Dividends and ‘The Magic Pants’

Seeking Alpha blogger Chuck Carnevale recently wrote a piece entitled “Debunking The Dividends Don t Add Shareholder Value Myth.” The following are six statements from Carnevale’s article that I would like to refute.

1. “I believe that it is undeniable that dividend income, if any, represents an important component of the total return provided to shareholders on any publicly traded company.“

First, it’s important to know that approximately 60 percent of U.S. stocks don’t pay dividends. Thus, the total return to investors in these stocks comes solely from capital gains, with dividends playing no role whatsoever.

Second, this line of thinking makes the mistake of confusing expected returns from realized returns. The best methods for estimating future returns that we have are based on valuation metrics, either a current earnings yield (the inverse of the more common price-to-earnings [P/E] ratio) or the yield based on Shiller’s Cyclical Adjusted P/E ratio. You’ll note that dividends aren’t considered.

Third, consider this example: If company A pays a dividend and company B does not, is Carnevale suggesting that Company A has a higher expected return because of the dividend? If so, does that mean the expected return on Company B goes up if it begins to pay a dividend? As a bit of anecdotal evidence, you might check out the realized returns of Microsoft (MSFT) for the 17 years it paid no cash dividend and its subsequent performance once it became a dividend payer. (Note that I’m not suggesting that the return would have been higher had it continued to not pay dividends, only that the dividend policy didn’t matter, it wasn’t what was driving returns.)

Fourth, for the past 20 years the workhorse model in finance has been what is generally referred to as the Fama-French four factor model – with the four factors being beta, size, value, and momentum. The model explains almost all of the differences in returns of diversified portfolios. If dividends played an important role in determining returns, than the four-factor model wouldn’t work as well as it does since dividends are not one of the factors. If, in fact, dividends added explanatory power beyond those of these factors, we would have a factor model that included dividends as one of the factors. But we don’t. The reason is that stocks with the same “loading,” or exposure, to the four factors have the same expected return regardless of their dividend policy. The new “q-factor” model, which is now competing with the Fama-French model, and helps explain almost all the anomalies that the Fama-French model cannot explain, also has four factors. They are beta, size, investment (which correlates highly with the value factor), and profitability (which correlates highly with the momentum factor), and doesn’t include dividends either. The bottom line is that while for some stocks dividends compromise a significant portion of the total return, the evidence demonstrates that their return isn’t impacted by the dividend policy.

2. “The primary point that this article will address is the debunking of the ‘dividends don’t matter myth.’ This myth is perpetuated by those who contend that dividends are irrelevant, because somehow in their mind’s eye a company has become permanently less valuable by precisely the amount of the dividend that they paid out to shareholders.”

While this is a commonly heard argument, it’s shocking to hear it stated, let alone repeated over and over again. The reason is that it’s the financial equivalent of saying 2-1=2. One commentor to Carnevale’s article provided this wonderful analogy: “You have a pair of pants. In the left pocket, you have a $100. You take $1 out of the left pocket and put in the right pocket. You now have a $101. There is no diminution of dollars in your left pocket. That is one magic pair of pants.”

Carnevale went on to provide a series of charts of the prices of various companies and what happened to the price after the dividend date. And looking at the chart one might even agree with him. But, there’s a lot of “noise” in daily pricing. Rather than cite financial theory (which states that dividend policy is irrelevant) or the evidence (that stock prices reflect the dividend) all one needs to show that this idea – that somehow dividends are a free lunch (the magic pants) – is wrongheaded is to consider one of the stocks Carnevale provided a chart of, PepsiCo Inc. (PEP).

PEP closed on March 12, 2014, at $81.80. With about 1.5 billion shares, it had a market capitalization of roughly $124B. I went back and found that just since 1992, the company has paid out about $22.5 a share in dividends. Now ask yourself, if you put $22.5 billion in cash back on the balance sheet, would the company still trade at $81.80, as Carnevale argues? Obviously, at the very least it would trade at about $104.30. Isn’t $1 in cash worth $1? Now, this doesn’t even consider the lost interest income the company would have earned had it not paid out the dividend and invested the cash in bonds. Nor does it consider the alternative of using the cash to pay off debt, which would have increased earnings even further by reducing interest expense. Nor does it consider that if the company had kept the cash and invested it, and been able to earn its cost of capital, the value added would have been much greater. Nor does it consider the fact that if the company had perhaps another $30 billion or so in cash it would have if it had not paid the dividend, the company would be considered a safer investment, and that might lower its cost of capital, producing a higher price-to-earnings ratio. Nor does it consider the alternative of using the cash to buy back shares which would have reduced the number of shares outstanding and thus the earnings per share would have been higher, as would the stock price (assuming it traded at the same price-to-earnings ratio). Arguing that the stock price isn’t permanently lowered, relative to where it would have been had it not paid the dividend and kept the cash instead, is saying $1 doesn’t equal $1.

To emphasize the point, consider Apple (AAPL), which ended 2013 with almost $160 billion in cash. If the company decided to pay out say $100 billion of its cash in a dividend, do you really believe that the stock would be worth the same price? And wouldn’t the stock always be worth at least that much less relative to whatever it traded it in the future?

