Dan Bortolotti Interview – Debunking Dividend Myths

Dan Bortolotti

Dan Bortolotti ~ Canadian Couch Potato

For those of you who don’t know Dan, he is an advocate for Index Investing, and his knowledge of this subject is extensive. His blog the Canadian Couch Potato is a fantastic resource for both the novice and experienced investor. Dan is also an accomplished author, and for more than 10 years he has contributed regular articles for Canada’s MoneySense magazine.

This interview is inspired from the Debunking Dividend Myths series which Dan wrote on his blog in January and February 2011. To say the least, a flood of responses and the lively debate quickly ensued with that series. During the sixth post, Dan had to grow a beard and wear sunglasses in public, to conceal his identity from stalking dividend investors.

The Dividend Ninja:
Hi Dan, first of all, I wanted to say thank you so much for coming over to the Dividend Ninja and taking the time for this interview on Dividend Investing. I know you have a busy schedule, so thanks again! Have you recovered from all the debate on your Debunking Dividend Myths? I think many readers will appreciate the excellent research and insight you provided in these articles.

Dan:
It’s my pleasure, Ninja. I learned a lot while researching and writing these posts, and from the feedback, I got from readers. But I’m glad that the series is over and I’m back to writing about indexing!

Dividend Ninja:
Dan, over the last couple of years we have really seen the increase in the popularity of dividend investing. There are a lot more blogs (sorry I’m guilty of being one of them) and information available to the average investor on dividend investing. Do you think this is the result of the low-interest rate environment we are in and the attraction to dividend yield? Or are there other factors at play here?

Dan:
Well, dividend-focused investment strategies are not new, but you’re right, they do seem to be more popular now. I think there are a couple of reasons for this. Certainly, the low-interest rates on bonds and GICs have prompted income-oriented investors to look more closely at dividends.

I also feel that many investors have lost their faith in the idea that they can rely on stocks for capital gains. In periods where growth stocks do well, dividend strategies can fall out of fashion and even look stodgy. We’ve certainly seen the pendulum swing in the opposite direction. Now we hear people saying they won’t even consider a stock that doesn’t pay a dividend, which I think is going too far.

Dividend Ninja:
More importantly, do you think investors are taking more risk than they should be under the umbrella of Dividend Blue Chips, as being safer and/or different than other growth investments?

Dan:
Dividend-paying blue-chip stocks are not unusually risky. Indeed, as equity strategies go, they’re fairly conservative. The reason I wrote such a long series of posts was that I was reading and hearing a lot from investors who seemed to have fundamental misunderstandings about dividends.

On the most basic level, many seemed to look only at yield and ignore total return, which is really the only thing that matters at the end of the day. Others talked about dividend stocks as a substitute for bonds or were looking at their yield on cost and thinking they were beating the market. Some thought that if two ETFs had different yields, the one with the higher yield was guaranteed to outperform.

At the end of the day, it’s none of my business what investing strategy anyone decides to use. However, I think you need to make sure you understand the strategy thoroughly, especially if you’re recommending it to others.

Dividend Ninja:
Dan, those are some good points. Throughout your Debunking Dividend Myths posts, you mention in your introduction that “many investors following a dividend-focused strategy may be better off with broad-based index funds.” So the issue comes down to passive index investing versus income oriented dividend investing. Are you convinced that passive index investing will provide investors with superior returns over dividend investing?

Dan:
I would never say that I’m convinced that indexing will beat any active strategy: there will always be some strategies that outperform, even over a decade or more. The only thing I am convinced of — because the data are overwhelming — is that indexing offers the greatest likelihood of coming out ahead. It’s simply a question of probabilities.

It’s also important to consider asset allocation if you’re going to compare returns. An investor whose portfolio includes only dividend-paying stocks will likely outperform a balanced Index portfolio that includes fixed income. However, those higher returns will come with greater risk and much higher volatility. It would have little or nothing to do with the investor’s skill in identifying stocks: it would simply be a question of getting more exposure to the equity markets. (Putting 100% in a diversified all-equity index portfolio would likely do better still.)

