On Dividend Investing Strategies

Every video/post about dividend investing should start with a big, clear disclaimer that says “This investment strategy is suboptimal; it might help you behaviourally but you are going to pay for the privilege”. Like those ads against piracy before a movie or the banners on cigarette packs.

Imaging investing using a strategy that you know, already at inception, will underperform…It is like supporting Team Italy in any national competition: you are going to suffer and you are conscious about it even before the game begins.

Buying high-dividend-yield and dividend-growth stocks incidentally gets you exposure to factors like Value, Quality and Profitability; factor investing can indeed improve returns, enhance diversification and reduce risk, over the long run. What I do not understand about dividend-investing zealots is how they managed to arrive…only halfway there.

I recently stumbled on this pic on Twitter:

Accompanied by this consideration: “Putting aside the factor premium arguments, the problem with these div growers charts is that they are ex-post results of a variable that provides no forward insight. This presumes you can cherry pick future dividend growers in advance with any degree of accuracy. There is no dividend growth momentum factor” Jason Pereira.

Jason’s tweet reminded me of my very early trading-model-building career. I was working on an FX carry model, in particular on the relationship between 2-year interest rates and related currency pairs. The model checked the relative moves in 2YR IRs and went long / short the appropriate currencies; nothing really fancy. The model worked great on paper…until I discovered that it was basically checking the end-of-day rate moves and then, with that information, was “going back in time” at the beginning of the same day and place trades based on that knowledge. In my defence, I later discovered this is a typical rookie mistake.

Obviously, the stocks of companies that grew their dividend over time had great performances. The issue (and this should not come as a surprise) is that “past performance is no guarantee of future results”. That graph is like a rear-view indicator; the only way an investor could have profited from that performance is if they knew AHEAD OF TIME which stocks would have increased their dividends IN THE FUTURE.

This aptly represents a common misconception among dividend zealots, that dividends are somehow something static..or worse, an amount that can only go in one direction: up. Unfortunately, dividends are related to profits and profits tend to go up and down. In particular, high dividend yields are more likely to go down because of a cut in the next dividend than because the stock price was unreasonably low.

This is not the only misconception circulating among the dividend zealots, so let’s dive into this fascinating world.

“If a company is not able to re-invest its profits at a reasonable rate of return, it is better that the company pays dividends to shareholders, so they can invest in an optimal way”

No misconception so far. It is what comes next that is somehow cognitive dissonanc-ing. If the Executive Team of a company tell investors they do not have enough good investment opportunities AND investors understand that…how do dividend zealots end up taking the dividends and re-invest them in the same company?!? They should spend their time looking for the NEXT big dividend payer, not the current one.

The idea of growing a dividend-distributing portfolio, especially when you do not need the cashflows, is an absurd left pocket/right pocket type of mental accounting. The investors should aim to build a portfolio of stocks that grow their profits, irrespective of the fact that those profits are paid out as dividends.

As a reminder, receiving a dividend or selling the same amount of stocks is the same thing. Dividends are a less practical choice, cash flow-wise, because it’s not the investor who chooses the amount but the company. The company doesn’t know your preferences or circumstances, they care about where they are in their lifecycle and what their average (or biggest, or loudest) investor preferences are.

“Accumulating ETFs continue to buy shares in any market regimes. Distributing ETFs are better because give control back to investors“

Ah ok, so you are good at market timing. Why don’t you generate extra profits out of your above-average forecasting prowess then?

This is a misconception because again, even if the investor would be able to profitably time the market, dividends would not matter; the investor could simply sell their portfolio holdings when they think it would be ideal to do so. Why should they re-adjust their portfolio based on the dividend amounts received? Why not more? Or less? Go on your broker platform, yes there, bottom right, you see that (usually) red button that says “SELL”? Yes, that’s the one. That button allows you to generate a cash flow whenever you feel like it…magic, innit?

“When markets are down hard, the dividend cash flow is a big psychological aid”

Well, if you manage to not peak at your portfolio p&l? Otherwise, you would see an even BIGGER loss. Again, this is just mental accounting. Being down 20%, however the split between the price change component and dividend income…the investor is still down 20%. But I get it, we are all different and might react differently under the same circumstances.

What is funny is how uncommon is to find the complete picture, i.e. price change + dividends. Alpha Architect just posted a paper that shows how rarely the financial press presents the true total return investors achieve: usually they limit themselves to price changes. Aside from Portfolio Visualiser and Bloomberg, it is really hard to find an ETF historical total return calculator. I used a few brokers in the past that wouldn’t give me that information about my account, I had to calculate it myself (thank God InteractiveBrokers is not one of them).

On the other extreme, I see many dividend zealots that report only their portfolio dividend flows without mentioning the underlying stock performances. If Cliff Asness calls Private Equity shops volatility launders, those guys are probably volatility…Clorox?. The Next Level craziness is represented by those guys that add option premiums to dividends and…that’s it, no other position is ever disclosed: the ultimate “let me show you how much I do not understand the meaning of income”.

Stock Picking

Picking names based on their open streak of dividend growth is easy; the hard part is to design profitable rules on how to turn the portfolio. The worst possible moment to sell this type of investment is probably just after the company announced a dividend cut. At least there is no misconception on this point among the zealots. But I find it telling how normalised even stock picking got in this bizarro angle of the investing world.

What I am reading now:

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