Mebane Faber wrote a controversial piece on dividend investing back in 2016.

Mebane said that there were many studies to show dividend paying stocks to beat non-dividend paying stocks or the broad market as a whole:

NDR

Looks impressive right?

Yeah! Dividend stocks for the win!

But little did people realise the dividend stocks that beat the broad market were because they were also VALUE stocks.

To help you understand the differences I have drawn a Venn diagram for you:

Value-and-Dividend

In a nutshell (I am generalising here to simplify the explanation),

Section A = Value Stocks = They tend to outperform the market as a whole

Section B = Dividend Stocks = They tend to underperform the market as a whole

Section C = Value Stocks that pay Dividends = They tend to outperform the market as a whole

It is important to note that we are comparing Total Returns (capital gains + dividend gains). Also, the reason I am using ‘as a whole’ is that there are failed examples in all sections if you dig hard enough. There are both value and dividend traps but if you hold a diversified portfolio in each section, the above outcomes hold true generally.

Bottomline, it is the value factor that determines if your portfolio of stocks outperforms, NOT whether the stock pays dividends. And value factors usually consist of low Price Multiples such as low P/E, P/B, P/S, P/FCF ratios. In the past, high dividend yield suggests undervaluation, but this assumption does not hold anymore due to the tax implications.

Mebane also added that high yielding stocks tend to be junk-like, with unsustainable payouts and high leverage. These stocks lure investors with the current high yields and subsequently reduce or stop dividend payments when they run into business problems.

Stock prices would dive following the bad news and investors would incur a large capital loss, often larger than the dividends received.

One good recent example would be Rickmers Maritime, which at one point in time was giving out 15% dividend yield as reported by one investor. It depends on how you would define the value of this stock because it can be subjective. If you look at NAV, it would be undervalued.

But to me, the CNAV would have discounted many of its ships and not qualify the stock as undervalued. For other investors who look at FCF and payout ratios would see a red flag early too. Basically, the stock offers high dividend yield but without value.

That said, it doesn’t mean you want to avoid dividends altogether. It still feels good seeing the money going into your bank account every year. The important lesson is that looking at dividend paying stocks is not good enough as a standalone criterion. You need a value factor.

You would want to find stocks in Section C.

The next question is how?

3 steps to find dividend stocks trading at undervalued prices

First, we shortlist stocks who are consistent dividend payers and growers. This means that we first qualify stocks that have the ability and the propensity to distribute dividends over long periods of time.

Second, we rank these stocks based on a value factor and group them into deciles. An investor should only look for stocks within the cheapest decile. This is to increase the probability of making a profit from the stock.

Third, we would look deeper into each stock and analyse their dividend growth rate, payout ratio, free-cash-flow, dividend yield-on-cost, dividend yield range, and even dividend tax considerations. Qualitative analysis would be added to catch important information that could be missed out from the numbers.

Conclusion

Essentially, we are picking dividend stocks which are value stocks with this method. We could narrow the universe of stocks into a few hundred globally, and rank them based on ‘cheapness’.

An investor would be able to achieve market-beating total returns while collecting regular dividends, enjoying best of both worlds.

This article originally appeared on Dr Wealth’s blog.

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