Scandalous accounting methods, massive corporate failures, and increased global economic and political instability over the past four years have produced one of the most volatile market environments many investors have ever experienced. The resulting greater risk built into the average investment has left many investors seeking methods to shore up returns while minimizing risk. We believe that a strategy focused on selective investment in dividend-paying stocks may offer just such a perfect blend of maximum return for a given level of risk.
Indeed, a recent study by the Investment Company Institute (see figure 1 on page 101) suggests that a good portion of the investing public has shifted to a lower-risk investing mindset. Wanting a lower-risk portfolio is one thing, but constructing a lower-risk investing strategy can prove to be a markedly complex endeavor. Historical evidence suggests, however, that an investment strategy focused squarely on dividend-paying stocks can offer market-beating returns at below-market risk.
The difficulty in building a lower-risk portfolio begins with the definition of risk. That's because distinct groups of investors view risk in different ways. For example, our experiences corroborate the findings in the Investment Company Institute study and suggest the average investor would be more than happy to perform as well as the market when it is rising but would throw heaps of scorn at the manager who did not guard against inevitable portfolio declines–even if his overall performance beats the market. Therefore, "risk" to the average investor means simply the potential for loss.
Among most professional market observers, however, the definition of risk is much more complex and is measured most often in terms of the potential upside as well as the downside of a stock. This group quantifies risk using a value known as beta, which measures the manner in which the returns of a specific security generally move in relation to those of the overall market. So beta measures the historical volatility of a security's returns in relation to a specific market index. A beta of greater than 1 means the security generally overshot the market when the latter was going up. A beta of less than 1 means the security saw a smaller decline than did a falling market. In sum, the risk of an investment in a particular security is most often measured by the volatility of the security's returns over time relative to a market proxy.
Lower Risk, Higher Returns
Referring back to Figure 1 at right, most investors opt for average returns in exchange for average volatility. That is, they look for stocks that experience price changes of a magnitude equal to those of the market. But what if they could invest in stocks that offer lower-than-market levels of risk while generating market-matching, even market-beating, returns?
It may be surprising for many investors to learn that in the past 15 years, the largest dividend-paying stocks posted superior returns relative to both the market and to their non-dividend-paying peers. But they offered lower levels of risk.
How can this be? Over the past 15 years, we found that large-capitalization dividend-paying stocks generated returns that were less volatile than their non-paying peers. That is, the beta on their returns over the study timeframe was 0.88, versus 1.57 for non-dividend payers. Dividend stocks therefore were less risky investments over the study timeframe. As surprising as it seems, though, the dividend payers achieved an average annualized total return (capital appreciation plus reinvested dividend income) of 13.4%. That exceeds the 11.7% obtained by their riskier non-paying peers. These results are featured in Figure 2 below.
It would be reasonable to assume the higher-beta, non-dividend payers would outperform the dividend payers. In fact, that was the case before the bursting of the bubble–the excessive growth in U.S. markets starting in late 1998 and ending in March 2000. Figure 2 illustrates that the largest non-dividend stocks began in mid-1999 to significantly outperform the dividend payers. At that point, the higher risk the investors supported began to really pay off. Turning to the "Large-Cap Risk/Return" portion of Figure 2 at bottom left, the 100 largest non-dividend payers returned an average of 27.7% per year in the 10 1&Mac218;4 years before April 2000, outpacing the dividend payers' 20.7% per year. Returns for the dividend payers still proved relatively less volatile, however, showing a beta of 0.94 versus the non-payers' 1.41.
Nonetheless, when the market turned south in 2000, lower volatility worked in favor of the dividend payers (see Figure 3 on following page). Large-cap dividend payers as a group lost 1% annually in the four and one-third years since the end of March 2000, and the Wilshire 5000 lost 6.5% per year in that timeframe. But the non-dividend payers lost 18.2% annually. That's just slightly less than the abysmal performance of the tech-heavy Nasdaq composite index, which has lost 18.5% per year since then. Once again, the dividend payers were less volatile in their performance, turning in a beta of 0.78 versus 1.81 for the non-dividend payers.
For Mid Caps, a Different Story
We extended our analysis to mid-cap stocks, for which we found a slightly different story in terms of overall returns, but one that still demonstrated a penchant for strong returns at sharply lower levels of volatility. These findings are detailed in Figure 4 on page 102.
It would be unwise to assume that dividend-paying stocks will continue to outperform the market and their more volatile peers while showing lower volatility, as the higher volatility experienced by the non-dividend payers should result in higher returns in the long run. In fact, current S&P 500 members that paid dividends in 2003 returned on average 34.1% last year, versus 62.7% for those that paid no dividend. But the former currently maintain an average beta of 0.8, versus 1.7 for the non-payers. That is an important feature in the context of returns for each group this year. In the seven months ended July 2004, S&P 500 dividend payers rose 3.9%, while non-payers lost 3.7%.
