Dividend vs non-dividend stocks – which provide higher returns?
Why do you buy a stock? Whether it be a dividend stock or a non-dividend stock, the fundamentals do not hugely differ. It is because you want to receive great overall returns. This may be from either capital appreciation or from dividend payments.
When choosing an individual company to invest in, you essentially trust this company to grow your money. In doing so, there are two conflicting arguments regarding dividends.
- A company will provide you dividends on a regular basis. By doing this, they are returning the growth they have earned on your original investment back to you. These are “dividend stocks”.
- A company will reinvest its profits (the growth they have earned for you), into future projects that will lead to further growth. They therefore do not distribute, or only make a small, annual dividend to investors. These are “non-dividend stocks”.
As a simple example, let’s imagine that you have invested $1000 into company X. Company X makes annual profits of 10%. The dividend stock pays $100 as a dividend. The non-dividend stock keeps the $100 and reinvests.
Therefore, in both examples, you have $1100. With the dividend stock, you have $1000 invested in the company and $100 in cash. With the non-dividend stock, you have $1100 invested in the company. What’s the difference?
Well, the monetary total is the same. However, in the non-dividend stock example, you effectively have more invested in the company. As a long-term investor, we are not interested in having this cash. In the long-term, it is always better to be invested in the market than in cash: returns on stocks historically outperform cash.
Assuming the company can afford to pay a dividend (they have sufficient growth, appropriate cash-flow, etc), one may assume that the non-dividend paying stock is better. The company is effectively arguing that they can reinvest your profits more effectively that you can. If you believe that the company is a great long-term play, then this should be true. This is most prominently the argument of Berkshire Hathaway, which has proven its worth in the long run:
Therefore, in theory, if you have confidence in the company, non-dividend stocks would seem like the better option. After all, if you are happy to invest in the company, you will be reinvesting the dividends anyway – so why not save the time, effort and expense of trading fees? Well, the historical data argues otherwise.
Long-term historical returns of dividend vs non-dividend stocks
The incredibly useful Ken French data library provides some great data on this subject for US companies going back to 1928. What does this data tell us?
The first thing the data provides is the simple average annual return of companies split into four sections:
- non-dividend stocks – dividends payments of 0%
- low-dividend stocks – the bottom 30% of companies ranked by dividend yield
- medium-dividend stocks – the middle 40% of companies ranked by dividend yield
- high-dividend stocks – the top 30% of companies ranked by dividend yield
What can we learn from the simple averages alone? Firstly, that there is some difference in the results. The average of “good dividend payers” (medium and high dividend) is 12.9%. The average of “low/no dividend payers” is 12.4%.
This 0.5% difference doesn’t seem like much. However, just $1,000 invested in 1928 at these average returns would lead to a pot today of $3.4m and $2.3m for good dividend payers and low/no dividend payers respectively. That means your worth today from that initial investment would be 46% higher in better paying dividend stocks.
Shorter-term historical returns of dividend vs non-dividend stocks
Sometimes, looking at very old data can be slightly midleading as the investing landscape changes over time. However, we do not want to be overly effected by recency bias, and only look at the last few years. Instead, here are the same simple returns since 1988:
Over the past 86 years, the average return has been 12.7%. Over the past 26 years, the average return has been 12.9%. Not a huge difference in the averages. However, this time the no/low dividend payers (13.1%) have outperformed the good dividend payers (12.7%).
The reason why this is the case provides some very interesting conclusions into why the long-term returns of high dividend paying stocks are higher than low dividend paying stocks.
Dividend paying stocks perform better in times of volatility
From the data sets above, we can see two things.
- In the past 86 years, 30% of the time the market returns an annual loss.
- In the past 26 years, 16% of the time the market returns an annual loss.
Non-dividend stocks (growth stocks) tend to perform to the extremes. In good years, they return higher profits that dividend stocks. However, in bad times, they create much greater losses than the dividend stocks.
To prove this, we have analysed the following from the data:
In good times, the average growth stock outperforms the high dividend payers by 37%. However, in bad times, the returns are 150% worse! Therefore, the lower percentage of negative years since 1988 explains the strong performance of no-dividend stocks in this period.
Standard deviation of dividend vs non-dividend stocks
This volatility can be statistically represented by looking at the standard deviation of each section:
As expected, the standard deviation (representing the volatility) of the no-dividend stocks is easily the highest. However, interestingly, the second most volatile class is the high dividend paying stocks. This is presumably as in tough times, the dividends have to be slashed or the company suffers difficulties with their dividend cover.
In the long-run, this is a double win for dividend stocks. Not only do they produce higher average dividends, their standard deviation is 21.17 compared to 33.58 for non-dividend stocks. This means that dividend stocks produce higher returns and are lower risk than non-dividend stocks!
Dividend stocks are better than non-dividend stocks
Overall, the data suggests that this is the case. Giving a score from 4 to 1, 4 being for the best result, 1 for the worst, the totals agree with the above conclusion.
Interestingly, the worst performing stocks are low-dividend stocks. Therefore, you should either go for pure growth stocks (non-dividend stocks), or high dividend paying stocks.
Why do dividend stocks provide a higher return than non-dividend stocks?
In our above analysis, we have already seen that one reason is that high dividend stocks are effected much less badly than growth stocks in times of trouble (-9.4% average falls in down years compared to -23.6% for growth stocks).
Another reason may be because “cash is king”. In business, a company’s cash flow (particularly in difficult economic times) is extremely important. Unless a company’s dividend cover ratio is extremely poor, a high dividend payment will usually suggest that the company has sufficient cash resources to pay the dividend.
Finally, a dividend policy may actually lead to more selective, higher returns. After paying the dividend, companies are often forced to restrict their investments more stringently and this generally leads to better decision making and therefore better overall returns.
A side note – a thumbs up for dollar averaging!
Finally, when pulling together this research, I noted something that was too important not to share with you! This was the importance of dollar averaging. I’ve investigated this subject before, and concluded that the overall long-term returns are not hugely different if you dollar average or not.
However, I made the point that due to volatility, it is safer for you to dollar average your investments.
An extract from the linked article suggests:
This data shows the importance of reducing the volatility over the first few years. The data starts in 1928, just before the great depression. As such, here are the “invest at once” vs “dollar average” returns on this data set:
Therefore, even though we have lost out on several years of potential returns (in reality, you would place your un-invested funds into cash), the returns by dollar averaging are much greater over time ($55m greater in the high-dividend example).
Another point worth mentioning to finish…
If you invested entered $10k into the market by dollar averaging between 1928 and 1937 in higher dividend paying shares, you would have $144 million in 2013!!!
Yes, you would have been 18 in 1928 and 104 today, but that’s a pretty good sum to be pushing down the family tree.
If this is all alien to you, here is an introduction from moneyweek on what dividend stocks are: