Episode #71: How to Outperform One of Investing’s Most Beloved Strategies
Guest: Episode #71 has no guest. It’s a “just Meb” show.
Date Recorded: 9/5/17
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Summary: Episode 71 is a solo-Meb show in which he reads a white paper we’ll soon be publishing. The white paper might be a tad controversial as it calls into question an investing strategy that’s so beloved, it borders on sacrosanct.
What’s the strategy? Since this is a shorter episode, we won’t reveal it here. Instead, here’s a bit from the paper’s introduction…
“…Similarly, if you worship at the altar of this wildly-popular investing strategy, you too may find this paper’s contents equally blasphemous.
Yet if you find yourself feeling that way, I would encourage you to keep an open mind, for rejecting what you’ll read today would only shortchange yourself. That’s because I believe the approach I’ll suggest you consider in place of this beloved strategy has the potential to increase your returns significantly. And that’s just the start, because it also carries benefits that could result in even greater improvements for taxable investors.”
What are these strategies? Find out in Episode 71.
Links from the Episode:
- 1:57 – Introduction
- 2:45 – Starting the reading of the white paper
- 2:58 – Why you might curse this information
- 4:35 – Challenging the dividend focused investing strategy
- 5:03 – “The Dividend Growth Myth” – Faber
- 5:19 – Fama-French Data
- 5:44 – The five buckets that were used to compare to test this theory and why the high yield dividend fund outperformed
- 6:44 – The real-world application of the strategy that is worth questioning
- 8:19 – Behavioral challenge of abandoning dividends and the brand they have created
- 11:28 – Sponsor: ROOFSTOCK
- 12:35 – Building a better mousetrap
- 12:51 – “What You Don’t Want to Hear About Dividend Stocks” – Faber
- 13:50 – Using and evaluating traditional value factors in your investing strategies
- 17:52 – Takeaways from the research
- 19:05 – Looking at some of the variances in strategies
- 21:06 – Who agrees with the non-dividend strategy….Warren Buffett
- 22:20 – The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success – Thorndike
- 22:59 – Invest Like the Best Podcast with Will Thorndike
- 24:00 – Buffett’s 2012 Letter to Shareholders
- 24:04 – Conclusion
Transcript of Episode 71:
Welcome Message: Welcome to The Meb Faber show where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the Co-founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Sponsor: Today’s episode is brought to you by Roofstock, the leading online marketplace for buying and selling lease single-family homes. Are you interested in adding rental real estate your portfolio? A recent white paper called the rate of return on everything examined low asset class returns all the way back to 1870, and concluded that residential real estate, not equity, has been the best long-run investment over the course of modern history. Roofstock offers quality prescreened, single-family rental homes located in some of the best real estate markets in the country. The quality tenants are already in place paying rent.
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Meb: Happy end of summer to all my podcast listeners out there. I am probably somewhere near the arctic circle while you’re listening to this. I’m gonna read today new research piece we have coming out which we haven’t even published yet. So, for those of you that love the sound of my monotone voice, good news, because there’s no Jeff, no guests. And if you hate it, and you can’t stand the audio version books that we do, well, you can sign off now. But we’re gonna talk about a really fun research piece today that goes against a lot of what people really believe. It’s one of the biggest sacred cows in investing. So, you can probably learn a lot, probably hate me for this one, a lot of you, but I think it to be a lot of fun. So let’s get started.
The title of this which will probably change, by the way, because it’s not the best title is called “The Simple Way to Be One of Investing’s Most Beloved Strategies.” I’ll take one sip of LaCroix and then we’ll get started. By the way, mango flavour, not the best. To the great dislike of the church in the early 1600s, Galileo is expanding upon Copernicus’s idea that the earth revolves around the sun. In short, things escalated, the pope got involved, there was a trial, the threat of torture. Eventually, Galileo was found vehemently suspect of heresy and sentenced to imprisonment. And to punctuate this point, the church required Galileo to abjure, cursed, and detest his own heliocentric opinions.
I bring this up because you may find yourself feeling a similar impulse to curse and detest this white paper or this podcast audiobook by the time you’re finished listening. Why? Because it calls into question investing strategy that is so beloved, it borders on sacrosanct. And just as the church found a heliocentric model blasphemous, similarly, if you worship at the altar of this wildly popular investing strategy, you too may find this paper’s contents equally blasphemous. Yet if you find yourself feeling that way, I would encourage you to keep an open mind for rejecting what you’ll read today and listen, would only shortchange yourself. That’s because I believe the approach I’ll suggest you consider in place of the strategy has the potential to increase your returns significantly.
