It’s human nature to crave excitement, which helps explain why so few investors successfully invest in stocks. Consider, first, the lowly lottery ticket. Why would anyone pay a buck for something worth $0.33 (the typical value of the prize pool, the remainder being siphoned off by the lottery operator and taxes)? A cogent explanation is that people focus on the huge but highly unlikely jackpot rather than the woeful odds stacked against them.
So, too, does it appear with stock investors. Individual investors (and even professional money managers) are looking for the game-changing pick—the home run, the next Google or Apple (or Facebook?). They’re looking for stocks that offer the possibility of large, quick moves that can move the needle on the performance numbers. And unfortunately, academia has buttressed this approach with its “capital asset pricing model” (CAPM), which insists that, to generate better stock market returns, one must indulge in more risk.
CAPM is an elegant model. Unfortunately, as I’ve written before, abundant empirical evidence contradicts the assumptions of this widely followed returns-follow-risks model. A recent report from a research team at Société Générale (SocGen), the large, French bank, drives another nail in the CAPM coffin when it comes to pricing stocks.
The report focuses on the importance of quality to stock investors. For SocGen, quality begins with dividends, which, the study notes, account for most of the real returns from stocks over the past 40 years. More important than the level of the dividends is their sustainability. The SocGen study concludes that poor balance sheet quality is the best predictor of dividend cuts.
To assure sustainable dividends, SocGen looks for financially robust companies, meaning those with both a strong balance sheet and a sound underlying business. It cites Nokia as a good example of a firm with a solid balance sheet (low debt) but with a rapidly deteriorating business, and thus not an attractive quality investment. SocGen concludes that low-risk, high-quality companies have proven to be better investments than high-risk, low-quality companies.
Why is this so? Again, SocGen turns to the behavior of investors, comparing equity managers to lottery ticket purchasers looking for the big hit. Quality businesses tend to be boring businesses to follow, with simple, boring balance sheets. Let’s call them “ho-hum stocks.” Because equity managers and individual stock buyers look for excitement and are willing to overpay for it, the unloved and unexciting ho-hum stocks are under-owned and, thus, undervalued.
And since the bulk of stock returns over the long haul come from dividends, not stock price appreciation, buying boring, dividend-paying companies with sound balance sheets and businesses turns out to provide better returns with less risk than the portfolios investors typically hold. SocGen has created an index of stocks that are both sustainable dividend payers and high-quality companies, which it calls the “Quality Income Index.”
At the present time, the SocGen-sponsored, exchanged-traded fund based on the QI index is only available on the Paris Bourse. But given the persuasive power of the research backing the index, I suspect we’ll see a U.S.-traded version in the not-too-distant future. If so, this will provide ordinary investors another good ETF alternative in the high-quality, low-volatility, dividend-paying sphere. To date, the best offering currently available to U.S. investors is the Vanguard Dividend Appreciation ETF (ticker symbol VIG), which is also available as a traditional mutual fund (ticker VDAIX) directly through Vanguard or over the counter at many brokerage firms such as Schwab.
Morningstar rates the Vanguard fund, available to investors since May 2006, as a five-star fund. Since inception, VIG/VDAIX has generated returns almost 3 percent better than an S&P 500 index fund, while taking somewhat less risk. The SocGen fund has only been available to investors since October 2012, so it will be a long time before the verdict is in on its performance versus risk. However, given my firm’s experience with our own portfolio of high-quality, dividend-growing stocks, I have a high degree of confidence that the SocGen fund will be a good performer if it sticks to the methodology outlined in its research report.
When it comes to stocks, boring is beautiful, and “ho-hum” is about the best reaction to have from your friends when discussing stocks at a cocktail party.
