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Beyond the Numbers

Beyond the Numbers

Trusted advice to help you think big and plan bigger.

In Defense of Dividends

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Research Analyst
Research, Cincinnati

A copy of this painting (Dividend Day at the Bank of England by George Elgar Hicks, 1859) hangs in my office, where it serves as a frequent reminder of the power of dividends. Romanticized though it may be, Hicks’ work depicts citizens from all walks of life eagerly waiting to receive a regular dividend check from their Bank of England investments. For better or for worse, there’s always been something about dividends that draws a crowd.  

In the 158 years since Hicks’ painting dried, academic studies have consistently found that, as a group, stocks with higher dividend yields exhibit lower risk characteristics, hold up better in market declines, and deliver attractive long-term returns.[1] In short, there’s a lot to like about dividends.

Unlike the interest on bonds, a regular dividend paid by a well-run business should grow over time, thereby keeping up with – or ideally exceeding – inflation. Perhaps unsurprisingly, then, dividends have been in demand in the post-financial crisis world where interest rates have left income-minded investors with few alternatives.

All aboard

Indeed, investor cash has poured into dividend-paying stocks in recent years. To illustrate, in 2016, inflows into dividend-focused exchange-traded funds (ETFs) rolled in at a shocking rate, accounting for as much as 25% of all equity ETF inflows through the third quarter, according to financial information firm, IHS Markit.[2]

To me, the renewed enthusiasm is a double-edged sword. Back in 2006, I distinctly remember looking for books on dividend investing and finding exactly one on the Barnes & Noble bookshelf. In this sense, it’s great to see more investors paying attention to dividends and expanding research on the topic. On the other hand, it’s a good rule of thumb to be skeptical of popular investment strategies of the day.

Curb your enthusiasm

So, what might today’s newly-minted dividend enthusiasts be missing?

  • Dividend payments are not guaranteed. Companies need to be confident in their ability to fully fund and grow their dividend payments in the coming years; otherwise, a dreaded dividend cut could occur. Before buying any dividend-paying stock, then, be sure to check its balance sheet health, competitive strengths, and free cash flow generation potential.
  • An ultra-high yield is often a code word for “ultra risky.” Whenever a stock yields more than two or two-and-a-half times the market average (today that would be above 4%-5%), there’s a good chance something is wrong with the story. Either growth has stalled or investors perceive significant risks to the underlying business. In a broadly efficient market like the one we have in the U.S., the market doesn’t easily give away high yields. Before buying, you always need to ask, “What might other investors know that I don’t know?”
  • Be mentally and emotionally prepared for a stock price plunge. While dividend-paying stocks as a group have historically shown resilience in bear markets, a 3% dividend yield is cold comfort when the stock price falls by 20% or more. Dividend stocks bear the most fruit with time, so before investing, make sure you are willing and able to own the stock for at least five years and even invest more if the price falls. This requires an understanding of and appreciation for the underlying business and its valuation.

All told, the last few years have been an ideal environment for dividend investing – low-interest rates, inflation, and market volatility. That could change over the next decade, so make sure you own dividend stocks for the right reasons.

Theory vs. practice

Some financial commentators have taken a much harsher stance against the new popularity of dividends, calling a dividend-focused approach, among other things, “irrational,” and a “fallacy.”[3],[4] Ouch.

Granted, some of the criticism is fair. Dividends are not “free money” as some think – the stock price adjusts lower on the ex-dividend date. Next, there’s a double taxation issue – corporate profits are taxed, as are dividends at the shareholder level. And one could, in theory, just as easily sell a few shares instead of receiving a cash dividend.

While it may be more tax efficient for shareholders if companies didn’t pay dividends, this would likely come at a much higher, less-obvious cost: value destruction.

How companies spend shareholder money

This isn’t to say that companies shouldn’t buyback shares, acquire businesses, and reinvest, but shareholders shouldn’t overlook the capital discipline dividends can place on management.

According to Credit Suisse, in 2015, U.S. companies deployed capital as follows.[5]

As you can see, dividends are a small piece of the total capital allocation pie. Between M&A and growth capital expenditures, management teams as a whole still have plenty of capital to deploy on growth projects. Further, excluding 2009, U.S. companies have spent more on buybacks than dividends each year since 1996, making buybacks the clear preferred vehicle of returning shareholder cash. Taken together, investors put great faith in management teams’ ability to allocate capital on their behalf.

This is a tall order, however, as you’re hoping management can consistently make smart acquisitions, invest in the right projects, and repurchase their stocks at good-to-fair prices.

