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ETF Specialist

Dividends--A Better Approach to Value?

Dividend strategies may offer a lower-risk way to take advantage of the value premium.

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Low interest rates have encouraged investors to accept greater risk in pursuit of higher yields to make up for lost income. While greater risk tends to accompany higher-yielding assets, a naive strategy of targeting stocks with high dividend yields to generate income would have historically outperformed the broad market, with lower volatility. But this return premium isn't unique to dividend-paying stocks. It's no secret that cheap stocks have historically outperformed their more expensive counterparts over the long run, a phenomenon known as the value effect. Dividend investing is essentially a repackaged value strategy. However, it may offer investors a lower-risk way to harness the value premium than traditional value strategies that rely on a broader range of metrics to identify cheap stocks.

The following chart illustrates the performance of stock portfolios sorted by dividend yield, book value/price, and price/earnings from August 1953 through July 2013. In each case, the cheaper categories outpaced their more expensive counterparts. These results are broadly consistent over time and in foreign markets. Efficient-market hypothesis advocates argue that this return gap represents compensation for risk, which is plausible. Relative to their more expensive counterparts, value stocks tend to be less profitable, face dim growth prospects, and may remain out of favor for years.

Alex Bryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.