Note that this section of the website is not particularly active; I hope to publish about one personal finance article per month.

Tuesday, August 19, 2014

Book Review: The Strategic Dividend Investor

The book "The Strategic Dividend Investor" by Daniel Peris provides an introduction to dividend investing. The book provides a lengthy explanation of the motivation why focussing on dividends matters; the stock market is apparently less efficient than theory states. The irony is that this inefficiency is partly the result of financial theory that is based upon the premise that the market is in fact efficient. He then gives an overview of dividend investing strategies, but this part of the book is probably too brief.

Book Description

The book was published in 2011, by McGraw Hill. It is 177 pages, including a brief index and endnotes. The chapters are:
  1. Why Invest for Dividends?
  2. The Tortoise Beats the Hare, Again
  3. How Did We Get into This Mess?
  4. How to Invest for Dividends
  5. \Putting It All Together
As the chapter titles suggest, a considerable portion of the book explains why dividend investing matters, but the portion of the book explaining how to do it is shorter. 

It is written at an introductory level. without particular knowledge of finance or financial analysis.This makes it either a starting point for someone new to finance, or possibly of interest to someone with financial knowledge and would want to see why dividends matter in analysis.

Daniel Peris is a portfolio manager for Federated Investors in the United States, where he actively manages a dividend portfolio. 

Dividends Dominate Total Return

The beginning of the book explains how dividends dominate total return; that is the initial dividend yield and the growth rate of dividends. The stock price at the beginning of the horizon determines the initial dividend yield, but the stock price at the end of the horizon does not matter that much. 

The growth rate of dividends is the part that can be overlooked when thinking about dividends. But if we take the most basic dividend growth model in which dividends grow at a constant growth rate, the return is equal to the initial dividend yield plus the growth rate. For example, that means that the two stocks:
  1. initial dividend yield of 5%, with dividends growing at 5% per year;
  2. initial dividend yield of 2%, with dividends growing at 8% per year;
will have the same return (10%). In dividend investing, it is not enough to maximise the initial dividend yield (which is easily done by screening stocks on the research pages of a broker website), but you need to have some growth as well.

I do not have access to the financial data to verify his exact claims about returns, but they are in line with my recollection of the data.

The Rise Of Trader Nation

He complains about the fixation on trading and speculation that has infected the popular view of the stock markets. People worry too much about short-term news and price action that has no long-term impact. The long bull market and short-termism in the financial media have led people to focus on capital gains. And bizarrely enough, the insights from academic finance, which are predicated upon efficient markets, probably led them to be less efficient.

Although I think that it makes little sense for retail investors to be involved in short-term speculation, I am not surprised by the fact that they do so. Daniel Peris argues that investors historically were focused upon dividend yields. Although that is true, that is largely because that was the only fundamental information available in those days. Even so, there was a lot of speculation in those earlier eras. It was only after the Great Crash of 1929 and the Depression of the 1930s that investors acted in a subdued manner for a couple of decades. By the 1960s, memories of the Depression faded, and speculation came back.

His complaints about the dysfunction in modern academic finance is interesting (to myself, at least). I had made some similar observations, and it is good to see that I am not alone. Academic finance argues that dividends are not important; rather investors should value companies based on the earnings or cash flow they generate. Dividends will be reinvested, raising future growth rates.

Daniel Peris is not convinced that top management will put the cash to good use. It will often be used for high prestige takeovers, which typically end up losing money for everyone other than the investment bankers that structure the deals. But it is mainly used for stock buybacks. I noted one of the problems with buybacks in an earlier article - buybacks only help an investor who sells the stock

I may discuss the theoretical shortcomings of academic finance in articles on my main web page. But in the context of the book, this may be of interest mainly to those who already are in finance. If you are a beginner, and you have not had your mind warped by academic finance, this material may not matter too much.

Investment Vehicles

If you broadly accept his thesis about equity investing, I see four avenues for investing in stocks.

  1. Buy passive broad equity funds, like exchange-traded funds (ETF's) that track the large stock indices. (Note: passive funds attempt to track a basket of stocks that are generated by some rule - like a stock index. An active fund attempts to pick stocks to maximise return, although the funds typically are constrained to follow a certain style of investment.)
  2. Buy passive funds that invest in indices that are targeted towards dividend or value stocks.
  3. Invest in actively-managed dividend (or possibly value) funds.
  4. Pick your own portfolio of dividend stocks.
I discuss each in turn.

