Angels, Pinheads, Capital Gains and Dividends

A Middle Aged Dispute

Medieval scholars have a reputation for disputation on the most abstract and rarefied of theological questions, the “how many angels can dance of the head of a pin” problem.  Of course, this is now a byword for particularly pointless, time-wasting debates.

Modern investors have their own equivalent conundrums, such as “does market growth come from dividends or capital growth?”  Just like its Middle Ages counterparts it turns out that the answer is neither obvious nor unimportant. 

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Dividends Keep You Anchored

Warp Drive Valuations

OK, we know that bubbles sometimes form in markets and we also know that sometimes the price of a stock doesn’t so much drift away from a realistic valuation as engage the Warp drive and disappear off into the Outer Limits. There’s also modelling research which also suggests that the way markets behave depends on the balance between short-term chartists and long-term fundamentalists.

Which is nice and all that, but doesn’t really explain how we should actually go about investing. After all, why is one method better than another and what should we actually invest in? To which the answer, it seems, is all tied up with dividends.

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A Yen For Yield

Retirement Nirvana Postponed

As countries have squashed their interest rates down over the past few years it's had the nasty consequence for millions of people approaching retirement of pushing back that nirvana of non-working bliss ever further into the future. By attempting to stimulate economies, by turning the lenders of last resort in free money machines, annuity rates – the interest received on retirement pots – have fallen, often quite dramatically.

When this happened in Japan the net effect was an extraordinary quest for a higher income in the most unlikely of places. Now, as the irrestistable force of the Boomer population moves inexorably into its retirement and is faced with the unmoveable object of yields on their investments that wouldn’t feed and clothe an anorexic sparrow on a crash diet, we’re likely to see yet another set of equally unintended consequences. If you want a trend to follow then don't bother with gold: look for yield.

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The Psychology of Dividends

Dividends Can’t Matter – Rationally

One of the more amusing failures of classical economics is its inability to explain why companies pay dividends. The Miller and Modigliani (1958, 1961) synthesis shows that rationally dividends are irrelevant to a corporation’s valuation: after all, if you give investors some of the company’s earnings then the company should be less wealthy to the same degree that investors are more, so there’s no net gain for shareholders.

Which is all nice and theoretically sound in the hermetically sealed world of rational economics but, unfortunately, when companies cut dividends their valuation usually drops, often quite dramatically, and when they raise them significantly the opposite happens. As usual, out in the real-world, it’s what people do, not what economics dictates, which rules.

Give and Take

The rational analysis of the irrelevance of dividends is perfectly grounded in straightforward economics. If I own a share which gives me access to $2 of a company’s earnings and the company gives me $1 directly then the company’s share price should drop by $1 and I will be $1 personally better off (minus taxes). So all things being equal a dividend should be irrelevant.

In fact dividends may well be damaging to a company’s prospects. If instead of giving me $1 the company invested it in product innovation, or marketing or an earnings enhancing acquisition (no laughing, please) it will be able to grow its earnings more quickly. I, the shareholder, benefit with a more rapidly increasing share price. If I want some of this for my own personal consumption I sell some stock.

Of course, large and mature companies may not be able to find sufficient earnings enhancing opportunities and so, all things still being equal, may decide that returning excess earnings to shareholders is the best thing. Again dividends aren’t the only way of doing this, although as we discussed in Buyback Brouhaha the main alternative – stock buybacks – is shrouded in managerial deceit and accounting opaqueness in a way that dividends aren’t. Although buybacks may be more tax efficient, depending on your taxation jurisdiction.

Dividend Signalling

So there are valid reasons for dividends, even if the classical view states that this won’t benefit shareholders directly. At least returning cash to shareholders allows us to redeploy these into other opportunities with better earnings prospects – although, as has often been pointed out, we can do that by selling one company’s shares and buying another’s.

Overall, then, it’s not at all obvious why companies should be overly concerned about dividends. However, they are, because they spend a great deal of effort manipulating dividends and giving indications about future dividend policy. And they’re right to do this because surprises in terms of dividends tend to cause significant share price movements in spite of what classical economics tells us should be the case. One of the possible explanations about why dividends persist in spite of economists saying they shouldn’t is their signalling effect.

