The Myth of High Dividend Stocks

Some myths are hard to dispel.

In its December 19 edition, La Presse carried a story from The Canadian Press entitled "Dividend stocks, a protection against inflation". A portfolio manager quoted in the article says that high-dividend stocks are the alternative of choice for investors looking for a regular income in a context of low interest rates on guaranteed investment certificates (GICs) and government bonds. They would even offer protection against inflation, precisely because of their high yield.

The arguments in favour of high-dividend stocks are intuitively appealing: dividends paid by publicly traded companies are a source of income that is generally stable despite the ups and downs of the markets and the economy. For those looking for a steady stream of income from their portfolio, dividend stocks seem to be a good solution.

However, our intuitions sometimes serve us very badly in investment.

It's the total return that counts

The first myth to debunk is that it is the total return of the stock portfolio that counts for the investor, even the one looking for income. This return is made up in part of the dividends paid out by companies, but also and above all of the appreciation of their share price on the stock market. Thus, if you focus too much on dividends, you run the risk of under-performing, either by excluding from your portfolio high-growth companies whose shares are rising on the stock market (Tesla and Shopify don't pay dividends!) or, even worse, by buying shares of companies that are unable to maintain their dividends over the medium or long term.

The following chart compares the stock market performance of the iShares High Dividend ETF (XEI) and the iShares S&P/TSX Canadian Composite ETF (XIC) over the past 5 years. Not only was XEI's yield (including dividend) 1.6% lower annually than XIC's (8.2% vs. 9.8%), but its share price also fell more sharply during the February-March 2020 market decline (-39% for XEI vs. -32% for XIC).

Applied to the U.S. stock market, this strategy of selecting high-dividend stocks has generated annual returns almost 10% lower than the S&P 500 index over the past five years.

Protection against inflation?

The argument that dividend stocks offer better protection against inflation is also dubious, to say the least. High-dividend stocks are more sensitive to changes in interest rates, since these companies often have a higher debt-to-equity ratio, which hurts their earnings when interest rates rise. Investors also tend to switch from these companies to bonds when rates rise, causing their prices to fall. Inflation is usually accompanied by rising interest rates, so it is better to invest in common stocks than in high-dividend stocks.

Taxes and fees

As we know, taxes and fees eat up a significant portion of the investor's returns and therefore net income. Here again, dividend stocks are at a disadvantage. On the one hand, dividends are often taxed more than capital gains when paid into a non-registered account. On the other hand, a dividend stock portfolio requires active management (to replace stocks that no longer meet the selection criteria) which forces the fund to realize its gains and its holders to include them in their taxable income. Common stocks, by contrast, pay fewer taxable dividends and require no active management, allowing taxable gains to be deferred often for decades.

The active management of a dividend fund also entails higher fees (0.22% for XEI versus 0.06% for XIC) which affect the investor's return.

What about bonds?

The manager quoted in the La Presse article is right about at least one thing: GICs and bonds do not offer protection against inflation. If inflation persists at current levels, their holders will indeed realize negative returns over time, after inflation. This doesn't mean we should sell our bonds and invest everything in stocks - dividend or not. Rather, the role of bonds is to provide protection against the other major risk: disinflation or its first cousin, deflation. And the current yield on a bond portfolio - including a reasonable portion of corporate bonds - compares favorably to the dividends on a common stock portfolio, which is about 2.8%.

In conclusion, if you are looking to optimize your portfolio's after-tax and after-fee return - whether to generate retirement income or to grow your capital over the long term - focus on a good mix of common stocks of all capitalizations and high-quality bonds. These 2 asset classes are available in low-cost ETFs. When it's time to withdraw from your portfolio, simply liquidate a portion of your ETFs to generate the cash you need and get closer to your target allocation.

If this sounds too complicated, a good portfolio manager will be happy to do it for you!