And that’s just a start because it also carries benefits that could result in even greater improvements for taxable investors. I can only hope this is not in with the threat of torture, the modern equivalent, are too grumpy emails and anonymous hecklers all across the financial blogosphere. So let’s get started.
Killing our sacred cows. The idea that might label me an investing heretic involves the dividend focus investing strategy. And there is abundant research supporting the historical outperformance of investing in dividend-paying stocks, and especially, high-yielding dividend stocks. And we’re not gonna get in this today, but if you want an interesting aside on the call to dividend growth investing, you’ve heard me talk about how much I hate it before as opposed to simple high yield which we will talk about today which beats dividend growth, by the way, please see our article, “The Dividend Growth Myth.” We’ll come back to that.
But if you google dividend stock performance, you’ll find hundreds of research pieces and charts demonstrating the historical outperformance of investing in dividend stocks, and we’ll show a figure in the book, but basically what we did is we took the French [SP] pharma data, which you can get for free by the way if you Google French [SP] pharma data, it has investing data goes all the way back to the 1920s. And they chop up all sorts of different ways, they get value and dividends and size and momentum. They even have some international stuff. It’s really one of the best investing resources a lot of people don’t know about. You can download it on Excel and it’s free.
So what we compared, we said, “All right, well, five series. We’ll chop this into third buckets of high-yielding stocks, medium yielding stocks, low-yielding stocks, and then another bucket of stocks that don’t pay any dividends, and of course, compared to the broader market.” And it is exactly what you’d expect. You would expect no dividends to be the worst performer, followed by low dividends, then the broad market, which is pretty darn close to the middle yields, and then high yield outperforms all of them. And no one should be surprised about that, that’s kind of basic investment theory over time, the dividend yielding stocks. And depending on how you weight them, if you market cap or if you equal weight them, outperform the broader S&P by, let’s call it, one to three percentage points per year. And that’s an enormous number.
Now, as some of the detractors would say, “Well, you have a little higher volatility, you take more risk in owning some of these high-yielding dividend stocks.” But in general, that outperformance is real. But from time to time, I’ve had a very real world implementation question. Research has shown that a significant portion of the total return of a dividend strategy comes from the reinvestment of the dividend payment itself. Of course, right, total return is simply price appreciation and dividends, but you have to reinvest those dividends to get that sort of total return really compounded.
But over the years, dividends have been subject to various tax treatments. We all know Uncle Sam will not be denied. So at times, high tax rates have substantially reduce this portion of returns because dividend, you get that check every quarter, you’re paying taxes on that every year. So, while they’re currently taxed at 15% or zero, if you’re in a low enough tax bracket, dividends have been totally exempt from taxes at times. And other times, they’ve typically been taxed in the individual’s income rate. And that’s been up to, and I’m not kidding you, as high as 90%.
So given this, I was curious so I wanted to run a thought experiment, “Could we create a strategy that replicated a dividend strategy’s total return and that one to three percent outperformance, but without the actual dividends? If so, could we sidestep this terrible tax treatment altogether and thus increase our after-tax returns?” Put another way, “Can we create a superior dividend strategy by avoiding dividends?” Now, for those readers who find this question distasteful and are about to stop listening, I humbly request you try to stomach the following reading. If you decide to stop listening, at least you’ll have done so with a more informed awareness of a bias which may be influencing your allegiance to dividends, possibly, to a far greater extent than you’re aware.
Let’s talk about the behavioural challenge with abandoning dividends first before we get into the nuts and bolts. Many dividend investors, listening to this, may find themselves sceptical of a strategy suggesting that they should avoid dividends, it’s understandable. So prior to even detailing the replacement strategy that’s the focus of this talk, let’s directly address the challenge that accompanies the strategic shift. Starts with a question, why do so many investors have a love affair with dividends in the first place? Thinking back to the 1980s may actually help provide an answer.
Back in the 80s, Pepsi started running the Pepsi challenge which was TV commercials featuring taste tests that would pit their soda against Coke. Tasters would take sips of each unmarked beverage and then were asked to declare which soda they preferred. Now, invariably, Pepsi was the favourite. Coke conducted its own trials, and astonishingly, found similar results. The offsider reason was that Pepsi’s formula’s sweeter and this led to the conclusion that Coke needed changes formula which resulted in the disastrous abomination called New Coke.
Now, what’s fascinating is that even though people prefer Pepsi when tasting blind, people still buy coke to the extent that it commands a much larger share of the soda marketplace than Pepsi. And more pointly in taste, research found that the full knowledge of the brand led to the results changing. People responded differently, the majority claiming to prefer the taste of coke. And I’m one of those people, I love coke, actually I like Diet Coke more, but Pepsi tastes really really too sweet for me. Why is this? Are people totally irrational or are there other factors at play?
