Although value stocks might sound unattractive, these stocks
should not be shunned by investors. First, investors’ expectations of low
growth may be incorrect. But, more importantly, even if these expecta-
tions are correct, these stocks might offer superior returns if their price is
low enough to compensate for the lower growth. In fact, as we shall
show below, value stocks generally give investors higher returns than
growth stocks.DIVIDEND YIELDS
Dividends have always been an important criterion for choosing stocks
as Graham and Dodd stated in 1940:Experience would confirm the established verdict of the stock market
that a dollar of earnings is worth more to the stockholder if paid him in
dividends than when carried to surplus. The common-stock investor
should ordinarily require both an adequate earning power and an ade-
quate dividend.^10Graham and Dodd’s claim has been supported by more recent re-
search. In 1978, Krishna Ramaswamy and Robert Litzenberger estab-
lished a significant correlation between dividend yield and subsequent
returns.^11 And more recently, James O’Shaughnessy has shown that in
the period 1951 through 1994, the 50 highest-dividend-yielding large-
capitalization stocks had a 1.7 percentage point higher return than the
market.^12
The historical analysis of the S&P 500 Index supports the case for
using dividend yields to obtain higher stock returns. Using December 31
of each year from 1957 onward, I sorted the firms in the S&P 500 Index
into five groups (or quintiles) ranked from the highest to the lowest div-
idend yields, and then I calculated the total returns over the next calen-
dar year.
The striking results are shown in Figure 9-2. In strictly increasing
order, the portfolios with higher dividend yields offered investors
higher total returns than portfolios of stocks with lower dividend yields.
If an investor put $1,000 in an S&P 500 Index fund at the end of Decem-CHAPTER 9 Outperforming the Market 145
(^10) Graham and Dodd, Security Analysis, 2d ed., p. 381.
(^11) See Robert Litzenberger and Krishna Ramaswamy, “The Effects of Personal Taxes and Dividends
on Capital Asset Prices: Theory and Empirical Evidence,” Journal of Financial Economics, 1979, pp.
163–195.
(^12) James P. O’Shaughnessy, What Works on Wall Street, 3rd ed., New York: McGraw-Hill, 2003.