Dividend-Based Strategies

With a dividend-based approach, you purchase income streams. This has several advantages.

1) Valuations are automatically taken into account since you buy dividend amounts.
2) Dividend amounts are (reasonably well) predictable in the first decade even though prices are not. [This is the most important period for retirees.]
3) Dividend income streams increase to match inflation.
4) Dividend income streams last in perpetuity. [You will need to reinvest a fraction of your gains to compensate for those investments that go sour.]
5) Psychologically, while you are still in the accumulation stage, you can see your financial independence become a reality right before your eyes. You can match every one of your bills with an income stream. For example, you will reach stages when you no longer have to worry about the electric bill ever again. A specific income stream covers it.
6) Dividend-based approaches contain a value premium over the stock market as a whole. This includes the much-maligned utility stocks that have been thought (incorrectly) to be market laggards.

Related Research

That dividend-based strategies can outperform the market has been shown convincingly in James O’Shaughnessy’s What Works On Wall Street and David Dreman‘s Contrarian Investment Strategies: The Next Generation. James O’Shaughnessy presents a complete set of data. This gives us confidence in his numbers. However, subtle flaws in his approach make us cautious when it comes to his more complex strategies. David Dreman presents representative samples from an extensive set of studies. There is sufficient overlap in his findings and those from O’Shaughnessy for us to have confidence in both. David Dreman is very thorough when it comes to the more practical side of investing. He identifies cause-and-effect relationships. This leads us to believe that observed advantages will persist.

The order of magnitude of outperformance from contrarian strategies is up to 3%. That is, the potential long-term advantage over the S&P500 index can be reliably estimated as high as a factor of 4 over 45 years. Historical returns suggest a greater upside potential, but I am reluctant to call higher numbers reliable.

High dividend (yield) strategies do not perform as well as other contrarian strategies. Their upside potential is of the order of 1.2% to 1.5% above the return of the S&P500 index. Performance improves if you make sure that dividends are sustainable and that they are likely to increase with time. You can combine a high dividend strategy with other value-based strategies to improve results.

Almost all studies, including James O’Shaughnessy’s, have excluded utility stocks from investigation into high dividend strategies. It has been assumed, without proof, that utilities underperform the market as a whole. Lowell Miller investigated this and reported in The Single Best Investment that the nominal annualized return of the Dow Jones Utility Index was 11.75% from 1945-1990. The S&P500 index had a nominal annualized return of 12.25% over that same period. The Dow Jones Utility Index had only half of the volatility of the S&P500 index. Lowell Miller went on to show that selecting utilities with middle level yields (relative to the utility sector, but much higher than those of the market overall) along with a high likelihood of dividend growth consistently outperformed the S&P500 index.

High dividend stocks really shine when market prices plunge. They decline about half as much as the overall market. What is more, retirees and other investors are likely to stick with their investments as long as dividends remain stable or grow.

Today’s Choices

Many will choose to stay on the sidelines during times of excessively high valuations. Others will remain committed to holding nothing but stocks regardless of valuations. At times such as this, it is important to consider the downside risk when making investment decisions.

It makes sense to select high dividend stocks for stock allocations considering today’s prices. For retirement portfolios, you can get a steady income stream of 3.8% from iShares Dow Jones Select Index DVY or 2.8% from Vanguard’s VEIPX. The Dow Jones Utility Index has had a yield of 3.47% recently. Those who are willing to select individual stocks should be able to bring in a sustainable yield a little bit higher than 4%.

There remains a substantial risk of a temporary loss of principal within the next decade. This is not a problem if you can avoid selling shares.

Have fun.

John Walter Russell
I wrote this on 9-25-04.