Q.

Since bond yields are at all time lows, should I buy high-yielding dividend stocks instead?

A.

I have been seeing various versions of this question on internet forums, comments sections, and various other blogs more and more lately.  Larry Swedroe has spoken out against this investing “technique” and I’d like to add my voice to the mix.

Stocks Aren’t Bonds


The first mistake I see people make is confusing a stock and a bond.  Remember that when you own a stock you own part of a business.  If the business does well, you do well.  If the business does poorly, you do poorly.  A bond, however, is a loan, whether made to a business or a government.  So long as that business or government remains sufficiently solvent to actually pay the loan back, the only thing that really affects its value is interest rates.  If the bond yields 4%, you get 4%, no matter if the business has a great year or if it just has a mediocre year.  If the US wins a war or takes gold at the Olympics treasuries don’t somehow give you a higher return.  Treating a stock yield like a bond yield is a rookie mistake.

Stocks, even “blue-chip”, “diversified”, “strong” stocks with a “decades long history of increasing their dividends”, are still subject to the risks of stocks, primarily the risk that the company will not make much money or that the stock market in general will go down, taking this stock with it.  Take GE for instance.  Surely you’ll agree this company isn’t going anywhere any time soon.  How much value did GE lose in the recent bear market?  80%.  Exxon?  40%.  Apple?  59%.  Johnson and Johnson?  33%.  Frankly, it doesn’t matter if it is yielding 3-4% when you could lose 1/3 to 4/5 of it at any given moment due to stock risk.

But Bonds Are Risky Now!

Those who suggest you should be investing in high-yield stocks instead of bonds also carry an irrational fear of bonds.  While I agree that returns going forward for bonds are likely to be rather disappointing at these yields, the fact is that if you keep your quality high and duration short that you won’t be taking any significant losses in your principal by investing in bonds.  Vanguard’s Total Bond Market fund has a duration of about 5 years.  That means if interest rates go up 1% (not just the short term interest rates the Fed controls, but all interest rates) then you’ll lose 5% of principal.  So let’s imagine a circumstance where interest rates go up 3% in a single year.  What would you lose?  About 15% of your principal.  That pales in comparison to the 33-80% losses you may take in high-yield stocks.  And when bond values drop, you now own an investment with a yield that is 3% higher than it was previously, and you’ll actually make up your losses in 5 years, and after that come out ahead.

When bond values go down due to rising interest rates, their yield goes up in a very predictable way.  When stock values go down, yield does go up, but not in a predictable way.  The stock value went down because the company isn’t worth as much as it was, and dividends are often cut.  In the recent bear market, 1092 companies cut their dividends.  So not only are you losing principal, you’ll losing income too.  When businesses do well, those who own them do well, whether their profits come in the form of dividends or capital gains.  When they do poorly, watch out!

Dividend Stocks Are The Most Expensive They’ve Been in 4 Decades

I love reading the Bridgeway annual reports.  John Montgomery always has some interesting insights.  In the most recent one, he writes this:

As many investors see money market rates near zero, or wonder what to do with the proceeds from maturing bonds, they look desperately for some extra yield, even a moderate amount. One place they have turned is high yield dividend paying stocks. While these stocks do provide some potential reduction of inflation risk, benefits from diversification (if owned along with fixed income and other asset classes), and the benefit of current income, Bridgeway’s investment team recently asked the question, “How cheap or expensive are these stocks?” The graph below provides an eye opening answer: On the basis of one measure of valuation, “price to book value”, they are the most expensive, relative to other stocks, we have seen at any time in our data history going back to 1972. On this measure, the price of these stocks has already been bid up on a relative basis. For the first time in at least four decades, high yield large cap stocks are actually more expensive than the broader market. Buyer Beware.

IMG

It’s a little hard to read I know, but basically the top line (at least the top line until the last year or two) is the Price to Book Value of the overall market, and the bottom line is the Price to Book Value of “high-yield” stocks.  You can see that in general, the high-yield stocks are the equivalent of value stocks, with P/B that is around 0.5 lower than the overall market.  During the tech stock bubble, the P/B of high-yield stocks was only 2.5, while the overall market ballooned to 4.5 prior to the crash.  Now, in the last two years, the P/B of high-yield stocks is actually LOWER than that of the overall market.  If that isn’t a high-yield stock bubble, I don’t know what is.

High Dividend Not The Best Of The Value Strategies

Now don’t get me wrong.  I like value stock investing and tilt my portfolio to both small and value.  But when analyzing various value strategies, it appears that a high dividend strategy may be the worst.  Rick Ferri recently posted a chart from the Ken French Library:

ValueStock-Fig2

 

 

 

 

 

 

 

 

 

Basically, there are four value strategies, high earnings/price ratio (E/P), high book to market (BtM), high cash flow to price (CF/P) and high dividends (Div$).  Last year, BtM was the best, followed by E/P, then CF/P.  Using a high dividend strategy was the worst of the value strategies.  Larry Swedroe discusses the long-term data (also from French’s website) using data from 1952 to 2009 and found this:

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

Remember that a Sharpe ratio measures risk-adjusted returns- the higher the better.  The highest Sharpe Ratio was the P/CF ratio.  The highest earnings came with the low P/E ratio strategy.  The price to dividend ratio not only had the lowest return, but it had the lowest risk-adjusted return.  Now, I’m not sure which of the value strategies will be the best going forward, but I don’t think betting on the dividend strategy is very wise given past results and current valuations.

But I Invest For Income!


I meet a lot of people who purport to be income investors and don’t care about capital gains.  However, income and gains are essentially interchangeable.  Not enough income?  Sell a few shares.  Too much income?  Invest in shares or another property.  There are some tax effects that make capital gains superior to dividends and rents, but for the most part, it’s the same thing.  That’s why you need to be a total return investor.  I once had an investor tout an investment to me showing “It has an 8% yield!”  He wasn’t quite as impressed with that once I pointed out to him that over the last few years the value of his principal had gone down about 5% a year.  Pay attention to the total return, not just the dividend yield.  Yes, gains tend to be more volatile than income, but far too many income investors don’t realize until it’s too late that dividends get cut, rents stagnate, and vacancies happen.  Income is no sure thing.  Not to mention that the value of the asset producing the income fluctuates whether they care about it right now or not.

The Answer

If your investment policy calls for you to hold bonds, then buy bonds.  Stocks with high dividends are NOT bond substitutes.  If people like John Montgomery, Rick Ferri, and Larry Swedroe (all of whom know far more about investing than I ever will) are warning against this strategy, it would behoove you to pay attention.

What do you think?  Agree?  Disagree?  Sound off below!