dividend stocks are persistent across the four highest deciles (equivalent to the two highest quintiles). Together these should allow enough companies to be selected that are both cheap on earnings and pay a high dividend yield.
In next week’s article, I will use these principles and the Stockopedia screening tools to create a diversified high income portfolio for these difficult times.
About Mark Simpson
Value Investor
Author of Excellent Investing: How to Build a Winning Portfolio. A practical guide for investors who are looking to elevate their investment performance to the next level. Learn how to play to your strengths, overcome your weaknesses and build an optimal portfolio.
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@alessio - my understanding is that unless the shares are held in an ISA or SIPP, you have to report dividends in your UK income tax return and pay increasing amounts of income tax on them - https://www.gov.uk/tax-on-divi...
I can't find the specific info on HMRC but on many other sites I read this https://realbusiness.co.uk/pay... (see section "Tax on Reinvested Dividends")
*Past performance is no indicator of future performance. Performance returns are based on hypothetical scenarios and do not represent an actual investment.
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excellent Myths erosion article.