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 DividendGrowth.ca, 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:
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.
Hey, I thought you said you were done with this series? :)
I’ll admit that I have used this argument when championing for dividend growth investing, but you raise valid concerns. However, you have once again cherry-picked an example to work out in your favour.
Yes, dividend growth + dividend yield will equal your total returns eventually. But most dividend growth stocks grow their dividend at a faster pace than 5% per year. The ones I follow (even the banks who haven’t raised dividends in a few years) are still averaging more than 10% dividend growth over the past 5 years.
So add that to the average yield between 3-4% and you have market beating total returns of 13-14%. And this is during a recession.
Thanks Dan! I’ve never understood the ‘yield on cost’ argument, which I was first introduced to from Connolly’s website. Let’s say Echo buys a bank stock that grows it’s dividend at 10% a year for 20 years. I don’t know what the yield on cost would be but it would be very impressive. In the meantime, I buy XIU and it grows so that in 20 years I sell it and I can buy the same number of shares in the same bank stock as Echo has. Is my yield on cost different? Of course not. The debate Echo would have with my example is that it’s not likely that XIU would grow at the same rate as his bank stock. That’s a debate no one can win until the 20 years are up.
It gets back to your original point: In the accumulation stage of a portfolio, assuming it’s registered, it’s total return that matters, not just dividend return.
@Echo: I’m done with it now — I promise. :)
“Dividend growth + dividend yield will equal your total returns eventually.” No, it won’t. This is exactly the misunderstanding I’ve been trying to point out. Total return equals dividend yield plus price appreciation.
If a company raises its dividend by 10%, that is not a 10% return. Some companies raised their dividends in 2008 even though their stock prices fell dramatically. They delivered negative overall returns, despite the dividend growth.
Which of your stocks have averaged 13% to 14% returns over the last five years?
For one thing, such a strategy regularly throws off cash. Obviously, this adds a risk-aversion flavor to your portfolio. Instead of hoping for good capital gains in the future, you can get some, perhaps even most, or your returns up front and according to a schedule that while not iron clad (companies can reduce or eliminate payouts if need be, as when business deteriorates badly) is a heck of a lot more visible than is usually the case for passive buy and hold equity strategies.
@Steve: You’re right if you’re talking about an RRSP or TFSA. If you’re investing in a taxable account, then there’s a better argument for using a dividend-focused strategy. The question then becomes, does this make sense if you haven’t maxed out your RRSP? That will vary hugely between individuals.
The XIU example is interesting, because throughout this debate we’ve sometimes ignored the fact that index investors collect dividends, too, and these dividends rise over time. (In the case of XIU, they’ve tripled since 2000.) The point of my argument was never supposed to be “dividends are bad.” Dividends are fantastic. The point is that selecting individual companies based on their dividend policy is not a reliable way to beat the market over the long-term — at least not on a risk-adjusted basis.
I used to fund an allowance for my sons with some BMO shares. I’ll admit that I used to like to focus on yield on cost for these shares. However, I never thought of this as being related to annual return. Your argument is spot on.
Excellent, this unexpected no.6 is the best article of the series. For a while I felt less clever than those dividend growth investors because I could’nt understand the logic of their arguments. I was reasoning exactly like you. Spot on. Thanks, I am not alone anymore!!
@Michael and Jusebastien: Yes, the intuitive appeal of “yield on cost” is really powerful. People like Connolly have manipulated it to great effect.
Hi Dan, you misunderstood my point. What I meant to say is that dividend growth + dividend yield will equal the total price appreciation eventually. You make this point in your example, since a stock that grows its dividend will have to have an increase in price too or the annual yield will become unsustainably high.
Here’s a perfect example – FTS.
Fortis has increased their dividend at a growth rate of 13.3% over the last 5 years. They have a 5 year average yield of 3.1%. Fortis’ total return over the same 5 year period is 69.53%. Do the math, that’s pretty close to what I’ve been saying here.
How about another example – ENB
Enbridge has increased their dividend at a growth rate of 10.42% over the last 5 years. They also have a 5 year average yield of 3.1%. Enbridge’s total return over the same 5 year period is 82.9%.
