Debunking Dividend Myths: Part 4

This post is the fourth in a series exploring the myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.

Dividend Myth #4: You can beat the market with common sense: just focus on blue-chip companies with a competitive advantage and a history of paying dividends.

I recently attended an investment show where one of the speakers (a well-known Canadian author) explained that his strategy was just common sense. It went something like this: “Think about the products and services you use every day. We all use toothpaste, cellphones, debit cards, oil and gas. So all you need to do is identify the best companies in these sectors: they should have strong brand recognition and a competitive advantage. Buy stocks in these companies, and then sit back and watch those dividends roll in.”

Peter Lynch was the pioneer of “buy what you know,” and here in Canada, Derek Foster has taken up the torch. I touched on this kind of folksy investing wisdom in a previous post back in November, after The Globe and Mail profiled an investor who explained his strategy this way: “I basically sat down and thought, what is absolutely essential to our society, and who provides those essentials?” In his view, it came down to pipelines, banks and railroads, and he chose his stocks accordingly.

Why do these strategies make more sense than simply buying a broad-market index fund? There’s a common-sense answer for that, too: “Buying an index fund is foolish, because you get the bad companies as well as the good ones.”

It’s easy to see why this approach to stock selection is so appealing. It’s intuitive, easy to understand, and empowering. And it makes no sense if your aim is to beat the market.

The problem here is not the premise of the argument—it’s the conclusion. Clearly blue-chip, dividend-paying companies like the big banks, telecoms, major retailers and energy producers are profitable businesses and can be expected to deliver a good return to shareholders. But this information has zero value to an investor trying to outperform the broad market, for the simple reason that everybody knows this.

Information is not insight

Financial author Larry Swedroe likes to compare stock picking with sports betting. When the first-place New England Patriots play the woeful Denver Broncos, it doesn’t take a genius to identify the favourite. So if you bet on the Patriots, they have to win by, say, 10 points or you lose the wager. Based on all available information — the teams’ records, injured players, home-field advantage — skilled bookmakers establish a point spread that makes the odds of winning the same no matter which side of the bet you take. In other words, knowing that New England is a better team is worthless information.

You can see the parallel with stocks. The “bookmakers” are the analysts who pore over every detail about public companies and trade millions of shares a day. They all know which ones have solid sales, a competitive advantage, a low price-to-earnings ratio and a record of dividend increases, and this knowledge is reflected in the (higher) price of those stocks. Companies and sectors that are struggling are just as easy to identify, and their (lower) stock prices reflect this, too.

In the end, buying Royal Bank or Telus rather than one of their competitors is like betting on the Patriots to beat the Broncos. You’re probably right about which company will prevail. But unless you can consistently cover the spread, you won’t beat the market.

The wisdom of the crowds

Common sense is a rare and precious asset, but it has no value when it comes to choosing stocks that will outperform a broad-based index. In an efficient market, every stock’s price already reflects the collective common sense of hundreds of thousands of informed investors. Once you accept this — and it’s clear that many people do not — then it’s wise to abandon the idea of selecting individual companies and simply embrace the market as a whole.

You can put your faith in your own unique ability to outsmart the market, or you can buy a slice of the entire world’s economy for less than 30 basis points. The right choice would seem to be common sense.

Other posts in this series:

Dividend Myth #1: Companies that pay dividends are inherently better investments than those that don’t.

Dividend Myth #2: Dividend investors are successful because they select excellent companies and buy them when they are attractively priced.

Dividend Myth #3: Dividend-paying stocks are a substitute for bonds in an income-oriented portfolio.

Dividend Myth #5: It’s easy to build a well diversified portfolio of Canadian dividend stocks.