Wednesday, July 8, 2015

Dividend stocks vs. broad market

A company can use its earnings two ways: distribute as dividends or reinvest in its business, adding to capitalization. Different companies have different dividend policies, some care about dividends to grow consistently each year (dividend aristocrats), some don't.

It may seem that from the total return point of view there should be no big difference between dividend stocks and the broad market, because there's no difference how the investor gets his profit: through dividends or through stock price appreciation. But it is not exactly so.

The fact is there is a significant number of investors who see the share as an income instrument, they buy it for a yield, like bond or note, to have an income flow in form of dividends. They see the stock price changes as a "paper" gain/loss, it is not as important for them as the live dividend cash, because the stock holder does not plan to sell the stock anytime soon. Definitely this is a pretty comfortable psychological setup to protect an investor from making stupid things like dumping stock on market corrections when the stock is cheap and its yield is decent.

This is a psychology thing, of course, but since there is a class of investors who see things this way, they can make an impact on market, creating some difference between high-dividend stocks and the broad market. And you may try to exploit this difference.

Let's take a look at the volatility-normalized pair* SDY ( High Yield Dividend Aristocrats ETF) against its benchmark ITOT (S&P 1500 ETF):



You can't assume that company's dividend policy should somehow impact company's earnings, so you might expect that the difference between high-dividend stocks and the broad market should have mean-reverting properties.

* Pair charts with each side being volatility-normalized are supposed to show
mean-reverting behaviour because a long-term trend would mean that one side of
the pair is consistently better in terms of return/volatility, which goes
against CAPM.

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