Do dividend stocks outperform in bear markets?

Since this question was brought up a couple of weeks ago it seems to have polarised a lot of opinion. Everyone has their favourite style of investing and many value investors don’t even care about whether or not a stock pays a dividend. While most do begrudgingly concede that a cash return is nice to have, the idea that dividend paying stocks may have some kind of edge over other investments leads to a sharpening of swords. Where there’s smoke there’s fire, so I thought I’d do a bit of hunting and try to generate enough research links to stoke up it up a bit.

World stock markets have unquestionably been in a long term secular bear market for the last dozen years. As discussed last week, these can be classified as ‘sideways markets’ characterised by the gradual decline of P/E ratios from the great highs achieved at the end of bull markets (such as seen at the peak of the internet bubble in 2000) to the extreme lows many years later. This long term process can take up to 20 years and needs to be thought of as distinct from the more dramatic but cyclical bull and bear swings that occur over the shorter spans in between. Buying and holding stocks can be fraught with danger in such an environment especially as the emotional impact tends to encourage selling and buying at the wrong parts of the cycle. But the relative stability, lower volatility and consistent cash returns of good quality dividend paying stocks do seem to provide a cushion against market falls and may help investors weather the worst of bad times, and even forge a good profit.

1. Dividends provide the majority of the return in bear markets

In his book Active Value Investing, Vitaliy Katsenelson illustrates that between 1900 and 2000 the average annual return from the S&P 500 was 10.4%, out of which 5.5% could be explained by dividends. But these returns were extremely lumpy depending on whether the prevailing environment was a secular bear or a secular bull. He discovered that while in secular bull markets dividends accounted for only 19% of annual average stock market returns (the rest coming from capital growth), whereas in sideways markets they accounted for 90% of the returns. Given that Katsenelson predicts that the current secular bear market will continue on until 2020 this finding alone ought to raise the odd dividend skeptic’s curiosity. The net result is that if you want to make a return from equities in sideways markets, you are going to find it very tough without investing in quality dividend paying stocks.

2. Dividends reinvested in downswings are ‘return accelerators’

In “The Future for investors” Dr Jeremy Siegel, a Finance Professor at Wharton, shows the extraordinary impact that dividend reinvestment can have on equity portfolios when bear markets recover. Siegel explains that there are two ways that dividends help your portfolio in bear markets. Firstly, the greater number of shares accumulated through reinvesting dividends can help ‘cushion’ the fall in value of the portfolio in a bear market, but also “those extra shares will greatly enhance future returns. So in addition to being a bear market protector, reinvesting dividends turns into a ‘return accelerator’ once stock prices turn up."

The maths of how this ‘return acceleration’ works are very simple but quite enlightening. As most companies are loathe to cut their dividend even in hard times, dividend payouts tend to be fairly stable even through bear markets and recessions. As a result if a share’s price falls, the stable cash return from the dividend allows shareholders to pick up a greater numbers of shares than they previously could when reinvesting.

This is easily illustrated. Imagine two companies that both pay a stable 5p dividend over a dozen years. Share A holds a steady price at £1, whereas Share B declines over the first 2 years to 50p before recovering to parity 10 years later. The very counter-intuitive result of such a price decline on total returns to shareholders in B is that they end up wealthier. The greater number of shares that can be bought at cheaper prices with the consistent 5p cash dividend result in the shareholder owning a larger stake of share B which ultimately ends up more profitable.

What is more, the historic evidence shows that it is the continuous reinvestment of dividends in this way that creates the majority of returns for investors in the future. According to an excellent March 2012 paper published by BlackRock, from 1900 to 2010 the return on $1 invested in US stocks with reinvested dividends became $851, whereas without it became just $8.50. Dividend Reinvestment provides all the growth!

3. Dividend payers provide protection against downside

There does though seem to be some disagreement over whether dividend stocks outperform in all market conditions. James Bianco of Bianco Research recently stated that “Rather than viewing dividend stocks as a way to capture extra yield, in the past we have stressed that dividend stocks should simply be viewed as a slightly less risky form of stock investing… As such, we should expect dividend-paying stocks to outperform during bear markets and underperform during bull markets.” Taken in isolation this is certainly true, but it’s the smaller drawdowns in bear markets that seem to have the greatest impact on future returns. Comparing the returns of US stocks in 15 Bull and 14 Bear markets, a Ned Davis research study found that since 1972 S&P dividend payers had outperformed non-payers by 12.5% on an average basis in each bear market while outperforming by 3.4% in each bull market.

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Caution 1: dividends are not a panacea!

While much of the above article has focused on the positives that dividend paying stocks provide in bear markets it must be remembered that the statistics shown are averages and that dividend stocks are not a panacea.  Anyone reading the above and rushing out to buy high yield stocks would probably need their head examined.  Amongst dividend paying stocks there is a huge divergence of returns due to the quality of the underlying company and the sustainability of the dividend.

Much research by Soc Gen has shown that ‘low quality’ stocks (as defined by them in their Quality Income Methodology) have had negative returns over the last decade, and not only that but the highest yielding quintiles of stocks actually have lower realised yields than lower quintiles due to the impact of dividend cuts.  Investors should not need reminded of the dangers of investing too heavily in high yielding names (e.g. the banks in 2007!).

Caution 2: dividends could be bubbling

The recent dividend outperformance and the ongoing hunt for income in a central bank dominated and yield starved world has forced investors to look beyond bonds and fixed income investments.   The rise of dividend ETFs have certainly encouraged a big surge of investment from retail investors and their increasing popularity has led to some quarters, such as the FT, to question whether a 'dividend bubble' has started.

To me the phrase dividend bubble is an oxymoron, as high dividend stocks by definition have low valuations, but in the modern witchcraft of finance where everything is relative, anything is possible.   Certainly the yield difference between highest dividend yield and lowest dividend yield quintiles in US stocks has rarely been narrower at around 1% for the Russell 1000 providing fuel for the dividend bears who insist the yield differential must widen.

But the bulls point to the fact that top dividend paying stocks are historically still very reasonably priced. According to Empirical Research Partners, aside from the 2009 lows, this is the only time that top non-US dividend payers have traded at less than 10x earnings since the 1990s.

To bring this ramble to an end, I'll say that all my reading and research in recent weeks has definitely swung my opinion to heavily favour a dividend biased approach to investing during secular bear markets.  Of course, red most blooded stock pickers I know would rarely have anything to do with boring dividend focused strategies.  When markets are swinging up and down from week to week like monkeys in the trees, focusing on dividend investments seems a bit like watching paint dry.  But that's probably why there are so few who have actually got rich from investing - most have got rich off OPM. 

Comments as ever encouraged.

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