Dividend Ninja:
Yet dividend investing provides you with the benefit of capital appreciation plus dividend income. Investors have seen a huge capital appreciation of dividend paying stocks from 2008 to 2010 – with the additional dividend income. (Of course, we have to realize that 2009 and 2010 were exceptional years for growth following 2008). So the premise that dividend paying stocks do not have the same capital appreciation as the overall broad market isn’t entirely correct. Your thoughts?

Dan:
This is really the key point, isn’t it? There is this persistent belief that capital appreciation and dividend income are two unrelated sources of returns. But they both come out of the same earnings. If a company pays generous dividends, then it has less money to reinvest in its business, and therefore less opportunity for capital appreciation. Unless you think the dividends are created magically out of thin air, it has to be a trade-off. If a company pays out $50 million in dividends, then its market capitalization falls by $50 million.

If you’re a utility, with few opportunities for expansion, it makes sense to pay your investors cash dividends. If you’re Berkshire Hathaway (or Apple or Google), your shareholders are probably better off if you reinvest your cash in the company. Other companies can increase value by buying back shares*. As an investor in the broad market, you get access to all these types of companies.

That said, there are some convincing arguments about why dividend paying companies offer an advantage. I had several discussions with knowledgeable people who read the dividend series, and they made some excellent points which I am happy to acknowledge.

One is that companies that have a tradition of paying dividends are often more disciplined in how they spend their free cash. For example, if a company pays out half of its free cash in dividends, they have only half as much to reinvest in the business, and that forces the managers to focus on only their best ideas.

* There’s also a convincing argument that share buybacks may just offset the dilution that occurs when management is compensated with stock options, so it really doesn’t really benefit individual shareholders.

Dividend Ninja:
Dan, I know we have discussed the idea of the Core and Explore portfolio. The idea is to build a foundation of index funds and ETF’s and then add dividend paying stocks to that core over time. The concept is that if you pick a bad stock or two, you won’t suffer a huge loss in your overall portfolio. So if an investor really wants to invest in dividend stocks, and index investing is a proven strategy, why not do both? And what percentage would you advise an investor to keep the stock picking section of their dividend portfolio?

Dan:
I don’t have a problem with that strategy at all, so long as the expectations are clear. Someone using a core and explore strategy is still unlikely to outperform a purely passive strategy. (Author Rick Ferri like to call it “core and pay more.”) However, if you know that you simply don’t have the temperament to be an index investor, then in the long run you probably are better off if you use a combination of the two strategies. As I always say, the best investment strategy is the one you will adhere to over the long term.

What percentage should you allot to your stock-picking strategy? As little as possible, I guess. If you’re investing in both an RRSP and in a taxable account, it might make sense for you to hold your Canadian equities in the taxable account and use a dividend strategy there. (Obviously, you would have to compensate by holding fewer Canadian equities in your RRSP your overall asset allocation on target.)

Dividend Ninja: 
Dan, in Debunking Dividend Myths, the issue of funding retirement income became quite apparent through the comments. The financial experts seem to agree that 4% is the golden rule -the amount you can safely withdraw before you deplete into capital. Yet most blue-chip dividend stocks (excluding income trusts and smaller caps) have around 3% to 3.5% dividend yield. For example, purposes let’s say the portfolio yields an above average 4% in dividend income and approximately another 5% per year in capital growth. So why can’t a primarly dividend paying portfolio sustain retirement income?

Dan: 
That’s a great question. It’s really important to understand the underlying assumptions of that 4% rule. That research is based on investors who hold a balanced portfolio of about 50% fixed income and 50% equities. A portfolio like that will clearly have much lower expected returns than a portfolio that is entirely made up of equities (whether they are dividend stocks or not). Of course, it will also be much less volatile.

So to answer your question, if your retirement portfolio was 100% dividend paying stocks, it almost certainly could sustain an annual withdrawal rate higher than 4%. William Bengen, who did the research, argues this explicitly. He actually encourages investors to hold as much in equities as they can stomach.

Unfortunately, many people simply do not have the fortitude to hold 100% of their retirement portfolio in equities. During an event like we went through in 2008–09, retired investors endured an enormous amount of stress. Yes, many companies continued paying dividends, and over the last two years the market has come back virtually all the way, but it sure didn’t feel like that in February 2009. Retired investors who panicked and sold their stocks were decimated. Those who had a balanced portfolio had a much easier time staying the course.