The first is rather strange, as he describes how standard market indices underperform dividend-oriented portfolios. I include it as a possibility for the case that you are not completely convinced that the advantages of dividend stocks outweighs the costs of going into a more specialised investment vehicle. A passive investment in a broad stock market index - with a low management cost - has been a very good default investment vehicle.

The second possibility - passive dividend-focussed funds - is mentioned in the book, but is not enthusiastically endorsed (for reasons I discuss further below). The main problem facing these vehicles is that they are harder to find, and to evaluate. I have seen some dividend-focussed ETF's, but you could probably lump in some similar funds. They are marketed as value funds, low volatility funds, or fundamental indices. There are differences in the way the baskets are performed, but they overlap in that they avoid expensive growth stocks, which have historically been a drag on stock market performance. (Investors pay too much for "growth stories".)

The third possibility is his preferred option for retail investors - investing in an actively managed dividend fund. I do not want to be too cynical, and I would argue that it is reasonable that believes in the product that he produces. I will note that my bias is not to pay for active management. But he makes a reasonable argument that dividend investing as a style cannot be easily reproduced by the passive "style" indices, such as value stock indices. The problem with the "value" indices is that they get all of the real dog companies dumped into them. They are cheap, but they are financially doomed and cannot pay or sustain dividends. The argument is plausible, but I do not follow equities enough to have a strong opinion. In any event, I am not going to make specific investment recommendations to random strangers on the internet; the reader would have to decide. All I can say is that if you invest in an active manager, you are forced to do more due diligence than for a passive fund.

The book is somewhat skeptical about the fourth option - picking stocks yourself. Doing it properly is a time-consuming task (but if you work in finance, you presumably should be spending time analysing investments). In addition to the time commitments he discusses, I would add that it is very difficult to assess whether you are wasting your time. A completely random basket of stocks should outperform about 50% of the time; it takes a considerable time to assess whether you are lucky or you are good. And human nature is such that people want to conclude that they are good, not lucky.

The Value Trap

The problem with focussing on value (such as high dividend yields), is that you are buying companies that have problems that you do not know about. He argues that professional portfolio managers spend the time to avoid walking into such traps, but that would be harder for individual investors that pick stocks in their spare time. 

The other issue with bottom-up stock-picking is that by focussing on the details, you risk getting run over by the macro-economy or by investor stampedes. He notes in the book how the attractive dividends of the banks going into the 2008 crisis proved to be a fairly effective trap. The narrower the focus of your portfolio, the greater the chance of walking into such a trap. For this reason, I have not ditched all of my broad market equity funds, even though I accept that value-style funds may outperform in the long run.

But What If I Want To Pick Stocks?

If you wish to ignore my and the book's bias against individuals' picking stocks, the book only offers the beginning of the training you need. If you already have an interest in finance, this is not too big a deal - you already covered that ground. But if you are a beginner, you would need to go quite a bit beyond the description in the book (it is basically within one chapter). The book runs through some sample financial statements, but it cannot hope to cover things like pension accounting. 

The problem is that you cannot just pick stocks with high dividends now; you need to decide whether the dividend can grow with time. Therefore, you need to see whether the trend in earnings and cash flow will cover the future dividend stream. The only way to do that is to roll up your sleeves, plough throw the financial statements, and understand what they mean.

In terms of a strategy, he says he aims for 5-5 portfolio: stocks with a 5% dividend yield, with a sustainable 5% growth rate. The idea is to find relatively high dividend yields, coupled with at least some growth. You can do well with stocks with poor growth prospects and higher yields, but you have to be careful. Conversely, relying on growth rates higher than 5% is a sign that the company is considered a growth story, and is probably overpriced as a result.

Concluding Remarks

The book provides a good introduction to why dividend-focussed stock investing makes sense. However, you would need to dig deeper if you want to start picking your own portfolio.

Finally, the book is available at The Strategic Dividend Investor (affiliate link),

(c) Brian Romanchuk 2014

1 comment:

  1. Thank you for this very helpful guide on the right way. This will be very helpful for those you are just starting to blog. Your post has been more than helpful.


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