Dividends

Alex Duty, our portfolio manager, wrote a great white paper on dividend investing. Dividend investing is a popular strategy and one we come across from incoming clients.  Alex’s position is that dividend stocks only earn abnormal returns due to their value tilt, not due to payout policy. Our firm has a value tilt. When Alex wrote the paper I passed it on to my husband, Barry Johnson who is a fan of dividend stocks. The email exchange that went back and forth exposed a deeper debate on this topic that also illuminates the mindset of a dividend investor. I hope you enjoy the exchange!

Alex:

Barry, what did you think of the ‘Investing in Dividend Stocks’ white paper I recently wrote?

Barry:

I did appreciate your analysis of the value factor being the foundation for the performance of higher-yielding stocks.  This is a good insight, and I would suggest that you have buried the lede by introducing it halfway through the piece.

Alex:

I understand you didn’t like my example with the $100 of cash company paying a $1 dividend though.

Barry:

I think the simplifying example is too simple.  As you note, in your synthetic example, you are the sole shareholder.  This implies, ipso facto, that you are the holder of a non-tradeable security.  Do you see where I am going here?  Enterprise value is a fantastic mental abstraction for evaluating companies, however it is not the same as, nor often even correlated with, the market value of a given firm.  I will return to the relevance of this point below.

But let me continue briefly with your simple example.  What if, despite being the sole shareholder, you, for reasons unknown, have very little control over management (although you do over the dividend policy)? Consider further that your experience with management is that they are not terribly effective investors of cash.  They often overpay for acquisitions. They build lavish new headquarters offices.  They excessively remunerate themselves.  They buy back shares from you and pat themselves on the back for increasing earnings per share despite the fact that they merely changed the denominator rather than the numerator of the equation. What if, in short, you believe you make superior investment decisions than management?  In that case, you might rationally think that leaving the firm with $99 and you with a $1, which you could more profitably invest than company management would leave you better off over time than letting management misallocate that $1.

Alex:

On the simple example, the whole point was to make it inescapably obvious that the price of a stock goes down by the amount of a dividend whenever one is paid.  My experience with fans of dividend stocks is that many of them don’t realize this.  I get the impression that some people think this dividend is truly an extra gain that corporate management creates out of thin air.  That may not be the case with all fans of dividend stocks, but it is definitely the case with some.  A cash dividend is the basically equivalent to a shareholder selling a little bit of his or her position and then the company having a stock split to increase the shareholder’s share count back to where it was prior to the sell.  The stock split would increase the share count and decrease the price per share just like the dividend decreases the price per share.  The taxation of the sale and stock split is not the same as for the cash dividend and there might be a commission on the sale and stock split that isn’t there with the cash dividend, but other than these minor differences, these two scenarios are actually identical.

This is why when I have heard from some dividend stock investors that while prices can deliver positive or negative contributions to returns, dividends always have a positive contribution, I have to disagree.  That is the perception, but the reality is that while prices can deliver positive or negative contributions to returns, dividends contribute nothing to returns.  Dividends deliver some positive cash flow, but this is exactly offset by a decline in the price that is directly related to the dividend.  This means a cash dividend’s true contribution to returns is always zero.  Just like if I sell some of my stock position, the contribution to my return from that sell order is also zero.

If you are distrustful of company management and think you can invest the cash paid out in the form of a dividend better than company management, isn’t receiving that cash dividend better than not receiving it?  I guess if you are distrustful of the management of a company and would prefer that they paid you $1 and kept the other $99 rather than keeping all $100, why wouldn’t you be concerned with how management is treating your other $99?  If there is concern about how the company is being run, should you even invest in that stock at all?  Again, if you really just wanted that $1 back, you could sell $1 worth of your position if there was no dividend.  You couldn’t make the stock split happen, but that just impacts share count, not capital invested, so it really isn’t important.

I guess if you are attracted to a company that is well run and pays a dividend, why can’t you be attracted to an equally well run company that pays no dividend?  If the two companies are equally well run and deliver the same total returns, does it really matter that one total return has a little bit more cash flow and less price return than the other?  It is possible that more direct measures of the responsibility of management (i.e. not overcompensating management or overspending on lavish offices) may have an impact on the attractiveness of a stock, but I’m not sure that dividend payout policy helps you directly pick which companies are responsible or not.  If it does, then perhaps responsible management (at least as perceived by investors) does not really matter as much for investors as they think.  If the end goal is to earn higher returns, at the end of the day, dividend stocks don’t earn abnormal returns after accounting for their value tilt.  Then again, maybe stocks with more responsible management are just trading at a premium price because investors recognize that responsibility and the value of it and are already reflecting that in the price.  These could all be reasonable explanations of why payout policy has no impact on future returns.  Regardless of which is true, payout policy doesn’t seem to impact total returns.