One only needs to consider the massive restructuring and impairment charges that occur in Corporate America each year and over a business cycle to appreciate that management “skill” all too often falls short of the mark. Even so, few management teams will readily admit they are below-average capital allocators. Consequently, investors need to consider management’s track record, incentives, and integrity when determining whether or not the company pays out the right level of dividends.

Show me the money

A compelling 2003 paper by Robert Arnott and Clifford Asness found that, contrary to popular belief, companies with higher dividend payout ratios (i.e. they pay out more of their earnings) produce the highest expected earnings growth. Among other hypotheses, the authors put forth an explanation that “high payout ratios lead to more carefully chosen projects,” while “low payout ratios lead to, or come with, inefficient empire building and the funding of less-than-ideal projects and investments.”[6]  In other words, if management’s “sandbox” of capital is too large, they’ll likely misuse it. Dividends can reduce the size of that sandbox and lead to greater capital discipline.

Though his firm is often cited as the case-in-point for not paying dividends, Warren Buffett is anything but anti-dividend. To illustrate, a shareholder asked Buffett at the 2008 Berkshire Hathaway meeting about his thoughts on dividends. He replied:

“I do believe in dividends, including dividends at companies where we own stock. The test on dividends is, ‘can you create more than one dollar of value with the one you retain?’… We like companies where we have investments to pay to us the money they can’t use effectively.”[7]

It makes good business sense for companies to return cash they can’t reinvest at high rates of return. With that cash in hand, shareholders can then decide for themselves the best place to reinvest. (Even better, if dividend-paying stocks are held in tax-advantaged accounts like IRAs, the “tax efficiency” argument against dividends is greatly diminished.)

Companies can also return cash via buybacks, of course, but there’s no implied “commitment” from management to maintain a certain level of buybacks each year. This is usually not the case with cash dividends, as most dividend-paying companies have a progressive dividend policy in which they aim to pay at least as much the prior year.

As such, buybacks provide less protection against management “empire building.” Further, management teams have broadly been inclined to buy back shares when the market’s good and then turn off the tap when the market is down. As investors, we know this is not a winning strategy.

 

Bottom line

As with any investment approach, there are positives and negatives to pursuing a dividend-focused strategy. All strategies fall in and out of favor, yet the power of dividends over long periods of time can be found in both academic studies and real-money portfolios. Maybe the pursuit of dividends is irrational and a fallacy, but the proof of the pudding is in the eating, so I believe I’ll have seconds.

Stay patient, stay focused.

Todd

Todd owns shares of Berkshire Hathaway. You can also follow Johnson Investment Counsel on Twitter @johnsoninv

What we’re reading

 

[1] http://www.tweedy.com/resources/library_docs/papers/WhatHasWorkedFundOct14Web.pdf

[2] https://www.markit.com/Commentary/NewsCommentarieFile?CMSID=e9c2f0a0c517499eaaf19edf2761f90f

[3] http://www.etf.com/sections/index-investor-corner/swedroe-irrelevance-dividends?nopaging=1

[4] http://www.cnbc.com/2016/12/08/dont-buy-in-to-the-dividend-fallacy-new-academic-paper-warns.html

[5] https://doc.research-and-analytics.csfb.com/docView?language=ENG&format=PDF&sourceid=em&document_id=1066007811&serialid=yKerDV9lV5lbOxhMTMaFhAZ9MZ8nzrqd4M0N8V3Gv9c%3d

[6]https://www.researchaffiliates.com/documents/FAJ_Jan_Feb_2003_Surprise_Higher_Dividends_Higher_Earnings_Growth.pdf

[7] http://seekingalpha.com/article/75598-2008-berkshire-hathaway-shareholder-meeting-detailed-notes

 

Disclaimer

Todd Wenning is a Research Analyst with Johnson Investment Counsel (“Johnson”). Todd and clients of Johnson own shares of Berkshire Hathaway.

The contents of this article express the opinions and views of the author and do not necessarily reflect the opinions or views of Johnson or its employees.

The views and opinions presented in this article are intended for entertainment and educational purposes only and should not be construed as a solicitation to effect transactions in securities or the rendering of personalized investment advice. The views and opinions expressed in this article are not intended to be tailored financial advice and may not be suitable for your situation. No person should assume that any advice or strategies presented in this article serves as the receipt of, or a substitute for, personalized individual advice from an investment professional. You should consult with a professional before taking any action inspired by the views and opinions presented in this article.