So, a change in dividend policy may often indicate a change in the company’s fortunes. A cut in dividends will often signal reduced earnings – although it sometimes indicates that there are better earnings enhancing opportunities around. Similarly an unexpectedly raised dividend will often see a share price surge – even though this often indicates that the management have run out of ideas about how to deploy their spare cash, which isn’t exactly a positive sign.

Desperate Dividends

However, to argue that the only reason dividends exist is to give managements a way of showing their confidence or lack of seems, well, desperate. After all management could rather more simply tell us directly that they have low visibility of future earnings – they’ve been doing that rather a lot recently. No, the real explanation seems to be that investors often prefer dividends: so why might investors have a preference for higher taxed dividends over internally reinvested earnings?

Well, firstly, returning free cash to shareholders removes from management the temptation to waste it on pet projects. It also has the rather odd effect of disciplining managements because they will more often have to raise additional capital in the market. Strange though it is, companies that pay out dividends are often simultaneously tapping the markets for additional capital. That additional capital costs the company money in fees, dividends cost the shareholders money in taxes and the total result is a significant reduction in earnings available to the company’s owners.

We live in a strange world.

The Psychology of Dividends

There are also multiple behavioural reasons why investors might prefer dividend paying stocks over non-dividends. Firstly, receiving an income stream means that investors don’t need to sell stock to receive an income, which can often be a source of regret (which we discussed in … err … Regret) if the company subsequently does well. Of course, investors could have reinvested their dividends in the stock but this is a sin of omission, as opposed to a sin of commission, and is far more easily ignored, as suggested by Shefrin and Statman.

Secondly, the problem of self-control that we discussed in Retirees, Procrastinate at Your Peril is far easier to manage if investors decide to spend only their dividends. Although the research suggests quite strongly that the only stock market growth available for long periods is through dividend reinvestment investors will often spend the “interest” on their dividends anyway. By avoiding any sale of capital it’s easier to control the urge to spend the lot. This is Mental Accounting again, of course.

Finally there’s a case that a stock paying a high dividend today is perceived as a better bet than one that may provide greater earnings and price increases in future. This is known as the “bird-in-the-hand” fallacy.

Residual Dividend Policies

One of the odder findings in research on dividend paying stocks is that those companies which follow a so-called residual dividend policy – essentially paying out their entire free cashflow to investors as dividends – are generally more financially sound than companies paying out less of their earnings. Explaining this isn’t easy, but it’s possibly worth noting that these higher dividend payers tend to be larger and find it easier to raise external capital.

It’s certainly a counter-intuitive idea for investors to look for larger companies with lower free cashflow, but those companies with residual dividend policies tend to have longer term outlooks than others. In essence these companies don’t actually aim to run with low free cashflow but instead set dividend policy based on expected long-term earnings, rather than adjusting based on the short-term winds of fortune. So perhaps this finding is simply stating that those companies whose managements take a long term view and want to maintain a stable shareholder base are likely to be better aligned with their long-term owners than others.

Note, though, that “alignment” means understanding shareholder psychology and playing to it, attending to the lessons of behavioural finance. This isn’t necessarily the same as maximising shareholder value as promoted by more orthodox economic theories. We’ll revisit this issue, soon.

Dividends Are Not Enough

However, it’s fairly clear that deciding on an investment policy purely on the basis of dividends without regard to the nature of the underlying corporation is a pretty stupid idea and one that’s founded in behavioural fallacies. The behavioural tricks and twitches that make people adopt this kind of approach regardless of the underlying robustness of the institutions involved is simply another facet of the psychological blindness that many investors have with regards to stockmarket investment.

In the end, there’s none so foolish as those that are blinded by their own behavioural failings. Most of us can recognise the psychological problems of stockmarket investing in others yet the majority of people will still fail to acknowledge their own issues. Dividends are simply the tip of a very a large problem. Still, on the positive side, well managed dividend payers are amongst the best bets in the market. Just don’t forget to reinvest the dividends while you can, otherwise you’re spending the majority of your future wealth.


Related Articles: Real Fortune Telling, Buyback Brouhaha, Debt Matters, Don’t Overpay for Growth