Dividend Ninja: 
You bring up the dividend investing strategy of “Buy what you know”. I think most dividend investors would agree that buying big brand name companies, with recognition, and holding to collect the dividends is a sound strategy. I don’t think dividend investors are necessarily trying to beat the market as you imply.

Investing in the “broad market” as you suggest, means an investor is placing faith in a lot of unknown companies. So how can you go wrong with buying a basket of solid blue-chips like McDonalds, Johnson and Johnson, Husky, TD Bank, or Starbucks?

Dan: 
Your assumption here is that a good company is the same thing as a good investment. Of course McDonald’s, Johnson & Johnson, Husky, TD Bank, and Starbucks are profitable, and you are unlikely to get into big trouble with them. However, if blue-chip stocks are recognized as being safer than the overall market, they cannot also be expected to produce better-than-market returns. You pay a premium for safety. If you didn’t, then investing would be a no-brainer.

The irony is that the “bad” companies often turn out to deliver the highest returns. Because people have such low expectations of them, they are priced cheaply, and if they do better than expected, they can be outstanding performers. That, after all, is the essence of value investing.

Andrew Hallam just did a fascinating post on his blog that gives some real examples. About a year ago, he asked people to pick the worst stocks they could possibly imagine the ones they thought were certain to end up in the toilet. On average, those stocks are currently up more than 8%. Several are up more than 20%, and two (including Krispy Kreme) have gained about 50%. The key point is that it doesn’t matter whether TD Bank is a “better” company than Krispy Kreme. It always comes down to the price. And consistently identifying underpriced securities is much more difficult than it sounds.

That’s why I believe the best strategy is to simply buy the whole market at the lowest possible cost and assume that most stocks are fairly priced. Undoubtedly there are price anomalies, but they cannot be reliably exploited.

Dividend Ninja:
You discuss the issue of global diversification as it relates to Canadian investors who hold primarily Canadian stocks in their portfolio. Your view would be there is less risk by investing globally than domestically. Why?

Dan: 
The first thing to understand here is that investing in any developed market should carry approximately the same amount of risk. Equity markets in Western Europe, Japan, the United States, and Canada have produced broadly similar returns over the very long term. So it’s not a matter of Canada being high-risk. It’s more a matter of concentrating too much on a tiny, poorly diversified economy that is exposed to some very specific risks, like commodity prices.

Even though all of the developed markets have produced similar returns, they have not followed the same path. They have all had periods of outperformance, and other periods where they have lagged the rest of the world. By holding a globally diversified portfolio and rebalancing it regularly, you should be able to enjoy higher long-term returns and lower volatility than if you focused on a single country.

Dividend Ninja: 
Yet global diversification did not protect investors from the 2008 and 2009 market crash.  In fact Europe was a mess, and still remains so with other countries on the verge of default. The US is just starting to recover with a frail banking system, and Japan is still a deflationary mess from its meltdown in 1989. Any many countries have systemic corruption and violence that makes doing business with them virtually impossible.

Dan: 
Here is another idea that won’t seem to go away: that a diversified equity portfolio will prevent you from losing money in a global economic meltdown. No one has ever promised that. During events like we experienced in 2008 and 2009, all risky assets lost value.

However, true diversification means building a portfolio that also contains asset classes that are not highly correlated with equities. An allocation to government bonds helped immensely during the meltdown. So would some exposure to the US dollar, or a small allocation to gold. You still would have lost money, but you would have lost a lot less.

Fortunately, most downturns are not as widespread as the crisis of 2008–09. As you point out, the US, Japan, and Europe have all experienced difficulties over the last 30 years, but these difficulties have not all come at the same time, nor could they had been predicted in advance. Over the last 30 years, you would have had a smoother ride — and with regular rebalancing, you may even have enjoyed higher overall returns — than if you had just picked one region.

Dividend Ninja: 
Good point Dan. Right now Canada looks like a solid place to invest by many other worldwide investors and countries.  Our banks are rock solid. Australian BHP attempted its takeover on Potash Corp last year, Globalive is trying to establish Wind Mobile, and China is actively working to invest in Canadian assets such as the oil sands and natural gas partnerships. While Canada is a small slice of the global economy, it seems everyone wants a piece of our pie. Your thoughts?