Childhood memories of drinking a coke with grandpa, sitting on the front porch swing, or perhaps warm, fuzzy feelings you have from watching the polar bear commercials during the Super Bowl. Regardless, the simple conclusion, there is more work than simply taste or even logic alone, brand means something. Now, is there any reason to believe it would be different with investing? Dividends also have a great story. You may have learned about them from your parents or perhaps when you took an investing course in college or perhaps you simply associate them with passive income. And chances are, your dividend investments might have performed well for you. That’s because, historically, when you invest in dividend stocks, you add a value tilt to your portfolio. This is one of the key reasons that investing in dividend stocks works, they’re value stocks.
However, I would argue that dividends have developed a great brand. Much like coke, thoughts of dividend stocks immediately conjure images of regular checks arriving in the mail from profitable, established companies as you lounge on a white sand beach sipping pina colada. It’s hard to overcome this deeply grooved neural with dividends and good. Just ask the person who will rule the preference for their own taste buds when seeing the name coke on the side of a can. So what’s an investor to do? It starts with awareness. In this case, I simply suggest that you be aware of the extent to which your first reaction is to reject the information you’re about to receive. Then, do your best to evaluate it objectively based on the numbers you’ll hear, not your preconceptions. But I believe what you’re going to find is that dividend investing, while generally, a solid market strategy with a great brand, is not necessarily the best wealth building strategy.
With that realization as a foundation, you can then ask yourself whether your allegiance is really to dividend investing or instead, to the brand of dividend investing.
Sponsor: Let’s pause for a moment to hear again from our sponsor. Today’s episode was brought to by Roofstock, the leading online marketplace for buying and selling lease single-family rental homes. I actually interviewed Roofstock’s founders, Gary and Gregor, back in Episode 63. And I was genuinely impressed with how these guys are radically simplifying rental real estate investing. The process used to be incredibly time intensive. Firstly thing you had to do, identify a market, look at tons of homes, then do some due diligence, make some offers, negotiate the price, and finally buy. And then, you had to find a property manager to handle leasing and operations for you. What a nightmare.
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Meb: So let’s talk about building a better mousetrap. Historically, dividend and value stocks share many similarities. Investing in dividend stocks in high yielders has historically worked since dividend stocks are traded at a valuation discount to the overall market, which we discussed in a 2016 piece, “What you don’t wanna hear about dividend stocks.” And we probably referenced one of those Shaughnessy pieces that says, “Dividend stocks historically have worked because they traded on a 20% discount to the overall market.” And like many factors, that valuation discount waxes and wanes. So it hit the biggest discount it has ever hit in the entire history of that study. I think it goes to the ’60s when it hit a 50% discount to the overall market in the late ’90s. No one wanted to have been in socks, you couldn’t sell them, everyone wanted the high-flying Internet stocks.
And then in this past decade, as the search for yield, as interest rates have come down, as returns have come down, people had to search for income. And so a lot of this is pushed dividend stocks actually get expensive for the first time ever. But in general, historically, they’ve worked because they are a value tilt. So my effort to find a non-dividend strategy with similar returns to a normal dividend strategy, why not use traditional value factors? So to test results, our partners with our old friends at Alpha architect, Wes Grey and Jack Vogel, both who have which have been on the podcast, and we examined the strategy all the way back to 1974 and the results are quite stunning.
So we’ll talk about a table here that examines the very strategies. First is S&P 500, so broad market cap weighted stocks. And by the way, market gap means you’re investing the most in the biggest stocks like Apple and Amazon who probably have like a four in a 3% weighting in the index. I mean, it’s simply their size, not the size the revenue’s earnings but the size the actual company as determined by price to share is outstanding. And it demonstrates the market that is the market, a market cap weighted index, but we’ve talked about a lot in this podcast not necessarily the most optimal way to weigh the stock portfolio.
So then we’ll talk about, we expand it a little bit in the say let’s go to Top 2,000 stocks and we equal weight them. And because the reason is we wanna show the difference between market cap weighting and equal weighting. So the perspective right now is S&P since 1974, this is through 2015, did 10.77% a year, pretty awesome returns. In the Top 2,000 stocks equal weighted, did 2% points better at 12.8%. So just moving away from market cap weighting, breaking that price base link, you end up outperforming by 200 basis points, two percentage points more than the S&P.
