Investors Who Seek "Significant" Alpha Should Not Seek Out Only Dividend Paying Stocks

I recently read an article by an author I have a great deal of respect for that concluded that dividend stocks outperform non-dividend payers. Although I share an appreciation and penchant for owning quality dividend paying growth stocks, I also took exception to the innuendo and conclusions that the article presented. Ironically, the article started out with one of my favorite and most cherished quotes by Thomas H. Huxley: "The deepest sin against the human mind is to believe things without evidence." The opening of the article, utilizing this extremely relevant quote, stirred up a great deal of FEAR on my part. I was FEAR-ful because the article suggested that a study, which the article quotes and is primarily based on, alleges to prove that dividend stocks outperform non-dividend stocks. Therefore, at least to my way of thinking, initially suggests that investors who want the best returns should ignore non-dividend paying stocks, and should seek out only dividend stocks. I believe this is a classic example of a "muddy study" and FEAR as I use it here is an acronym for - False Evidence Appearing Real. Of course, my real fear is that articles and studies like those represented in the above article will mislead prospective investors into ignoring non-dividend paying stocks when developing their investment plans. Later in this article I will present evidence that the greatest returns and most signification Alpha generation will be earned from fast-growing non-dividend paying stocks. When very exciting and dynamic high quality companies are in the sweet spot of their growth phases, they rarely pay dividends. Moreover, this is also the phase where they make the most money for their shareholders in the shortest period of time, and if the principle of valuation is adhered to, at very reasonable levels of risk. Earnings Growth and Valuation the True Drivers of Return In a nutshell, this is my problem: First and foremost, I intend to demonstrate that dividends are not drivers of return. Instead, dividends are a component of return and not a creator. The true drivers and creators of return are earnings growth, but only when purchased at sound valuation. Consequently, the reason that dividend paying stocks tend to produce strong performance is due to the fact that the underlying company paying the dividends generates stable and growing earnings. Dividends come from the company's earnings and are expressed as a payout ratio. But it's the earnings that generate both capital appreciation and dividends and dividend growth. To clarify even further, two companies generating the same earnings growth will tend to produce similar long-term returns for their shareholders. Of course this is true only as long as valuations are consistent and aligned with the underlying company's earnings growth. Also, it's important to recognize that the capital appreciation component of return comes from the market capitalizing a given level of earnings. This is expressed as the price earnings ratio or PE. The income component of a common stock, which comes from dividends, will be in addition to the capital appreciation component. The two together make up total return. However, the market tends to recognize the additional return that dividends offer, by applying a higher multiple to the dividend payer. In essence, this can partially mitigate some of the dividend advantage, but usually not all of it. On the other hand, a company with consistent and very fast growing earnings will outperform a company with less earnings growth regardless of whether it pays a dividend or not. However, to take this thesis one step farther, it is rare to find a dividend paying stock with super fast earnings growth. For the most part, companies only start paying dividends when the very fast phase of their growth matures into moderate or slower growth rates. With growth slowing, dividends are offered because retained earnings are no longer needed to fund high growth. Therefore, the companies will reward shareholders with dividend income to augment their now muted capital appreciation potential. The Key Distinguishing Factor From what has been written thus far, it should be recognized that most dividend paying companies will generate solid long-term returns through the combination of growth and income. The primary reason for this is, because in order to pay a dividend, the underlying company has to have solid earnings to support the dividend. In other words, dividend paying stocks tend to have good earnings, which as previously stated, is the primary driver of return. Consequently, dividend paying stocks will, as the studies indicate, outperform almost all non-dividend paying companies that have poor earnings.123... Read more