Understanding Dividends and Dividend Irrelevance Theory
Although we strive to remain above the fray when providing financial advice and allocating investment portfolios, it can be accretive to indulge in some of the financial industry’s more polarizing subject matter. One such heated debate centers around the relevance of equity dividends. The focus of the discussion is on how stock dividends impact returns and an investor’s ability to draw regular sums from their portfolio. Many individual and institutional investors have expressed a preference for owning shares in dividend paying companies and the primary reasons are as follows:
1-Signal of Financial Health - A consistent dividend payout can be seen as a signal of acompany's financial health and stability. Companies that regularly pay dividends are oftenviewed as having reliable cash flows and a commitment to returning value to shareholders.
2-Historical Stability - Dividends have historically been a significant component of total returnsfor stocks as a whole. Even during periods of market volatility or downturns, companies with ahistory of paying dividends often continue to do so, providing some level of real and perceivedstability to investors.
3-Regular Income - Dividends provide a steady stream of income for investors, which can beparticularly attractive for those seeking regular cash flow, such as retirees or income-focusedinvestors.
Although I would not take issue with the first or second line of reasoning, there are theoretical and empirical problems with thinking of dividend income as “free money” that is paid out by corporations to provide investors with regular income.
Enter the Dividend Irrelevance Theory. Assuming that there is no signaling effect (meaning that the company's dividend decisions do not convey information about its future prospects), there should be no change to a firm's value based on how it chooses to distribute its profits (via dividends, share repurchases, or increases to retained earnings). The Dividend Irrelevance Theory suggests that the value of a stock is based on its future growth prospects and risk characteristics, not on how it does or does not distribute its earnings.
On the ex-dividend date (the date on which all current holders of the stock are guaranteed to receive a future dividend payment), the price of the stock should (and often does) adjust downward by the amount of the dividend to reflect the fact that new buyers of the stock will not be entitled to the next dividend payment, and that the company's assets will decrease by the amount of the upcoming dividend payment. This can be difficult to see in practice when looking at a stock chart because most annual dividend yields average around 2%, so only ~0.50% gets paid out on a quarterly basis. Because stock prices are constantly adjusting to incorporate new information, this relatively small decline in price on the ex-dividend date can be subsumed by regular intraday volatility. However, logic dictates that had the company in question retained its earnings (opposed to distributing them as dividends), the value of its shares would likely increase by the amount of the cash value of those retained earnings and based on the prospects for investing that cash in future growth opportunities. With the above in mind, an investor should be indifferent between arranging an automatic periodic sale of shares to fund distribution needs or using dividend income to pay for living expenses.
Furthermore, for non-qualified account investors, in paying a dividend, a company is effectively forcing you (the investor) into a taxable event. With non-dividend paying firms, only a sale of shares (by you the owner) will result in a taxable event, whereas with dividend payers the dividends will either be taxable as income or at the capitals gains rate. In that way, a reliance on dividend income may reduce investors’ autonomy in managing their tax situation.
While some investors will continue to prefer shares of dividend paying companies for the convenience of their cash flows, it is important to recognize that dividends are not “free money" (they do tend to negatively impact the share price of the issuing company on the ex-dividend date) and that there may be additional negative attributes to consider (like reduced control over your tax situation).
As part of the Red Oak asset management process, we seek to allocate to equities in a diversified and risk-aware manner with a focus on total return (income plus capital appreciation), although at some points in the economic cycle our preference may be for owning dividend paying stocks in an outsized proportion. Such tilts will often be based on the characteristics that define most dividend payers (steady revenues and high quality earnings), whereas we are less likely to recommend an allocation to specific companies or sectors solely for the purpose of increasing portfolio cash flow.
Aaron
