Years of near-zero interest rates have prompted many income-hungry investors to turn to high-yielding stocks as a substitute for bonds. As stocks have climbed to all-time highs and bond yields have continued to languish, that’s likely worked out well so far.

Now some advisors are reviewing their dividend strategies a bit nervously, well aware that a stock-market correction could erode capital invested in “bond substitute” stocks and potentially wipe out income received from dividends.

Given the increased volatility, now is a good time to examine some of the subtleties of dividends and dividend-paying stocks. It's worth keeping in mind the following points, which come from both our own close focus on dividends as value-focused investors seeking undervalued stocks and our research on historical patterns of risk and return.

1. The highest-yielding U.S. stocks tend to underperform over time.

We analyzed the returns of all equity securities listed on NYSE, Amex, NASDAQ and NYSE Arca from 1928 through 2013 (data from Kenneth French, CRSP and University of Chicago Booth School of Business). We divided all companies into six groups: non-dividend payers plus five quintiles of dividend payers, based on yield and rebalanced annually. The nonpayers underperformed all groups of dividend payers, both over the full 86-year data set and many 20-year subsets (a more likely time horizon for most investors).

Among dividend payers, however, the highest-yielding stocks showed an average Sharpe ratio of 0.3 for the 86-year period -- compared with 0.38 for the next-highest paying group. Those “next-highest” yielders also outperformed the universe in most of the 20-year periods within the full data set.

These results emphasize the importance of being wary of “yield traps” among the highest-paying companies. Because earnings ultimately drive dividends, a sustained drop in anticipated earnings usually foreshadows a dividend cut or, in severe cases, bankruptcy. Companies that miss or lower their dividends are often severely punished by the market.

Yield traps can also arise slowly, as a company with deteriorating earnings fundamentals attempts to maintain its dividend policy. In such cases, the company’s payout ratio usually increases -- often a red flag in our analysis of individual stocks.

2. Dividends matter to investors in international stocks.

Domestic equity investors have long understood the importance of dividends. Particularly when the U.S. economy is experiencing slower long-term growth, dividends can make a substantial contribution to total return.

Yet many investors seem not to have noticed that dividends can play at least as important a role on a global scale. There may be an assumption that higher capital appreciation potential makes the dividend policy irrelevant.

In partnership with Dr. G. Kevin Spellman, CFA of the University of Wisconsin-Milwaukee, we analyzed international stocks in a manner similar to the domestic study noted above -- in this case focusing on small- and mid-cap dividend-paying non-U.S. companies over the period between Dec. 31, 1993 through June 28, 2013 (data from FactSet Fundamentals global database). The average 12-month return for the group of highest-yielding stocks was over 16 percentage points higher than for the lowest payers and over 10 percentage points higher than for the universe as a whole.

The Sharpe ratio for the highest payers was also significantly higher than for all other groups.

The moral of the story is to approach dividends as a consequential component of overall returns in all equity investing, not just domestically. The results demonstrate that dividend-yielding stocks can make a meaningful contribution to an international portfolio -- and that higher returns are not always associated with higher risk.

3. Dividend-paying stocks have historically provided some downside protection.

Our historical research on domestic stocks has shown that dividend payers tend to offer some downside protection -- likely due to both their relative earnings stability and their dividend income itself.

On the other hand, nonpayers tend to show relative strength during the initial phase of a recovery -- one reason that value-focused investing can lag on an absolute basis during market upswings.
At the current time, with stocks touching all-time highs, a strategy that embraces downside protection may be especially warranted. Yet there are additional layers of subtlety here -- such as the possibility of investors piling out of “bond-like” stocks if interest rates jump upward.

Another wrinkle relates to sector concentration: Chasing the highest yielders may lead to overrepresentation of vulnerable sectors -- such as financial services prior to the 2008 crash. But on the other hand, our study of international stocks showed a dividend strategy can work well regardless of sector.

The challenge, then, is to look beyond dividends themselves to select attractive companies that not only pay a dividend but offer growth prospects or a catalyst for wider recognition of its value by investors as a whole.

Over the long term, dividends (plus real growth in dividends) are a very important component of equity returns. Since dividend policy is often dependent upon specific company characteristics, industry dynamics and the efficacy of management decision-making, we see value in applying a fundamental investment approach that considers dividend policies in conjunction with other important return factors.

As advisors rebalance portfolios across opportunities for both income and capital appreciation, it may be helpful to take some of these historical perspectives into account in an effort to avoid unpleasant surprises.

Adam Peck, CFA, is co-portfolio manager of the Heartland Value Plus Fund. Robert Sharpe is co-portfolio manager of the Heartland International Value Fund.

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