Here’s another example – SJR.B
Shaw Communications has increased their dividend at a growth rate of 43.18% over the last 5 years. They have a 5 year average yield of 3.3%. Shaw’s total return over the same 5 year period is 77.27%. *(they obviously can’t keep up that dividend growth pace long term so the growth rate will slow and begin to mirror the total price appreciation eventually)
Last example, just to show a slower growth rate – EMP.A
Empire Co. has increased their dividend at a growth rate of 7.8% over the last 5 years. They have a 5 year average yield of 1.5%. Empire’s total return over the same 5 year period is 42.47%.
@Echo: I didn’t misunderstand the point. My argument is that a company that raises its dividend by 8% or 13% every year must also grow its share price at a similar rate for this to be sustainable. And while some companies may be able to do this for a period of time, it is ridiculous to expect that over the long term. Do you believe that the expected long-term price appreciation of Fortis going forward will be 13% a year? Or that Enbridge’s share price will increase by an average of 10% a year? If so, you will indeed blow away the market. But that is an absurdly optimistic expectation.
I cringe every time I hear the “yield-on-cost” argument. The market doesn’t care that I paid $X for my investment 20 years back. What matters is the stock price today and future earnings prospects. And naturally, the market’s guess of a stock’s price is most certainly better than that of most average investors.
Dan, you should extend this series to one more post. I see investors (as in this thread) making the mistake of extrapolating recent dividend growth forever. That’s not how markets work. First, dividend growth has a natural speed limit: earnings growth. Companies can’t boost dividends faster than earnings forever. Second, if you look at the long-term, dividends have grown at a glacial pace in inflation-adjusted terms.
Sorry. I forgot to add this post I wrote about historical dividend growth from “Triumph of the Optimists”:
Will this series ever end? ;)
@Echo – I don’t think you will see all that many companies that can raise their dividends more than 5% per year for a long time.
Look at the Canadian banks – they had a great run for a while, but then they stopped raising their dividends.
I wrote this post in 2007, but it still holds true today:
@CC and MoneySmarts: The series ends here, I promise. I’ve already had to grow a beard and wear sunglasses in public. The other day I think I saw a ninja in the tree outside my window, and he looked angry.
@Canadian Couch Potato
Ninja is all good :) Remember Ninjas bake potatoes (while they collect their dividends).
Whoa guys, relax!
Dan asked for an example of stocks that have returned 13% per year over the last 5 years, so that’s what I gave him – while also trying to show that their dividend growth + yield was pretty close to the total price return over that time.
I did not say, nor do I assume that SJR.B will continue to raise it’s dividend by 43% per year. Please Dan, call off the dogs!
Ok, let’s look at Canadian banks if you want to go there. Remember, the financial sector got clobbered worse than any other and the banks halted dividend increases for the past few years.
BNS has increased their dividend at a growth rate of 7.77% per year over the last 5 years. BNS’ total return over the same 5 year period is 43.74%
TD has increased their dividend at a growth rate of 8.5% per year over the last 5 years. TD’s total return over the same 5 year period is 43.78%
RY has increased their dividend at a growth rate of 11% per year over the last 5 years. RY’s total return over the same 5 year period is 43.13%
8-9% per year average return is pretty good considering how badly they were hammered in ’08-’09. They all had strong 5 year dividend growth rate averages even without increasing dividends for the past few years. And when the dividend increases start again this year (make no mistake, the increases are on hold, they have not stopped indefinitely) what do you think will happen to the share prices?
As I said a few articles ago, there are arguments on both sides. Most of my portfolio is in good dividend paying stocks, and a few ETFs, REITS…etc. It works very well, kept me from selling in 08, and the DRIPS made me buy more at a lower price. It’s only been 15 years for me, but wow does it ever work!
part 5 was excellent; 15-20 stocks is not enough & focussing only on dividend paying stocks can be dangerous ( can be out of favor for more than a decade ).
As I wrote on a previous post, I see dividend paying stocks as a separate asset class, between bonds & broad market index.