So next, we said, “All right, what if we take the top 100 stocks equal weighted by yield, by dividend yield, how does that do?” Well, it turns out that that adds about another one percentage point outperformance over the equal weight, so 13.87%. A lot of people would have compared that to the S&P where they say, “Oh my God, it outperforms by three percentage points per year.” Well, realize two percentage of that outperformance is probably due to equal weighting and moving away from the market cap weighting. It’s already right there, you can see that, yes, dividend yield does work, but it’s not as dramatic when compared to equal weight versus S&P.
Next, we say, “All right,” you know, a lot of people would talk about value factors in different ways, some people would say price earnings, some price sales, price to book, enterprise value to EBITDA. Well, let’s just combine all four of those into one value composite, that way you get a just pretty good overall viewer value in general. We’re not trying to cherry pick one of these factors. And so if you take the top 100 stocks versus value composite, it’s 17.38% returns, monster returns. Now, part of that’s we’ve known value works but in general, that’s over three percentage points more than dividend yield investing.
So right there, it goes the show that value investing has, can be a much better…focusing on value can be a much better value strategy than relying solely on dividend yield. Now, the extension we make now is to say, “Okay, what happens if we take away part of the dividend universe first?” So, we’re gonna run that same value screen but after excluding 25%, 50% of the dividend stocks and then excluding all dividend stocks. So, could we replicate the value returns? Originally, the original idea was to replicate the dividend returns but then can we replicate something similar to value by executing part of the dividend universe? And it turns out by excluding the top 25%, you only reduce your returns by about ten basis points. You take out the top 50% of dividend stocks, that’s probably taking the universe down pretty far, you’re only reducing returns from the value composite by about 1.4%. So that still outperforms dividend yield by two percentage points.
So, the cool part is you’re now taking, I think, the average dividend yield on that portfolio, the high yielders back to the ’70s was something like 12 percentage points. I mean, amazing, right? The highest yielding portfolio in dividend world now is like four, maybe six. But then you have, just by doing, removing the top 25%, you take that all the way down to, I think, 4%. So it’s like a third of the dividend yield. So all of a sudden, you’re gonna be a lot more tax efficient because the yield is much lower. So we’ll get to that in a second.
So what can we take away from this research in general? The first simple takeaway is that every one of the value strategies we just examined, so value composite, then avoiding 25%, 50% of dividend stocks and all of them beats the dividend strategy. And that’s a pretty stunning conclusion. So, I was hoping to find a strategy that might approximate the returns of a dividend strategy as a starting point before then factoring in tax advantage, but it turns out, by focusing on value and avoiding or eliminating dividends entirely, we’re already miles ahead. But it’s about to get better because now is the time to include the tax effect. And when we account for Uncle Sam, the outperformance of the dividend avoidance, low valuation strategies even more pronounced.
So, while those fat 4%, 6%, 8%, or even higher dividend yield sound great, realize you got to pay taxes on that income every year. So, we ran a couple simulations using real historical tax rates at the lowest and highest tax brackets. And we found that the benefit of avoiding dividend stocks while adding a value till reaps huge rewards over time. And so we’ll talk about the best and worst performing variants here in a bit, and obviously, the white paper will have this out in charts and tables, you can study it much more when you’re not driving or at the gym.
But so, first, we’ll take a look an investor who pay no dividend taxes or liquidation tax. And that’s a pretty rosy scenario but that might be a person who invests in a retirement account and then decided to donate it to charity. You know, and so, as you see, remember value still trumps everything, you know, that’s a much better strategy, historically, than dividend yield alone. But that’s a pretty unique sort of situation, not many people have retirement accounts and donate it, they usually pay taxes at some point. So next, we examine a taxable account but then still assume he donates the shares. So that if you look at the S&P…So we’ll talk, we’ll look at a high tax rate because there’s about 12 of these variants, I don’t want to talk about them all, you’ll fall asleep. But that takes the S&P’s return from 10.7 down to 9.83. And then it takes…but it takes the dividend yield from 13.87% all the way down to 9.27.
So, despite the fact that the dividend yield strategy beat the S&P by three percentage points, after tax, it now underperforms the S&P. And one of the biggest takeaways from the study it was pretty much that you should almost never own dividend stocks in a taxable account ever because very rarely do they outperform the S&P just on its own. And the second takeaway was, of course, you should don’t value instead of dividends. So, if you then look at, we have one, two, three, four, five, six, seven simulations. Six of the seven simulations, if you do a value strategy, where do you avoid the top quarter of dividends, outperforms everything else? And so that’s talking about liquidating the portfolio and getting taxed at various rates, dividend rates at low, at high, in six of the seven value excluding dividend stocks, high dividend stocks outperforms everything else. And the only time it doesn’t is in a no tax world and then just straight up value outperforms and it’s only by 20 basis points.
