Investing for dividends or total return?

We are often asked about investment style and strategies.

One question we are asked is: whether we focus on high dividend paying stocks?

Or, do we invest for total return? Investing for total return means investing for a combination of growth and income from stocks, but not putting the primary emphasis on the dividend yield.

We recommend investing for total return. While dividends are an important component of a portfolio’s long term overall return, we do not recommend that you invest primarily in high dividend paying stocks.

While each client and investor is unique and has their own personal goals, a common goal is for your assets to grow over time. Thus, our focus is on what strategy will provide the long-term investment growth that you desire.

Some clients, particularly those in retirement, want income from their portfolio to provide for their living expenses, as well as other goals, such as charitable giving or gifts to family members. We view the optimal way to get this income is from the total portfolio, regardless of whether it is from the actual dividends of the mutual funds that we recommend or stocks that you may own. The income (withdrawals) that you desire do not necessarily need to come from only the interest and dividends that the portfolio earns, the withdrawals can come from the principal, particularly if the principal is growing over time.

We recommend focusing on the amount of your capital and its growth over time, rather than the annual dividend yield of the portfolio. If the stocks within the portfolio grow at a greater pace than the dividend yield, then you will be much further ahead.

Let’s look at a hypothetical example based on a sample of 6 large US company stocks which have greater than average dividend yields and compare them to the S & P 500 over the past 5 years. The dividend yield of these companies (dividend payout/stock price) is around 4%, whereas the S&P 500 dividend yield is around 1.90%.

If you had invested $500,000 in each of the 6 companies (GE, IBM, Pfizer, Verizon, Wal-Mart and Enterprise Products Partners, a large energy company) five years ago, you would have the following:

 

As you can see, the growth of the diversified portfolio did much better, increasing $2 million more than the 6 high dividend paying stocks. This means that you would have much more capital to withdraw from the diversified portfolio, regardless of whether it came from dividend income or the principal, even after accounting for capital gains taxes.

But what about the dividends? For the high yielding stocks, they would be paying about $161,000 annually, based oeir current value.

The S&P 500 is currently paying a dividend yield of 1.87%, or approximately $111,700 per year.

While this is $49,000 less than the 6 companies are paying in dividends per year, you would have $2 million more in investable assets from which to draw cash, if you needed it. We think most investors would rather have the more significant growth of their investable capital than the higher annual dividend income, as that amount is a fraction of the growth in the capital.

This is only an example, and a rather small one, but we feel it is very illustrative. If other stocks and different time periods were tested, the figures would certainly be different. However, I think the general conclusion would be the same, which is that a broadly diversified portfolio of companies will provide you greater investment capital over the long term than a collection of high dividend paying stocks. For example, over the past 10 years, 5 of the 6 stocks significantly trailed the S&P 500, so the conclusion would be the same over that longer time period, for these companies.

In the actual portfolios which we manage, we stress global diversification across many industries, geographic sectors and sizes of companies (large and small, growth and value). We do not recommend just investing in US Large companies, such as the S&P 500. This was used for only for comparative purposes in this post.

High dividend paying stocks tend to be companies which are having difficulty. They are often companies which are growing slower than the overall stock market, or even declining as a business.

  • IBM just announced their 21st consecutive quarter of declining revenue.
  • So while IBM’s stock pays a 3.73% dividend yield, which is double the S&P 500’s dividend yield, IBM’s stock performance has greatly lagged the S&P 500 over the past 5 years, losing almost 1% per year versus growth of almost 15% per year by the S&P 500.

One theme that I have noticed in recent years is the concept of legacy stocks, which many of these high dividend paying stocks are. These are companies which were in their prime in past decades, are in industries which have gone through significant changes or are quickly evolving now. In general, they are not the companies that are growing and providing the returns which have been driving world-wide stock markets.  We would recommend modifying your portfolio for the future if it now consists heavily of individual legacy stocks.

  • Wal-Mart is facing tough competition from Amazon and online retailing.
  • EPD is facing challenges due to the significant decline in energy prices.
  • IBM is struggling to compete against numerous technology companies.
  • Verizon is facing wireless competition which is causing revenue/subscriber to drop, as well as issues with content and keeping subscribers to their various businesses.
  • Pfizer is quite profitable, but large pharmaceutical companies are always looking for the next major drug.
  • GE has struggled as a company over the past 10+ years. It has undergone a significant transformation, purchased new subsidiaries and sold off other segments of their business.

Each of these companies may succeed in the future. That is not the key issue for us, as investment advisors

Our role is to provide you with the optimal investment strategy that will be durable and successful over the next 5, 10 and 20 years. We are confident that a globally diversified strategy of stock mutual funds will far outperform a portfolio consisting of high dividend paying stocks in the long run.

 

Notes: The above example is for illustrative purposes only. The mutual funds which we recommend own each of the above individual stocks, as a small percentage of certain funds. The illustration does not include the impact of advisor fees and taxes, which would affect actual investment results, but would not change the conclusion of the illustration.

The five year annualized return for the stocks cited above, which is the basis of the calculations in the illustration, are:

This means that the average return per year, over the past 5 years, for WMT (Wal-Mart) was 3.29%. During that same time period, the S&P 500 fund returned an average of 14.77% per year, over the past 5 years.

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