Keen readers of the financial papers or websites, may be familiar with the dividend chasing stories that focus on high dividend paying stocks or ‘income’ funds. The thought is that it’s possible to take an income from a portfolio without the need to sell shares, which – at least superficially – can be appealing to some. This is sometimes known as taking ‘natural yield’ from a portfolio.
This sounds appealing, but it’s an approach that’s not without cost. As we’ll shortly explore, this approach introduces risks into the portfolio that are best avoided, and reduces the extent to which a positive outcome can be expected over the long term.
Different sectors of the economy have different attitudes to paying dividends. Tech companies for example, tend to reinvest most of their cash flows into product development and attaining greater market share, whilst energy companies – operating in a more mature industry – may not be able to find projects with an expected return that’s in excess of their cost of capital and as a result, are more likely to return money to shareholders via dividends.
An investment approach focussed on dividends rather than on capturing the return available from the whole market will therefore exhibit a few characteristics as a result of this reality:
1. It will be less diversified. By virtue of the requirement that a company must be paying a dividend to warrant inclusion in the portfolio, the pool of companies which can be included in a portfolio is much smaller. Diversification is one of the closest things we have to a free lunch in investing, and investing for income reduces it.
Where possible investors should be seeking to hold as many companies as possible within an efficient portfolio, a move that reduces the risk that the behaviour of any single company can have a meaningful impact on the success of the financial plan it’s powering.
2. It will be sectorally skewed versus the broad market. An income portfolio ends up taking bets on certain sectors of the market that don’t necessarily stack up in the cold light of day. There’s little evidence, for example, to suggest that a portfolio that excludes tech or consumer stocks will be able to more efficiently power a financial plan, yet that’s exactly where you’d end up with a portfolio focussed entirely on dividend payment.
3. It will be geographically skewed versus the broad market. In a similar vein to the above, the dispersal of companies around the world isn’t uniform. Certain countries have a greater exposure to certain sectors. As such, in addition to the sector skew that investing to income introduces, it also introduces a geographic skew. For example, given the focus within the US market on technology, you’d expect an income portfolio to be taking an unsubstantiated bet against the world’s largest stock market.
Finally, it’s worth remembering that there is no such thing as a free lunch in the world of investing, there are only trade-offs. The payment of a dividend is simply a decision by a company to use the profits it’s generated to reward shareholders rather than reinvesting them back into its own operations.
Reinvested profits can be used to improve the business for example by opening up new markets or product lines with the aim of driving greater cash flows. When realised, these cash flows drive higher stock prices. The investor who’s paid a dividend today is doing so at the expense of tomorrow’s price growth.
The dividend policy of a firm makes little difference to its total expected return and it should be broadly ignored by those seeking to build a portfolio for all seasons to efficiently power their financial plan.
As for the title of this article, I hope any fans of nineties indie bands will get the reference. For those who don’t, put simply, chasing dividends don’t work!