Expected Return = Dividend Yield + Dividend Growth Rate (Gordon Equation)
There is a lot of companies that have increased their dividends for more than 20 years ( see SDY ). The dividend yield has nothing to do with the company increasing it.
It has to do with the valuation of the stock on the market.
COKE was $ 60.95 on 12/2000 and a dividend of $0.68
on 12/2010: $65.75 and a dividend of $1.73. The ongoing dividend stream, not the expected growth, provides the lion’s share of return. The yield on cost is almost the same for a new buyer. Coke & the whole market were expensive in 2000, both with a dividend yield around 1%.
Same goes for the entire market. I prefer to buy when the whole market has a yield of 4% than 2%. Most arguments for index investing & capital appreciation are based on a relative short period (80-2010). Before 1980, more than half of total returns came from the dividends and since 2000, most of it.
Are we going back to the late 90’s period of pure speculation? I don’t know and that’s why I like to have some dividend paying stoks (or ETF) as well as bonds and broad market index.
I think that you got a good discussion going. I dividend invest and that is how I make money to live on. It has been good for me. However, there are pros and cons about it and certainly there are risks. The reason I like the discussion is that people may need education on the pros, cons and risks of this sort of investing. The discussion also bought out different points of view. Good job.
@spbrunner: Thanks for adding your voice to the discussion. Always good to hear from long-time investors with experience. Cheers.
Norm Rothery pointed me at this series and it’s been worth reading. Kudos to Dan and the commenters. Let me just throw in one general comment and then one specifically @ Echo.
Dividends (and dividend growth) work well until they don’t. Recent experience in Canada has been very favourable but you cannot count on this always. Five years ago, there were a plethora of fat (and consistent) dividend yielding shares, as well as a large contingent in the dividend growth category in the U.S. 2008/9 was brutal for many of these stocks and even investors who thought they were well diversified got very hurt. It wasn’t just their portfolio “values” that melted away either. Their dividend incomes were cut substantially and have not recovered even now. It was a hard lesson for U.S. investors. Canadians didn’t learn that in 2008/9, and that’s probably a bad thing.
@Echo: You wrote above (and I am picking this one stock for a very good reason), “BNS has increased their dividend at a growth rate of 7.77% per year over the last 5 years. BNS’ total return over the same 5 year period is 43.74%.” BNS and all the other big banks have enviable records for dividend growth since the mid-1990s. One can even argue that they have all been pretty good since about 1980. So that’s a stellar 30 year track record to hang your hat on. Something that has worked for 30 years straight seems like a pretty fair bet.
You might be surprised, then, to learn that BNS investors in the past waited as long as 60 years for their annual dividends to match inflation. The BNS dividend in 1974 was, in real terms, no higher than the dividend in 1914. It seems hard to believe, almost impossible these days.
It’s easy to be happy with the dividend payer you own when your income is up 30% in real terms in the last 5 years. Waiting 60 years to get back to where you started is a tougher go.
It’s happened before. It can happen again. Stay alert.
@Norbert: Many thanks for stopping by and adding your wisdom on this topic.
Dan, you waited until Myth # 6 to start the beard and wearing sunglasses in public?
You DO live dangerously don’t you? I hope your booth in Toronto isn’t beside Derek Foster or David Stanley? :)
Kidding aside, this has been an excellent series and even better discussion from “both sides”. No doubt you know I’m a fan of dividend-payers but I cannot and will not ignore the simplicity of index investing using ETFs to build my nest egg as well.
I love what someone said above:
“Are we going back to the late 90′s period of pure speculation? I don’t know and that’s why I like to have some dividend paying stoks (or ETF) as well as bonds and broad market index.” This comment and approach, means you can take advantage of both worlds and that’s what I’m doing.
The yield on cost argument from Connolly is suspect, no doubt, but I was inspired by Connolly (and others) about the dividend-investing journey nonetheless. My inspiration doesn’t mean blind faith in Connolly, dividend-investing nor the risk/reward relationship involved. Ram probably said it best that “The market doesn’t care that I paid $X for my investment 20 years back. What matters is the stock price today and future earnings prospects.” I don’t think for a minute that all my dividend-paying stocks will continually grow their dividends by 5% every year for the next 30+ years AND the stock price will also appreciate by the same value, running away from the market because earnings are also always on a 5% upswing or more. It would be nice, but it is not realistic. That said, I do believe in what dividends can provide me, another great way to generate income, tax-advantaged at that, over time.
