It is a common belief among many investors that if total returns are your primary objective, you should forget about dividend stocks and invest heavily in tech stocks like Nvidia (NVDA) and cryptocurrencies like Bitcoin (BTC-USD), perhaps with an allocation to prominent companies like Berkshire Hathaway (BRK.A) (BRK.B) as well, to maximize your total returns over the long term. However, we believe this notion is misguided because it is grounded in recency bias, and it ignores the fact that dividends and total returns are not mutually exclusive. In fact, by implementing an actively managed high-yield portfolio, we have been able to significantly outperform not only the broader universe of high-yield (DIV) and dividend growth (SCHD) stocks but also the S&P 500 (SPY) since our portfolio launched in 2020.
In this article, we will explore this notion further and apply it to explain how the Vanguard Dividend Appreciation Index ETF (NYSEARCA:VIG) is a sound fund for doubling down on this philosophy over the long term.
Why Dividend Stocks Can Generate Strong Long-Term Total Returns
Dividends can help enhance a stock’s total return over the long term for numerous reasons. One primary reason is that paying a dividend forces management to be highly disciplined in how it allocates capital, since it must pay out a meaningful percentage of earnings periodically to shareholders via dividends, often even increasing that payout per share each year. This compels management to run the company with a long-term perspective, taking care of its balance sheet and ensuring that its investments are geared towards generating increasing earnings year after year. Otherwise, it faces the embarrassing prospect of having to cut its dividend, which could anger shareholders and attract activist investors who may then pressure management into resigning or even lead to the board firing senior leadership for mismanaging the company’s balance sheet and earnings power.
Moreover, with less cash on hand, management is automatically forced to high-grade its investments to the highest returning and lowest risk opportunities, thereby improving returns on invested capital or returns on equity over time, which in turn leads to higher total returns.
Another reason why a stock paying a dividend could lead to higher total returns is that it provides a strong reminder to management and the board on a monthly or quarterly basis that their primary responsibility is to the shareholders. In an age of “stakeholder capitalism,” where companies are increasingly focusing on broader causes, this is a welcome reminder for capital allocators that shareholders’ interests should be prioritized.
Another way dividends can help maximize total returns over the long term is by attracting a stable investor base and providing a stronger floor for the stock price since companies that pay consistent and growing dividends over time are often viewed as reliable income vehicles by retirees and institutional investors. This shareholder base tends to be more long-term oriented, avoiding short-term speculative plays on the stock. This can lead to more stable stock prices and therefore a more stable cost of capital for management with which to fund growth investments and help to avoid steep sell-offs in the stock during periods of market volatility. This, in turn, can aid investor psychology and help to protect their principal against sudden sharp declines, also enabling them to hold for the long term through periods of severe market turmoil as they focus on the income stream their stock generates rather than short-term market gyrations.
Why VIG Is A Good Dividend ETF For Total Returns
For these reasons, we think that a fund like VIG could make for an outstanding long-term investment. This is particularly true in this fund’s case because it has one of the lowest expense ratios of any dividend growth fund in the market, at 0.06%. Additionally, it is well-diversified with technology serving as its largest sector, thereby giving it exposure to growth and the benefits of the artificial intelligence revolution, headlined by its top three holdings in Microsoft (MSFT), Apple (AAPL), and Broadcom (AVGO). However, technology only accounts for 22.35% of its portfolio, and it has significant exposure to numerous other sectors such as financials, healthcare, industrials, and consumer stocks, making it a more resilient fund across market cycles.
Last but not least, it is focused on investing in stocks that generate strong dividend growth, as evidenced by its 11.39% three-year dividend growth CAGR, which means that the aforementioned advantages of investing in dividend-growth stocks certainly apply to the fund. This makes it a fund that has a very strong chance of not only generating powerful dividend growth for shareholders over the long term, but also one that generates very attractive total returns.
While it is true that VIG has underperformed the S&P 500 since its inception, the underperformance is not huge, especially given that technology stocks have significantly outperformed over that period. In fact, prior to the recent strong run in technology stocks, VIG was actually slightly outperforming SPY. Moreover, looking further back into history, we see other significant periods where technology stocks have underperformed the broader market. As a result, especially when accounting for the elevated valuations seen in many mega-cap technology stocks right now, we think that VIG is in a tremendous position to potentially outperform the S&P 500 moving forward.
Investor Takeaway
We prefer to pick individual dividend stocks when constructing our portfolio, given our strong track record of outperforming both dividend and the S&P 500 indexes since the inception of our portfolio. However, for investors who want a broadly diversified, low-cost, and completely passive vehicle for gaining exposure to the majority of the benefits that come with dividend investing, we think that VIG is a tremendous tool for accomplishing that and generating very strong total returns that could potentially even outperform the S&P 500 over time.
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