Dan: 
I don’t think the world is nearly as interested in Canada as we think. Do you think US investors are loading up on Canadian stocks? What about German pension funds? How about the Japanese? If you were watching the business news in France, do you think your reaction would be, “Wow, look how much the world is talking about Canada?” Of course not. They all have the same home bias that we do.

Yes, Canada has done very well recently, but over the last decade Australia has absolutely blown away the rest of the developed world with annualized returns of almost 15%. This is not one or two lucky years: it’s more than ten years of magnificent performance. Of course, hardly anyone in Canada has noticed.

Now, Australia is a politically stable democracy, has a solid financial system, a resource-based economy that is well positioned to sell to the emerging markets, and a currency that has appreciated strongly against the US dollar. Australians can’t understand why anyone would diversify globally, either: according to this report (pdf file), Aussies hold about 83% of their portfolios in domestic stocks, even though they make up about 4% of the world market. Sound familiar?

Would you put all of your equity holdings in Australian stocks? If not, why not? Why does that suggestion sound more ridiculous than putting all of your equity holdings in Canada? Because home bias is an incredibly powerful force.

Canada has enjoyed outstanding returns in recent years. But if you are a long-term investor, you need to ask yourself whether you truly believe that one country’s tiny, poorly diversified market will continue to outperform the rest of the world for decades to come.

(Tom Bradley of Steadyhand just wrote an interesting post on the subject that I think every Canadian should read.)

Dividend Ninja: 
Dan, if 2008 wasn’t enough it looks like investors could get hit with another bubble- this time it could be bonds as interest rates begin to rise. China, the US, and some European countries are already feeling the effects of inflation on the prices of consumer goods. Stock markets are once again looking precariously high. How do you feel investors can best protect themselves in 2011? And putting the Couch Potato aside, where do you feel the best opportunities will be in the global economy?

Dan: 
Investors can protect themselves in 2011 the same way they should protect themselves in any other year: by building a broadly diversified portfolio that is exposed to a variety of risks, so it cannot be torpedoed by any one of them.

The coming year does not look good for bonds — but everyone said that last year, too, and they performed very well. And if we do end up having a correction in the equity markets, you are going to want those government bonds in your portfolio to act as a cushion.

The threat of inflation, rising interest rates, the potential for significant losses in the stock market — none of these risks are new. Neither are they predictable. Unless you have confidence in your ability to forecast the future, the only sensible approach is to diversify widely.

Dividend Ninja: 
Once again Dan, thank you so much for taking the time for this interview – I know you spent a lot of time answering these questions. I hope readers enjoyed this interview as much as I did!

13 Responses to “Dan Bortolotti Interview – Debunking Dividend Myths”

  1. My Own Advisor

    Feb 22. 2011

    Nice stuff Ninja (and Dan)!

    I liked Dan’s acknowledgement of dividend-paying blue-chip stocks are “not usually risky. Indeed, as equity strategies go, they’re fairly conservative.”

    Absolutely right.

    I do appreciate Dan’s efforts to debunk a few myths; such as some investors thinking dividend stocks are a substitute for bonds; not even close 🙂

    I look forward to part 2!

  2. The Dividend Ninja

    Feb 22. 2011

    @My Own Advisor
    Thanx for posting! You will like Part-2 🙂

    For the record the question I really meant to ask Dan was “do you think investors are taking more risk than they should be under the umbrella of Dividend Blue Chips dividend stocks, as being safer and/or different than other growth investments?”

    But since I had already asked the quesiton and Dan answered, it’s good to go!

  3. Michel

    Feb 23. 2011

    Good work, Ninja.
    I guess I could look for it, but what does the research say, let’s say for a decade, what performance is better, an cdn index stock fund, a cdn balanced fund or a cdn dividend etf?

  4. The Dividend Ninja

    Feb 23. 2011

    @Michel,
    Now that’s a good question. I’ll put together some returns of various index funds, etfs, mutual funds and post this next week 🙂

    I would say right of the bat the Canadian Index Fund is the way to go. You won’t beat the market, but you won’t do any worse either. How can you bet against the market? The balanced fund would be a dog and I am sure the stats will prove it. Becuase its balanced it holds less equity, and is subject to higher MER, trailer fees, and commissions etc. There isn’t a lot of choice for Canadian Dividend ETF’s, that I will get to in the post.