At least your presentation wasn’t entitled “Only My Friends Stay Passive”.
Enjoy TO. Share your presentation questions and your impressions of show when you get back on your blog.
I appreciate your comments and wisdom on the subject. You and many others in this thread point out the risks associated with counting on dividend investing to perform at a high level for the long term. I am well aware of the history that prior to 1980 the track record of this method has not been stellar. Please understand that I am not counting on dividends to entirely replace my income in retirement. I am fortunate enough to have a DBP indexed to inflation, so my risk tolerance is higher than most.
Yes, dividends can be cut and increases can be halted, and I will need to stay alert to identify these companies and remove them from my portfolio. I would argue there is risk that the broad index could also remain flat for long periods of time where dividends are the only returns provided. Time will tell.
Dividend investing is an income strategy.
Yield on cost is important. It’s a personnal measure usefull for comparaisons with the yield on various bonds.
Dividends are a form of return of capital invested.
When you buy an apartment building, the rents are the same as dividends .
If you are a speculator, you want the building value to appreciate a lot in order to sell.
If you are an investor, you want to collect the rents over the years (rents that would hopefully increase) and become morgage- free. After that, the money can be invested in a new project.
Dan, thank you for poviding this most fascinating and enlightening series. Obviously Index Investing and Dividend Investing are two very diverse strategies – one relying on overall market gains and the other primarily based on compounding income. I’m with My Own Advisor, both strategies combined is going to be a solid portfolio for me in the years to come. Don’t worry, the Ninja will offer you protection against militant dividend investors :)
@Ninja: Thanks for the protection — it’s always good to have a ninja watching your back.
Very interesting discussions! Just my 2 cents. Today I attended seminar with Benjamin Tal, Senior Economist, CIBC World Markets. It was very interesting lecture (I also asked him privately couple of questions after lecture), I won’t be repeating everything he said, but several points. I his opinion the best investments in 2011:
– commodities (especially oil, energy)
– US and probably Canadian manufacture who export staff to emerging markets (especially China)
– dividend stocks (in his opinion they will well outperform indexes, like VTI or VEA) .
P.S. Personally, I have very diversified portfolio: dividend stocks (CAN and US), bonds, hitech no-dividend stocks , GIC, white metals, ETFs and so on
Wanted to add something regarding dividend stocks… it’s more physiological issue , people see big yield, assume good income regardless market movement and …. buying , so price is going up.
Do not forget that Canadian have now huge , huge amount of cash (don’t remember exact number),, and above 85% of those money have people age 55+. As per B. Tal “they wouldn’t like to send their money into adventure trip”, so most likely they will go to dividend blue chip
What if you do the same calculations but factor in re-investing the dividends to get more shares to DRIP?
@X: If you reinvest the dividends (as opposed to spending them), then your money will of course compound more quickly. But the annual return on the stock is the same one way or the other.
@Eric: “When you buy an apartment building, the rents are the same as dividends.”
There’s problem with thinking this way. The amount paid out in rent doesn’t have an affect on the apartment’s value. But the amount paid out in dividends depletes a company’s capital and will drop it’s share price by a similar amount.
Wanted to compliment you for Debunking Dividend Myths. Very good posts!
Could you please tell me, is it right to see dividends shares as short term investments for people who have short time horizon?
Usually shares viewed as long term investment however dividend shares are used by people after retirement. In case I balance the risk with money markets and short term bonds, is it reasonable to think that I will do better with “dividend shares” than with “growth shares” in the short run?
@David: I don’t think you should ever think of stocks as a short-term investment. They will always be vulnerable to 30% or 40% price drops — witness what happened to them in 2008. But as you suggest, dividend stocks can certainly be part of a diversified retirement portfolio, in combination with safer investments to dampen overall volatility.