Barry: 

You made a comment in response to my comment about not trusting management’s decisions regarding the investment of excess cash and the possible unwisdom of being invested in a company without trust in management.  I would suggest that it’s less a matter of trusting management’s judgment broadly versus trusting them to make uniformly good investment decisions, particularly in the presence of excess capital.  And the principal/agent problem can never be fully eliminated – one can’t simply wish away self-interest.  Maybe if a company were run by Dominican monks (or other orders with a poverty vow) it might reduce this issue…  There is also the issue of the investor having a reasonable opinion that the company or the industry is not the singularly best place to invest cash even if they want some exposure to it.

Alex: 

I also made the point in my paper that dividend stocks are not very tax efficient.  Barry, what do you think about this point?

Barry: 

Regarding the issue of taxation – this is a fair point, however an investor with both taxable and tax-exempt accounts would rationally allocate their yield into the exempt account, somewhat mitigating this issue.  However, mentioning the taxation issue raises, but does not address, the fundamental iniquity of the tax treatment of returning cash to shareholders.  Yes, we currently have a system of taxation in which dividend payments are penalized over the so-called capital gain that comes from selling appreciated shares.  I say “so-called” because thanks to the “miracle” of share buy-backs, there is often no actual gain in the company’s true capital value, but only an appreciation in the per-share price.  Thus, a tax treatment intended to encourage capital formation and entrepreneurship (and true corporate growth), simply becomes a tool of large corporations to line their management’s pockets.

Alex: 

I would have to agree with your point that the issue of taxation is really only a minor disadvantage of dividend stocks that can be mitigated by holding them in an IRA.

Barry:

Returning to the issue of dividends as a component of the value an investor sees in a security, touched on above, is that there is also the question of market value of the security to consider.  A well-run company with a rational dividend policy can continue to pay that dividend regardless of the performance of the share price (which may be affected by specific bearishness on the security, the sector, or the market as a whole).  An investor who owns a stock chiefly for its dividend yield can rest untroubled by market turbulence, provided that turbulence doesn’t signal an impending economic calamity which will impact the fundamental performance of the company and thus its ability to pay the dividend.  This is a particularly useful attribute for non-professional investors, about whom there is much evidence of their habit of mis-timed emotionally-motivated sales which lock in losses during steep, if transitory, price declines.

In short, and I cannot speak for all who invest in stocks with a solid dividend, the preference for dividend yield is in many ways an ideological one.  It reflects a view about to whom the money in a company actually belongs (management or shareholders), a view of the principal-agent problem in joint stock corporations, and a desire to insulate oneself from the oscillations of the market.

Alex: 

Ideology aside, I still get back to the point that payout policy doesn’t have any impact on expected returns.  As for the desire to insulate oneself from the oscillations of the market, the price of high dividend stocks will fall during a market downturn just like the price of low to no dividend stocks will fall.  The receipt of a cash flow, which can easily be replicated with a sell order, seems to me to offer nothing more than emotional support.  I suppose I shouldn’t downplay the significance of emotional support though because it is important.  However, I think getting broader asset class diversification to protect in a stock market downturn is ultimately going to reduce volatility and the size of drawdowns in total returns more than focusing on dividend stocks.  This reduction in volatility should offer just as much emotional support as dividends do.  Admittedly, this doesn’t address the ideology of to whom the money in a company actually belongs though.  If that is the biggest reason why you like dividend stocks, I probably won’t be able to convince you to change your view.

Any final thoughts, Barry?

Barry:

If a company does have a regular buyback program which continues to ratchet up the price of their shares independent of the performance of the company (assuming a fixed PE ratio for sake of discussion), one could always periodically sell a portion of their shares to raise cash, resulting in the investor having an equivalent mix of cash and remaining value invested in the company as if a dividend were paid.  However, this is something that is more practical for a managed fund than an individual due to transaction costs.  This is a difference between individual-scale versus institutional-scale investors.

Maybe the real positioning is that while chasing dividends might be rational for an individual investor, another value/point of professional management is the ability to optimize on the same goals in a more financially (at least tax-wise) efficient way.

I do still nonetheless believe that companies should disgorge their cash to their owners in ways that do not chiefly have the effect of “artificially” inflating EPS (i.e. inflating EPS in the absence of an equivalent increase in core business performance).

 

 

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