The Canadian stock market as a whole was bested again by high-yield stocks in 2022. But that shouldn’t be a surprise, because stocks with high yields have outperformed in 28 of the past 46 years – often by a substantial margin.
The good news comes from Dartmouth College professor Kenneth French, who recently updated his database of international returns. He tracks a portfolio of Canadian high-yield stocks, which gained an average of 13.7 per cent annually from the end of 1976 to the end of 2022, while the market portfolio grew by an average of 10.1 per cent annually over the same 46-year period. (The returns herein include dividend reinvestment but not fees, commissions or other trading frictions.)
More recently, the market fell by 5.7 per cent in 2022, while the high-yield portfolio held up better with a decline of 1.1 per cent.
Today I’ll focus on four of the portfolios tracked by Prof. French, which represent a mere fraction of his wider efforts. The first is a market portfolio that includes all the Canadian stocks in his database with book values.
His other three portfolios are based on yield. The high-yield portfolio tracks the 30 per cent of stocks with the highest yields. The low-yield portfolio follows the 30 per cent of stocks with the lowest positive yields while the zero-yield portfolio holds stocks that don’t pay dividends.
All of the portfolios are weighted by market capitalization and rebalanced (reformed) at the end of December each year.
If you read my recent exploration of the poor returns generated by stocks with extremely high yields, you might be surprised at the 13.7-per-cent average annual return of the high-yield portfolio.
The good returns are partly the result of a large number of solid dividend payers making up for a few dividend duds. Prof. French’s portfolios are also weighted by market capitalization, which means they invest more in large stocks than smaller stocks. As a result, the returns of the large stocks tend to dominate, which helps to weed out depressed stocks.
That is, stocks usually get extremely high yields after their share prices have fallen a great deal due to weak business results or worries about bad times to come. A falling share price directly pushes down a company’s market capitalization, which is calculated by multiplying its share price by the number of its shares outstanding.
As a result, stocks with extremely high yields tend to have smaller market capitalizations than healthier firms paying more reasonable yields, and they make up a smaller fraction of the assets of Prof. French’s four portfolios.
Speaking of duds, the long-term returns of the zero-yield portfolio are shockingly poor. Things started on a good note in the late 1970s, when the zero-yield portfolio jumped skyward and peaked in the summer of 1981. But then it collapsed rapidly, and has yet to fully recover. Overall, it gained an average of 2.7 per cent from the end of 1976 to the end of 2022.
The poor returns of the zero-yield portfolio were likely influenced by disastrous results from a small number of stocks that dominated the portfolio in different periods. It’s an issue because only a few large stocks fail to pay dividends in Canada.
For instance, a market-capitalization weighed portfolio of stocks in the S&P/TSX Composite Index that don’t pay dividends today would have about 28 per cent of its assets invested in Shopify Inc. (SHOP-T), and more than half of its money in the largest five non-payers, based on data from S&P Global Market Intelligence. In short, the zero-yield portfolio is fairly lopsided.
(I hasten to add that stocks lacking dividends are not doomed to poor performance. After all, Berkshire Hathaway Inc. (BRK-B-N) has done very well over the years without paying a dividend. I hope Shopify, and the others, will grow and help to reverse the fortunes of the zero-yield portfolio.)
The low-yield portfolio fared better, with average annual returns of 9.8 per cent from the end of 1976 to the end of 2022, which is just a touch lower than the market’s average annual return of of 10.1 per cent. The low-yield portfolio lagged because it tended fall more in downturns than the market or the high-yield portfolios.
But all four portfolios fared poorly in the financial crisis that started in 2008, when the low-yield and market portfolios fell 43 per cent from their prior peaks and the high-yield portfolio tumbled 42 per cent, based on monthly data.
On a practical note, there are a few Canadian index funds and exchange-traded funds that invest in high-yield stocks. For instance, the Vanguard FTSE Canadian High Dividend Yield Index exchange-traded fund (VDY-T) tracks a market-capitalization weighted portfolio that holds about 50 Canadian dividend stocks with above-average yields (based on expected dividends). The fund has an annual fee (or MER) of 0.22 per cent, which is lower than many of its specialty-fund peers.
But one of the problems with market-capitalization weighting is evident in the fund’s portfolio, which had 14.1 per cent of its assets invested in the Royal Bank of Canada (RY-T) and 12.6 per cent in Toronto-Dominion Bank (TD-T) at the end of 2022. Its Top 10 holdings represented 71.4 per cent of its assets.
As a result, it would be a fairly simple matter to buy its largest stocks and thereby avoid the fund’s, admittedly modest, fee. One might also opt for a more equally-weighted portfolio, which should offer a diversification benefit.
While Canadian stocks with generous yields have thrived over the past few decades, and I hope they continue to do so, investors should expect some nasty bumps along the way. Investing can be simple and profitable, but it’s rarely easy.