Advisor Blog

One of our really astute clients asked me why DFA's funds do not emphasize dividend paying stocks.  It's a good question and certainly timely.  It seems that every issue of Barron's and every CNBC show has some "expert" proclaiming that, because corporate earnings have grown and stock prices have remained depressed by fear, there are extraordinary opportunities to buy stocks that pay a high dividend.

Since a dividend is a distribution of corporate earnings to shareholders, it is always accompanied by a similar reduction in the share price.  It is simply a transfer of ownership and it is a taxable event to the shareholder.  Under our current tax law, non-qualified dividends are taxable at the shareholder's ordinary income rate.  In general, dividends paid by US companies that are held for a certain period of time are qualified dividends.  Qualified dividends are taxed according to a more advantageous rate, like long-term capital gains.  So, in a taxable account, the dividend distribution actually results in realization of a gain and taxation that would not have occurred if the earnings had been retained. 

What is the difference between a dollar paid as a dividend and a dollar that is the result of a capital gain?  Ignoring taxes, not a thing.  So, why would a dollar paid as a dividend be so desirable?  It's not.  But, it turns out that stocks that pay a high dividend tend to perform better than stocks that pay no dividend or a low dividend.  Why?  Because they are value stocks. 

But, is sorting stocks by the dividend/price ratio an effective way of adding value exposure to a portfolio?  Academic research indicates that it is not.  The purpose of any scaled price ratio based sort is to produce dispersion in the returns of stocks that can then be used to select stocks with the highest return.  It turns out that the dividend/price ratio does this, but it is a weak relationship and it is statistically unreliable as compared to other methods (and even to other scaled price ratios, like earnings/price and cash flow/price).  What works the best?  According to the research, it's the book-to-market value, or BtM.  And, guess what?  That's the factor that DFA uses to define value stocks.  It's already built into our portfolios.

I saw one of those dumb Scottrade commercials last night where the founder (when he's not out flying around in his purple Scottrade helicopter) touts their "research" capability and suggests that individual investors should use it to pick stocks.  A quick Google search turns up a zillion or so websites and newsletters touting how to do that using dividends.  And, of course, you could.  But, it's unlikely that the results will be quite as spectacular as they might like you to believe.