Yields of Dreams: A Closer Look at Dividends


Investors often see dividends as a way to generate income. But dividend strategies are not the only way to produce cash, and investors should be aware of the potential tradeoffs that accompany a focus on dividends.

For stockholders who own dividend-paying shares, those payments arrive on a schedule (quarterly, in many cases). The cash to fund a dividend must come from somewhere, however. We know the price of a stock is potentially influenced by all expected future cash flows to shareholders. If cash is paid today in the form of a dividend, the stock price—and total market capitalisation—of the issuing company may therefore fall, as the hypothetical Portfolio A in Exhibit 1 shows. That means, all else being equal, an investor who receives a dividend may also be left with a less valuable equity holding.

Exhibit 1

Pay, Your Way

Comparing methods of income generation

For illustrative purposes only. Assumes the stock price will fall by roughly the amount of the dividend and assumes no nondividend-related price movement.

Cash Considerations

An alternative method of raising cash is to simply sell shares. Exhibit 1 compares the two methods of generating income by contrasting Portfolio A with the similarly valued hypothetical Portfolio B. While Portfolio A receives income through a dividend payout, Portfolio B generates it through a stock sale.

The investor in Portfolio A, in which a dividend is issued, ends up holding the same number of shares as were held prior to the dividend payout, but we assume that those shares have declined in value. The investor in Portfolio B holds a reduced number of shares that haven’t seen their value decrease as a result of a dividend payout. The two approaches arrive at the same place—both investors end up with $100 in cash and $1,900 in stock, notwithstanding potential trading costs or tax implications. But there are potential downsides to the dividend approach when contrasted with the stock-sale approach.

First, the average proportion of firms paying dividends in the US was about 52% from 1963 through 2019,1 meaning an investor focusing only on those stocks is missing out on nearly half of investible US companies. A second consideration is that a dividend’s value, while not subject to the same degree of fluctuation as a stock price, isn’t guaranteed. Just 10 years ago, more than half of dividend-paying firms cut or eliminated those payouts following the financial crisis.2 More recently, a company that had consistently paid dividends for more than a century, General Electric, slashed its payout to just one cent a share,3 and the UK’s Vodafone Group cut its full‑year dividend for the first time in two decades.4 Thirdly, investors may give up flexibility in terms of the timing and the size of the payout when they rely on company-issued dividends. With stock sales, an investor determines the amount and schedule of the income.

Total Return

When considering an investment, it is also important to assess total return, which accounts for capital appreciation (or loss) alongside dividend income. High dividend yields may not lead to high total returns. Exhibit 2 plots the trailing 12-month returns of S&P 500 Index constituents as of 31 December, 2019, with each dot representing a company. It’s clear that companies with greater dividend yields, the dots located higher up the vertical axis, weren’t consistently those with a higher total return over that period.

Exhibit 2

Income Facts

Dividend yields and 12-month returns for S&P 500 firms as of 31 December, 2019

Note: Plotted yield of 18.38% reflects a stock that paid special dividends.


Income generation may be a priority for some investors, but other important investment considerations, such as diversification and flexibility, needn’t fall victim to that aim. While the use of stock sales instead of dividends to create cash flow may involve trading costs and tax considerations, those concerns may be offset by the benefits of investing in companies that don’t currently pay dividends. An approach focused on income derived through dividends may not be the most desirable choice when weighing broader investment goals.

Footnotes

  1. 1Source: Dimensional, using data from CRSP. Stocks are sorted at the end of each June based on whether a dividend was issued in the preceding 12 months.

  2. 2Stanley Black, “Global Dividend-Paying Stocks: A Recent History” (white paper, Dimensional Fund Advisors, March 2013).

  3. 3Janet Babin, “GE cuts dividend to a penny per share. Why bother keeping it at all?” Marketplace, American Public Media, October 30, 2018.

  4. 4Adrià Calatayud, “Vodafone cuts dividend after swinging to 2019 loss.” MarketWatch, May 14, 2019.

Disclosures

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NEW ZEALAND: This material is issued by DFA Australia Limited (incorporated in Australia, AFS License No. 238093, ABN 46 065 937 671). This material is provided for information only. This material does not give any recommendation or opinion to acquire any financial product or any financial advice product, and is not financial advice to you or any other person. No account has been taken of the objectives, financial situation or needs of any particular person. Accordingly, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. Investors should also consider the Product Disclosure Statement (PDS) and for the Dimensional Wholesale Trusts the target market determination (TMD) that has been made for each financial product or financial advice product either issued or distributed by DFA Australia Limited prior to acquiring or continuing to hold any investment. Go to dimensional.com/funds to access a copy of the PDS or the relevant TMD. Any opinions expressed in this material reflect our judgement at the date of publication and are subject to change.