  5. Very nice interview. Thanks for putting it together.

    I am unsure about this statement though: “If a company pays out $50 million in dividends, then its market capitalization falls by $50 million.”

    I understand the theory but market capitalization is calculated based on number of shares and share price. Share prices don’t always fall when dividends are paid. If they do, they bounce back in time. Most of the time, the dip in share price happens on the ex-div because dividend chasers are pulling out but they also made the price go up to get in. If the $50 million is not paid in dividends, you don’t know how it’s used … and it could still be spent and not generate any return on equity. I don’t think it warrants to follow the mathematic theory here because we can’t establish how the money will be spent by management. Jarislowsky is a big proponent on proper company management by board of directors and has been fighting the abuse for many years. Just pointing out the other side of letting the company manage the money here.

    I still believe that capital appreciation and dividend income can be accomplished.

    Index investing is the way to go if you cannot spend time to understand and invest in the companies though.

  6. The Dividend Ninja

    Feb 24. 2011

    @PIE
    Thanx for posting! 🙂 As Dan points out dividends do not come out of thin air. If a company distributes $50M to shareholders, then it must take the money from its own assets to distribute those dividends – hence its market capitalization will also fall by $50M.

    What you are not taking into account are all the other factors such as daily revenue, net share purchases and sales, as well as daily fluctuations in share price. All of those are unpredictable.

    Let’s look at the Royal Bank for example, it has a current share price of $56.70 per share, with a dividend of $2 per share or 3.6% dividend yield. It pays the dividend quarterly. So if the Royal Bank paid a dividend today it would be 50 cents on $56.70 or .88326%. On any given day Royal Bank shares have daily fluctuations of 1% to 2%. So the change in share price would essentially be unnoticeable. If you invest in Shaw, that 4% yield is paid monthly, hence you don’t even notice a significant change in share price.

    Whether the share price goes up or down is the result of people buying and selling, people’s perceptions of a stock price, and not dividends. If anything analysts expectations of earnings has far more influence on share price than dividend payments.

  7. @Ninja
    What I meant to say is that market capitalization is unaffected by dividend payment but the balance sheet is affected. The capitalization is based on share price and share amount. The balance sheet and cash on one hand is affected. It certainly has an impact on the value of the company but the value really depends on the cash flow and debt levels and many other points.

    To summarize,
    – Market Capitalization is unchanged when a dividend is paid. With the exception of the daily market fluctuation.
    – The valuation of the company is changed but since it’s a dividend paying company, it’s factored into the price already.

    What Dan is saying is that whether the company is paying dividend or not, the form by which the investor is rewarded by the influx of cash is either by dividends (immediate) or stock valuation (future potential and possibly greater). For me, one is fixed and known, the other one is unknown. As you pointed out, some of the companies can provide both dividends and future valuation.

    I am absolutely horrible at determining future valuation. If dividends weren’t around, I’d be doing index investing because it averages the bet. Play the roulette and bet on black and red and you won’t lose but you won’t win. (just a figure of speech here) Since dividends are around, I get to possibly gain from stock valuation while having a predictable expectation of income.

    Anyways, my point was that market cap is not affected but valuation is. Just a correction.

  8. @Ninja
    What I meant to say is that market capitalization is unaffected by dividend payment but the balance sheet is affected. The capitalization is based on share price and share amount. The balance sheet and cash on one hand is affected. It certainly has an impact on the value of the company but the value really depends on the cash flow and debt levels and many other points.

    To summarize,
    – Market Capitalization is unchanged when a dividend is paid. With the exception of the daily market fluctuation.
    – The valuation of the company is changed but since it’s a dividend paying company, it’s factored into the price already.

    What Dan is saying is that whether the company is paying dividend or not, the form by which the investor is rewarded by the influx of cash is either by dividends (immediate) or stock valuation (future potential and possibly greater). For me, one is fixed and known, the other one is unknown. As you pointed out, some of the companies can provide both dividends and future valuation.

    I am absolutely horrible at determining future valuation. If dividends weren’t around, I’d be doing index investing because it averages the bet. Play the roulette and bet on black and red and you won’t lose but you won’t win. (just a figure of speech here) Since dividends are around, I get to possibly gain from stock valuation while having a predictable expectation of income.

    Anyways, my point was that market cap is not affected but valuation is. Just a correction.

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