A True and False Claim on Dividends

In our daily perusal of the financial news, we caught what we found to be a curious, offhand comment in a piece about gold: Income streams are “the main driver of total returns from most investments.”^[i] We found this statement amusing, as it can be both right and not-quite correct, in our opinion. How so? Read on!

“Total return” refers to, well, all the money investors earn from an investment. For stocks, that means price appreciation plus reinvested dividends. If we look at long-term charts, it seems clear that dividends play a very, very big role. We see it in the US-orientated S&P 500 index, where dollar-denominated price-only returns since 1925 are 37,281.1%, which might sound big until you compare it with the 1,316,578.7% return with reinvested dividends. Exhibit 1 shows the gap using a logarithmic scale to remove compounding’s skew on later returns (and to avoid looking silly, in our view). Exhibit 2 does the same for UK stocks, whose gap is smaller due to the MSCI UK index’s shorter history.

Exhibit 1: S&P 500 Price and Total Returns

Source: Global Financial Data, Inc., as of 19/9/2024. S&P 500 total and price return in USD, 31/12/1925 – 31/12/2023. Presented in US dollars. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.

Exhibit 2: MSCI UK Index Price and Total Returns

Source: FactSet, as of 19/9/2024. MSCI UK total and price return in GBP, 31/12/1969 – 31/12/2023.

Objectively, these are really, really big gaps! So big as to be almost meaningless, in our view, so here are the annualised returns (the compound annual growth rate that would deliver the cumulative return over a given period). For the S&P 500, the dollar-denominated annualised price return in this stretch is 6.2%, whilst total return is 10.2%.^[ii] The UK’s gap is even bigger, 5.9% for pound-denominated price returns and 10.3% for total.^[iii]

So whilst we think it is probably a stretch to call dividends the “main driver” of total returns, given they account for less than half the long-term annualised return and contribute less to return today than they did in earlier decades, they are a really big piece. And that big piece tips stocks over the edge relative to other asset classes, so the statement strikes us as fair enough.^[iv]

But also, it glosses over some key things, and we think the UK’s bigger gap illustrates the reason why. The UK has a heavier weighting to high dividend-paying sectors than the US (e.g., Energy and Financials).^[v] This is part of its general value-orientated tilt.^[vi] And we think it is also a big reason why the UK’s price-only annualised return is lower.

You see, dividends aren’t a return on one’s investment. They are a return of one’s investment. It is a company paying investors their own money back to them versus investing it or buying back shares. Hence, when a stock pays a dividend, the stock price falls by the amount of the dividend. Let us imagine a hypothetical fake company, WidgetWorths, pays a £1 per share dividend, its share price falls from £38 to £37 on the date the dividend becomes official. This is called the ex. dividend date, because it is the date on which the stock price excludes the dividend. In our view, this is one key reason why dividends are not equivalent to bond interest.

So because UK stocks have traditionally paid more dividends, they have more dividends subtracted from the share price. Total return accounts for this by keeping them in place and assuming they are reinvested into the company, where they continue to grow alongside the rest of one’s investment.

In our view, the real lesson here isn’t that dividends are important to returns. Rather, it is that we think price-only returns are an incomplete measure. To properly gauge an investment’s long-term prowess in both absolute terms and relative to its competitors and peers, total return is the only level playing field, in our view.

Here is another way to see it. WidgetWorths doesn’t have a monopoly on the widgeting world. It has stiff competition from WoolWidgets … which doesn’t pay a dividend. So on the day WidgetWorths pays its £1 dividend and its share price falls from £38 to £37, WoolWidgets’ price holds steady at £38 (we will assume they have identical fundamentals and the market was flat that day). For three years, they magically have identical percentage returns, but WidgetWorths has £12 worth of quarterly dividends backed out of its price in this span. Price-only returns would show it to be an inferior investment. Total returns, however, would rightly show the two as equal.

That is kind of a mouthful, so here is a totally made-up chart. To keep it clean, we suppose that both companies’ stock prices rise 0.23% every day … except on the last day of the calendar quarter, when WidgetWorths pays its £1 dividend. On this day, WoolWidgets is conveniently flat, whilst WidgetWorths drops by its standard - £1. Again, totally unrealistic, nothing here matches what an investor’s actual experience would be, STOCK RETURNS AREN’T STEADY, this is just illustrative.^[vii]

Exhibit 3: A Totally Made-Up Example of Dividends’ Stock Price Impact

Source: Math and the thin blue air, where all hypothetical things come from. Assumes identical daily percentage returns and a £1 dividend paid by WidgetWorths on the final day of each calendar quarter.

If an investor didn’t know WidgetWorths was paying a dividend, they might think it is inferior. Only through total returns would it rightly show the two were performing identically—just with different philosophies about the best use of leftover pounds at the end of the quarter.

Again, dividends are important to returns, in our view. But only because total return is the most accurate representation of an investor’s experience and we don’t think price returns account for dividends in a relatable manner. Dividends themselves, we are agnostic on. Again, return of capital, not return on capital. They can get cut and reduced at any time, and we find loading up on them can concentrate investors in certain sectors, which can limit their opportunity set and disadvantage them when other areas do well. In our experience, some people like dividends for cash flow, but we think selling stocks is a fine way to generate what we call home-grown dividends as part of general portfolio maintenance. Dividends can be nice, but we don’t think they alone are reason to own any stock.