September 13th, 2012 | Forbes
The Mystery Behind Dividend Yield Investing
“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” John D. Rockefeller
Dividend investing is back in fashion. Extremely low interest rates are enticing many investors to seek income in high-yielding stocks. Sluggish economic growth and elevated market volatility have enhanced the attractiveness of stocks that are anchored by generous dividend distributions. Aging baby-boomers and retirees seek the steady income stream of dividend payers. From January 1, 2011 to August 31, 2012 the FTSE High Dividend Yield Index of US stocks returned 23% compared to just 16% for the S&P 500 Index.
But what happens to high-yielding stocks when taxation of dividend income rises next year—potentially from 15% in 2012 to 43.4% in 2013? And is it really the high yield that makes dividend stocks attractive, or is it something else? We’ll address the second question first since our research has yielded some surprising results.
The Dividend Yield Factor
We analyzed the sources of stock returns over the 33-year period from Aug. 1, 1979-July 31, 2012 by separating out risk factors such as value, growth, momentum and company size. We divided the Russell 3000 Index into 10 deciles and honed in on two portfolios: one representing the entire market and the other just the decile comprised of the highest-yielding stocks—the 10% of stocks with maximum exposure to the dividend yield factor.* Not surprisingly, the dividend yield factor portfolio was heavily weighted towards sectors that traditionally are big dividend payers, including utilities, telecoms and consumer staples. We updated the portfolios monthly (quarterly prior to 1987 due to unavailable data).
Result: the high-yield portfolio’s annualized return was 1.27 percentage points greater than that of the total market portfolio—12.42% against 11.15%–which was enough to compound wealth 48-fold during 33 years, compared to 33-fold for the market portfolio. But here’s the catch. When we decompose factors explaining the returns we find that the dividend yield factor actually contributed negative 1.02% annualized to the excess return.
Tilting to Value
Here’s what’s happened. By tilting to dividend yield, investors unwittingly tilted to value stocks, which explain the excess performance. During the 33- year period, the dividend yield portfolio consistently had a high positive correlation with the value factor (defined as low book value to price ratio); i.e., the portfolio inherently tilted towards value. The value factor (high exposure to value vs. the benchmark) added 0.4 percentage points to annual returns. Moreover, the dividend yield factor tilt also brought with it a high exposure to the earnings yield factor (EY is stock earnings per share divided by price per share), a commonly used method for identifying value stocks. The earnings yield factor contributed 2.28 percentage points—the most of any risk factor—to excess returns.
So to reiterate, dividend yield per se is not the source of excess returns. Rather, a yield factor portfolio automatically tilts towards value, which is the actual source of excess returns. (So maybe John D. Rockefeller was inadvertently an early value investor.)
The Yield Factor and Taxes
Now to address the tax question: unless current law is amended before the end of 2012, from Jan. 1, 2013 investors will face the single steepest increase in dividend taxation in history. For taxpayers in the highest income brackets, if the sun sets on the current 15% qualified dividend tax and dividends are taxed as ordinary income, they could be paying 43.4% (including the 3.8% health care surtax: for more on this new tax, see: Start Planning for Higher Taxes. In other words, $1000 of dividends will shrink to $566 after the tax man gets his cut, instead of $850 this year.
I’m not going to address the question of what impact such a sharp increase would have on the stock market and on high-yielding stocks in particular. We don’t play the market prediction game, and anyway I don’t believe the outcome (or Congressional action on taxes before the end of 2012) is knowable in advance. But there are perhaps some clues in the interesting patterns around tax changes that our research has uncovered.
Using the same multi-factor analysis, we can see that the dividend yield factor is highly sensitive (short-term) to changes in tax laws. For example, in the graph below you can see that in 2003 the contribution of the dividend yield factor spiked in early January when the Bush tax law changes were announced and again in late May when the law was enacted. In a similar vein, the yield factor spiked in August 1986, when President Reagan cut taxes. By contrast, when President Clinton’s bill to increase taxes passed the House in May 1993, the dividend yield factor declined until July. But the pattern is clear: the prominent spikes in the yield factor are short-term around the news of tax changes, but over the longer term in each case the factor reverted to normal. The chart starts in late 2002.
Historically, from August 1, 1979 to July 31, 2012, a portfolio of dividend-yielding stocks has outperformed the general market, but this outperformance is due to the inherent exposure to the value factor. In fact, the exposure to the yield factor has detracted from performance. Investors should be careful about chasing yield and may be better off in a pure value strategy.
*All assets may not have been recognized as a part of the Russell 3000 Index or the decile portfolios due to lack of data availability.
As Published On: Forbes
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