So almost in every possible scenario, you should invest in a value approach, avoiding most of the high yielders. Let that sink in for a second. So, many investors, including retirees, in particular, value those quarterly dividend checks. But recognize the huge opportunity cost one pays for them, the proverbial bird in the hand, so to speak, is costing about three or four in the bush.
So next question is why hasn’t this been done? And the answer is it has. So, would it help to know that Warren Buffett, for example, would likely agree with this non-dividend strategy? Buffett’s Berkshire Hathaway has never paid a dividend. Actually, that’s not entirely true, they paid one single 10 cent dividend in 1967. Buffett later joked, “I must have been in the bathroom when the decision was made.” And he later punctuated there’s no dividend sense with the caller of a quote saying, “All you get with Berkshire stock is you can stick in your safe deposit box and every year you take it out and funnel it.”
So, why does Buffett, someone who regularly invest in dividend-paying companies, avoid paying dividend to his own Berkshire shareholders? And answering, let’s start with a different question. What does Buffett seek? Buffett’s focus on creating value for himself and to shareholders. His letter to shareholders are filled with practical advice on how managers can create value and destroy it. And they create it by buying mispriced quality assets, they destroy it by repricing incoming shares at prices above intrinsic value and so on. You can read one of his, and my favourite investing books on managing cash flows in the capital allocation process in the book “The Outsiders.”
So, through his value lens, dividends appear different to Buffett than do many investors. While the common opinion is that dividends are always valuable, to Buffett, they can fall into the value destroyer camp if there is a better use of that capital elsewhere. Now, the reason larger reduces opportunity costs, dividends are highly tax inefficient, and that’s the Achilles heel. So, when compared to other ways in which a company might use its free cash flow to generate greater value for investors, buy back shares, acquiring a cash entering business, reducing debt and carrying costs, dividends come up short.
But Buffett isn’t the only successful professional money manager to feel this way. On his podcast, “Investor of the Best,” Patrick Goodbud, who I was just on his podcast recently and trying to see…interviewed Will Thorndike in May 2017, and he’s the author of the above-referenced book “The Outsiders,” focuses on the best CEOs in the world who excel at capital allocation. Highly recommend this book. And in the episode, O’Shaughnessy poses a question to Thorndyke, he says, “Dividends have always been popular, always a significant quoted source of total return. What do you find in common between these eight and maybe beyond these eight very successful capital allocators as it pertains to the dividend policy, their view toward dividends, whether or not they paid them and so on? And Thorndike replies, “So they were very unconventional in that regard. Specifically, they generally disdain dividends. They generally, either avoided them, or their dividend yield was substantially lower than the peer group. And the reason for that in every case was tax inefficiency. So one of the common threads across it was a real focus on tax minimisation, and dividends are just inherently deeply taxed inefficient.”
So if you’re interested in reading further on topic, we post a link to the show notes discussing, summarizing some of Buffet’s thoughts in dividends in his 2012 letter to shareholders. So we’re gonna wrap it up here quick in conclusion, which the best way to take about this whole paper and put it together is think about it’s about value, not dividends. So, I started with a question, by avoiding dividends, might we improve dividend investing? But by removing the dividend, it inadvertently refocuses the selection methodology on pure value. My research turned out to be a backdoor way of reminding myself that value investing and dividend investing were often confused as the same thing or distinct strategies. And more times than not, value wins. It turns out that simple value strategy, which included avoiding high-yield stocks, produce higher returns than dividend strategy, not just similar returns. In other words, before you even get to the tax benefits, value had already trumped dividends. And after factoring in taxes, even more outperformers.
For any stubborn dividend investors ready to remain faithful to their strategy despite the above data, I hope you’ll at least be willing to concede one point, you’re paying quite a bit for those quarterly dividend payments.
Well, hope you haven’t fallen asleep now. That was the end of our quick read, we’d love your feedback. We’re gonna publish this paper soon if not already. And I would love to hear your thoughts. So, shoot me an email, Jeff and I read them, firstname.lastname@example.org. Thanks for taking the time to listen today. You hate these style or love them, please let us know while we’re trying to figure out the best way to deliver good content. You can mine or you can find, we’ll post the show notes here from this episode. There’s not many of them, but other episodes, you can always find at mebfaber.com/podcast. Subscribe to the show on iTunes. If you’re enjoying it, leave us a review even if you hate it. Thanks for listening, friends, and good investing.