Is Investing in High Dividend Yield Stocks a Sucker's Bet?

Wesley Gray |

PT_Barnum.jpgIt can be tempting to base an investment decision solely on yield...but it can also be an efficient way to separate a fool from his money.

That's why we want to highlight that investing in high dividend yield stocks - without considering the valuation - is often a very BAD idea.

We've noticed that many market participants point to the historical performance of high dividend yield investing as a way to outperform the benchmarks. While there is a degree of truth to this claim, it is also notably misleading.

An associate and I published a paper on the subject of high-yield strategies a few years ago (a copy of the paper can be found here), but the bottomline is as follows:

High dividend yield stocks do not reliably earn above-average risk-adjusted returns. More complete measures of shareholder yield, which account for net share repurchases, perform better.


In short, sophisticated yield strategies work better than plain vanilla yield strategies, but dividend yield strategies are not great - at least after adjusting for market factors such as beta, value, and size exposures.

What we didn't emphasize in this paper, but probably should have emphasized in retrospect, is that all yield-based strategies are essentially noisy proxies for "value" investing strategies - that's why they outperform. High dividend yield stocks are good expected bets if they are cheap; they are not good expected bets if they are expensive. Historically, high yield stocks have been "cheap stocks," but today, high yield stocks are actually expensive. And if history is any guide, buying expensive stocks rarely ends up with a favorable outcome.

So Why are High Dividend-yield Stocks so Expensive?

Consider a typical day in the marketplace: Investors screaming "I want yield!' Asset managers launching product to fulfill demand, exclaiming " _______ Dividend Yield Fund just launched!"

Wall Street knows how to create products that fulfill the Pavlovian dog response to the word "yield." In fact, they are a little too good at fulfilling investor demands for yield (see this piece on how mutual funds manipulate yield numbers to drive client demand).

Visualizing Current High Dividend Yield Names

High Dividend Yield Stock Valuations

We first look at two measures of cheapness: EBIT/TEV and P/E. Ideally, we want to see that the current crop of the top 50 dividend yielding S&P 500 stocks are also cheap.

Turns out, they're not.

They are actually quite a bit more expensive than the median S&P 500 stock. Thus, high yield no longer equals cheap.

To illustrate this fact, let's look at valuations based on EBIT/TEV (higher is cheaper; lower is more expensive). The green line is the S&P 500 median EBIT/TEV; the red line is the median EBIT/TEV for the top 50 yield names; and the bars highlight the distribution of EBIT/TEV for the high yield portfolio.

ebitThe results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

You'll notice that high yield stocks are generally more expensive than the market (green line is above the red line). There are certainly some cheap high-yield stocks, but on average, the bucket of 50 names isn't cheap.

For valuations based on P/E (higher is more expensive; lower is cheaper), it's a similar story: high yield stocks are more expensive than the market (the red line is above the green line).

unnamed (1)The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

In summary, the top 50 high dividend yield names are expensive relative to the market on EBIT/TEV or P/E metrics. That's not good.

But Perhaps High-dividend Yield Companies are Higher Quality?

You might say, "Well, yeah, they are expensive, but these high yield companies are exceptional companies so they deserve a premium." It's a nice story...but there is little evidence to support it.

First, a look at return on equity. High yield stocks have much lower ROE than the typical S&P 500 firm.

roeThe results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

But how about return on assets? A similar, but muted finding: High yield stocks have lower ROA than the typical S&P 500 stock.


roaThe results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

In summary, high dividend yield stocks don't seem to be much higher quality than the market. Also, don't forget that dividends are taxable, meaning that to the extent that your total return consists of a larger amount deriving from taxable yields you are actually losing tax deferral benefits.

Still Excited to Buy High-Priced Low-Quality Stocks?

If you are venturing into high dividend yield funds in the hopes that you will earn some extra income, you might be in for a nasty surprise. As Ben Graham discussed in the past, intelligent investing is about buying stocks with a margin of safety...he didn't suggest that investors focus on high-yield stocks.

In other words, focus on cheap stocks where expectations are lowest and fundamentals are sound. Put differently, buy value investing funds that focus on cheap, high-quality firms; not dividend yield funds that buy expensive, relatively low-quality firms.

Unfortunately, high yield strategies today are not following Ben Graham's advice. Of course, time will only tell if Ben Graham's investment advice rings as true in the next 100 years as it has rung true over the past 100 years.

 

For more market anaylsis from Wesley R. Gray, check out his blog at Alpha Architects here

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Comments

Emerging Growth

Nano One Materials Corp.

Nano One Materials Corp is a technology company. The Company manufactures storage materials for lithium ion batteries.

Private Markets

MyForce, Inc.

As parents, we constantly worry about the safety of our loved ones. The media bombards us with incidents from across the nation school shootings, frequent assaults on campuses, and crimes…

Dropbox, Inc.

Dropbox is a service that allows their users to bring all photos, docs, and videos anywhere, and share them easily. Any file saved to Dropbox will automatically save to all…