This post is the sixth (and last) in a series exploring the myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.

Dividend Myth #6: Investors who follow a dividend growth strategy will eventually beat the market on yield alone.

I was hoping to wrap up this series on dividend myths after Part 5, but I bumped into another fundamental misunderstanding that I just couldn’t ignore. It’s proclaimed on Tom Connolly’s website, and I’ve heard it cited several times by other investors. According to Connolly: “With dividend growth investing, after a few years (maybe a decade) of dividend growth, you can beat the market with yield alone.”

This would be a very compelling argument in favour of a dividend growth strategy — if only it were true. Unfortunately, it’s just terrible math. Here’s an example of the logic that investors use to arrive at this spurious conclusion:

  • In 2000, I bought 1,000 shares in Phil’s Nails for $20 each. The stock’s yield was 4%, or $0.80 per share.
  • Over the next ten years, Phil’s Nails increased its dividend by 5% every year, so by 2010 it had grown to $1.30 per share.
  • Since my original cost was $20 and I’m now receiving $1.30 per share in dividends, my yield on cost is 6.5% ($1.30 / $20).
  • Therefore, I earned 6.5% in 2010 on dividends alone.

The first three statements here are fine, but everything falls apart in the last point. The investor here has assumed that his yield on cost and his annual return are the same. They’re not.

Investment returns are expressed in annual terms, while yield on cost is a completely different measurement that doesn’t consider how long an investment has been held. If you confuse the two, you will quickly fall into the trap of believing that your investments are doing better than they really are. You might even think you’re beating the market.

Increasing income does not mean increasing returns

Our shareholder in Phil’s Nails seems to believe that if his dividend grows every year, then his returns must also be increasing. Otherwise, how could he think he will someday “beat the market on yield alone”?

To see if that’s true, consider how the company’s stock price might have behaved over the last ten years. I have to make a few assumptions here, but the specifics are not important. The idea is to illustrate that dividend increases do not not translate into growing annual returns.

Phil’s Nails increases its dividend amount by 5% every year: from $0.80 in the first year to $0.84 in the second, and so on. But we cannot assume that the company’s dividend yield will also rise. For that to happen, the stock’s price would have to stay the same or fall every year — and it’s hard to imagine how any investor would see that as a positive thing. So let’s assume that the current yield remains constant at 4% for ten years, which is generous, but reasonable.

If the dividend amount increases by 5%, but the current yield stays constant, then the price of the stock would have to rise by 5% a year to make this possible. Here’s how the stock’s performance would look, assuming that the market moved in a straight line:

Share Dividend Current Yield
price amount Yield on cost
2000 $20.00 $0.80 4% 4.0%
2001 21.00 0.84 4% 4.2%
2002 22.05 0.88 4% 4.4%
2003 23.15 0.93 4% 4.6%
2004 24.31 0.97 4% 4.9%
2005 25.53 1.02 4% 5.1%
2006 26.80 1.07 4% 5.4%
2007 28.14 1.13 4% 5.6%
2008 29.55 1.18 4% 5.9%
2009 31.03 1.24 4% 6.2%
2010 32.58 1.30 4% 6.5%

So how have Phil’s shareholders fared? The investor who is focused only on the dividend will enthusiastically point out that his income has risen by 5% every year, and that he’s now earning a 6.5% yield on cost. But any way you slice it, the stock has returned 9% each and every year: a 5% price increase, plus a 4% dividend. The investor has done well, but he’s not likely to be beating the market, period, never mind “on yield alone.”

Why yield on cost is an illusion

Here’s a thought experiment. Imagine you bought 1,000 shares of MegaBank in 1990 when they were trading at $10. You’ve held them in your RRSP for 20 years, and the stock is now at $40, with an annual dividend of $1.60 per share. That means your yield on cost ($1.60 / $10) is a whopping 16%. One day your spouse accesses your account and sells all the shares. What would you do?

Your first reaction might be to shriek: “You just sold an investment that was yielding 16%! I’ll never be able to replace it!” But the correct course of action should be obvious: you should buy another 1,000 shares in MegaBank immediately.

Yes, you’ll be out two trading commissions and will lose a bit on the bid-ask spread — all told, you’ll be down perhaps $50. But otherwise, you’re back where you started, because your investment wasn’t yielding 16%, it was yielding 4%. You didn’t have a $10,000 investment yielding $1,600 — you never did. You had a $40,000 investment paying $1,600 in dividends. Your yield on cost is a historical relic that has no bearing on anything going forward.

I know this is hard for some investors to accept: read the comments under this Motley Fool article for some examples of the confusion. But if you take a deep breath and think about it, you’ll see that it must be true. If I buy MegaBank today, and you bought it 20 years ago, our yield on cost will be vastly different, but our annual returns will be exactly the same from now on. And if that’s the case, one of us can’t be beating the market while the other is not.

The power of compounding

There seems to be a stubborn belief that dividend growth stocks are fundamentally different from other equities. Dividend investors dwell on their “growing income” and “increasing yield on cost” as though these are unique to their strategy. But every other equity investor benefits from exactly the same concept. It’s called compounding.

Consider the most popular ETF in Canada, the iShares S&P/TSX 60 Index Fund (XIU), which holds the 60 largest companies in the country with no attempt to screen them for dividend growth.

In 2000, this ETF paid $0.15 per share in dividends. The distribution increased in eight of the last ten years (it fell by two cents in 2002 and five cents in 2009), and is now about $0.45 per share. Which means a boring old index investor who bought XIU in 2000 would now be collecting three times as much income as he did a decade ago, and his yield on cost would have tripled. That’s just how compounding works.

Some of the issues I’ve explored in this series come down to differences of opinion, but not this one. The idea that dividend growth stocks will eventually “beat the market on yield alone” is nonsense, pure and simple. If this is the basis for your investing strategy, then you’re guaranteed to be disappointed.

Other posts in this series:

Dividend Myth #1: Companies that pay dividends are inherently better investments than those that don’t.

Dividend Myth #2: Dividend investors are successful because they select excellent companies and buy them when they are attractively priced.

Dividend Myth #3: Dividend-paying stocks are a substitute for bonds in an income-oriented portfolio.

Dividend Myth #4: You can beat the market with common sense: just focus on blue-chip companies with a competitive advantage and a history of paying dividends.

Dividend Myth #5: It’s easy to build a well diversified portfolio of Canadian dividend stocks.