Has Dividend Investing Worked, And Will It Work Going Forward?

June 4th, 2015

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This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

"You look a lot like Warren Buffett"

"Yeah, I get that a lot" - Warren Buffett

Many people have a hard time recognizing Warren Buffett in person. Buffett doesn't dress like how people expect a billionaire would, eats at McDonald's, and regularly shops at Walmart.

Buffett is not the only frugal rich person. Sam Walton, the founder of Walmart, drove an "old pick-up truck with cages in the back for my bird dogs". Carlos Slim, who was the richest man in the world not too long ago, lives in a modest 6 bedroom home he's lived in for the past 30 years.

My point is this: you can't look at the way a person spends his/her money, and deduce how rich they are. Yes, people who spend money on Ferraris probably earn a lot. But you can't say that someone who doesn't have a Ferrari earns less.

The same principle applies to stocks. Many investors today think that companies that pay a lot of dividends earn a lot of money. These "dividend investors" restrict their investments to companies that pay a high and growing dividend yield. In doing so, they prejudice against perfectly good companies that don't pay any dividends.

This is like betting that some average Joe who recently bought a Ferrari is richer than Warren Buffett.

Still, that didn't stop novice investors from becoming enamoured with the idea of dividend investing. In this article, I'll examine how well dividend investing has done so far, and how well I think they'll do in the future.

Performance Of U.S. Dividend Stocks

First, let's take a look at how well dividend investing has fared in the U.S.. To determine how well dividend investing has done, let's look at the performance of the most popular U.S. dividend ETFs, which are VIG, DVY and SDY. If you want to know what ETFs are, please read our free book.

This chart compares the performance of the dividend ETFs against another ETF called SPY, which is the most popular ETF that tracks that overall U.S. stock market. Unfortunately, the performances on the chart doesn't take dividend payments into account. But surprisingly, that doesn't matter very much.

SPY has a dividend yield of 2.33% per year. This is only marginally lower than the yields of VIG (2.44% per year) and DVY (2.92% per year), and it's actually higher than the yield of SDY (2.26% per year). This happens because VIG and SDY include companies that have a history of growing their dividends (this strategy is called dividend growth investing) regardless of their current yields. These companies tend to have lower yields today.

The marginal difference in dividend yields is not enough to change the conclusions we can draw from looking at the chart. All three of the most popular dividend ETFs have underperformed the overall U.S. market over the past 5 years. This is especially the case over the past 2 years, when SPY outperformed the dividend ETFs by 5-10% overall (i.e. 2.5% to 5% per year).

To me, this is not a surprise. I've argued in the past that dividend investing won't work. But still, I think it would be helpful to go beyond the theory and examine why it hasn't worked. To do that, let's examine one company that consistently shows up in the portfolio of dividend investors: McDonald's.

McDonald's Woe

As a business, McDonald's needs no introduction. As the burger chain expanded its reach around the globe, its profits had grown for many years. The company decided to pay out a substantial amount of their earnings in dividends. As a result, its dividends grew from $2.20 per share 5 years ago, to $3.24 per share currently. Today, the dividend yield stands at 3.65%.

The 5 year history of McDonald's share price tells the familiar story we saw with dividend ETFs. McDonald's did well in the first half of the past 5 years, but did very poorly in the second half. The second half's performance outweighed the first half performance, and McDonald's ended up underperforming the the overall U.S. market by a sizable margin.

It's easy to understand why McDonald's shares have suffered recently. Today's consumers, especially the younger generations, have been flocking to healthier fast food chains like Chipotle. In the burger industry, many new competitors such as Five Guys have sprung up, and old competitors like Burger King have been reinvigorated. As a result of intense competition, McDonald's sales have stalled, and may even start to go down in the future. If that happens, their earnings will go down as well.

A company's ability to pay dividends is dependent on its earnings, the same way the someone's ability to buy a Ferrari is tied to his/her own income. Given the dimmer outlook of McDonald's ability to pay dividends, the stock market is right to assign lower value to its shares.

However, dividend investing doesn't consider any of this. It only looks at the past trend of dividend payments, and naively extrapolates those payments into the future. Whereas the stock market looks forward, dividend investors only stare at the rear-view mirror.

Of course, not every dividend stock has a similarly dim outlook as McDonald's. Some have done well, whereas others have done poorly. But as a result of the huge surge in popularity of dividend investing, many companies had become overvalued around 2011-2012, and thus handicapped even the more healthier dividend stocks from outperforming the overall stock market.

Performance Of Canadian Dividend Stocks

Whereas the U.S. dividend ETFs have underperformed the overall U.S. stock market in recent years, we can't say the same about Canadian dividend ETFs.

The 3 most popular Canadian dividend ETFs are XDV.TO, CDZ.TO, and ZDV.TO. As this chart shows, CDZ.TO and XDV.TO outperformed XIC.TO, the ETF that tracks the overall Canadian stock market over the past 5 years (ZDV.TO underperformed). You might think 2 out of 3 is a good result for dividend investing, but their advantage has been waning. Over the past year, only CDZ.TO has outperformed XIC.TO by a small margin, while the other two ETFs underperformed XIC.TO by a wide margin.

So why did Canadian dividend ETFs outperform its respective overall stock market while U.S. ETFs didn't? The answer lies in the composition of the Canadian stock market.

Whereas the U.S. stock market is very diversified among different industries ranging from technology, healthcare and others, the Canadian stock market is much less diversified. The Canadian stock market is comprised of about one third financials (i.e. banks and insurance companies), one third resources (i.e. oil, gas and mining), and one third everything else.

The Canadian dividend ETFs are even more concentrated, by overwhelmingly favouring financial stocks. For example, over 55% of XDV.TO consists of financials. On the other hand, only 11% of its holdings comprise of resource stocks.

Over the past couple of years, resources stocks have fallen on hard times. The price of metals such as copper and gold have gone down for the past 3 years, hurting mining stocks like Barrick Gold. Oil prices have crashed in the past few months, taking oil and gas stocks with it. Given that dividend ETFs have concentrated on the more stable financials, it's a wonder that they haven't outperformed the Canadian stock market by wider margins.

My Prediction

Even though dividend investing has "somewhat" worked in Canada, I don't believe it will continue to work in the future. My reasoning again goes back to the dividend ETF's heavy concentration in financials.

In the coming years, I believe the Canadian banks will face some big challenges. This is worthy of an article itself, so I won't go into it too deeply here. But for now, let me just say that Canadian households carry too much debt today, and I believe that will come back to bite the banks. Also, Canadian banks lack the opportunity for growth that other sectors of the economy have.

Also, I don't believe resource stocks will continue to slide indefinitely into the future. I'm especially optimistic about oil and gas stocks going forward. With many of them having fallen by over 50% in recent months, I think an eventual recovery in oil prices will lift their share prices higher. For stocks that have fallen by more than 50%, going back up to the same level as before would mean greater than 100% gains.

Whereas smart investors will load up on oil and gas stocks, dividend ETFs will do the opposite. Dividend ETFs must follow a prescribed rule in selecting which stocks to hold in its portfolio, and many of those rules will force them to sell stocks that have cut their dividends recently (see page 21 of this document). Many oil and gas companies have cut their dividends recently.

I believe dividend ETFs will kick out oil and gas stocks at the worst possible time, and this brings us to my prediction for the year 2015. I believe that in 2015, all 3 Canadian dividend ETFs I mentioned (XDV.TO, CDZ.TO, ZDV.TO) will underperform XIC.TO. In other words, in 2015, dividend investing won't "work". Will I be right? Let's see a year from now.

This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.