3. “First of all and practically speaking, once I receive a dividend from a company I own, I have less money at risk precisely proportionate to the amount of my dividend check. Therefore, I understand that I simultaneously have reduced the risk of owning that stock simply because I now have less money at risk. Moreover, I did not have to sell any shares to receive that cash back, therefore, my beneficial ownership interest in the company remains intact. More simply stated, I still have all my shares.”

This concept fails to understand the simple math that shows that a homemade dividend, created by selling shares equal to the amount of a dividend, produces the same result. By selling shares you reduce your exposure to the stock’s risk in the same way, and by the same amount, as a dividend does. And to demonstrate the point that the two are equivalent we’ll consider two companies that are identical in all respects but one: Company A one pays a dividend and Company B does not. To simplify the math, we’ll assume that the stocks of both companies trade at their book value (while stocks don’t always do that, the findings would be the same regardless).

The two companies have a beginning book value of $10. They both earn $2 a share. Company A pays a $1 dividend, while Company B pays none. An investor in A owns 10,000 shares and takes the $10,000 dividend to meet his spending requirements. At the end of year one the book value of Company A will be $11 (beginning value of $10 + $2 earnings – $1 dividend). The investor will have an asset allocation of $110,000 in stock ($11 x 10,000 shares) and $10,000 in cash for a total of $120,000. Now let’s look at the investor in B. Since the book value of B is now $12 ($10 beginning book value + $2 earnings), his asset allocation is $120,000 in stock and $0 in cash. He must sell shares to generate the $10,000 he needs to meet his spending needs. So he sells 833 shares and generates $9,996. With the sale, he now has just 9,167 shares. However, those shares are $12, so his asset allocation is $110,004 in stock and $9,996 in cash, virtually identical to that of the investor in Company A.

Another way to show the two are equivalent is to consider the investor in A who instead of spending the dividend reinvests it. With the stock now at $11, his $10,000 dividend allows him to purchase 909.09 shares. Thus, he now has 10,909.09 shares. With the stock at $11 his asset allocation is the same as the asset allocation of the investor in B: $120,000 in stock.

It’s important to understand that Company B now has a somewhat higher expected growth in earnings because it has more capital to invest. The higher expected earnings offsets the lesser number of shares owned by the investor who sold shares to create the home made dividend, with the assumption being that the company will earn its cost of capital.

4. “I believe that the dividend I receive also represents a return bonus. This belief is based on the reality that the payment of the dividend does not reduce the amount of earnings that the company reported on its last financial statements. Therefore, my experience indicates that ‘Mr. Market’ will continue to capitalize the company’s future earnings in the aggregate, just as they always have and do.”

While not reducing past earnings, paying a dividend obviously reduces the value of the company. As we explained earlier, a $1 is worth $1. In addition, if the company invests the cash (as opposed to putting it under a mattress), future earnings are expected to be higher. If it paid down debt, future earnings would be higher. If it just invests in bonds, future earnings will be higher. And if instead of paying a dividend it pays down debt or invests in bonds the company’s leverage is reduced, making it a less risky company. And that could lead to an increase in the price-to-earnings ratio.

5. “I am not alone on this position. In his excellent and newly released book titled ‘Top 40 Dividend Growth Stocks For 2014,’ author and fellow Seeking Alpha contributor David Van Knapp has this to say on the subject. ‘Because of this price adjustment, shareholders who owned the stock before the ex-dividend date, and who hold on straight through, see the price of their stock momentarily lowered by the amount of the dividend. In practice, as soon as trading opens on the ex-dividend date, market participants establish the actual price of the stock. The exchange’s price adjustment is usually hard to detect after an hour or two of trading. There certainly is no long-term impairment to the price of the stock [emphasis mine].”

Here we have another person who believes $1 isn’t worth $1. It’s amazing what beliefs people will hold onto simply because they are long held and they have much vested in the belief. They find it hard to accept even the obvious because somehow it goes against their accepted beliefs. Saying a company with less cash is worth the same as a company worth more cash (all else equal) is like saying the sun doesn’t rise in the East.

6. “Moreover, the reality that dividends provide important benefits to shareholders is clear and observable to anyone who’s reviewed the evidence or that applies common sense. In my last article, I referenced that I was stating the obvious. To me, the reality that dividends are beneficial is readily apparent. Not only are they a component of total return that does not reduce the value of the business, they also represent significant risk-mitigation.”

We have already addressed the ideas that dividends don’t reduce the value of the business. And we have also addressed the reduction in risk (which of course isn’t the case for the millions of investors who reinvest their dividends), which can be accomplished via self-dividends just as cash flow can be accomplished in that manner. So we’ll move to addressing the idea that dividends are beneficial.

First, consider the following example. Assume Company A and Company B have identical cash flows and have identical opportunities to invest in profitable projects. Company A pays a dividend, B doesn’t. If company A wants to invest an equal amount in new projects as Company B, it may have to borrow money since it has paid out some of its cash flow to shareholders as a dividend. Do dividend fans believe it is wise for the company to take on more debt in order to fund new projects and also maintain its dividend? And wouldn’t the increase in interest expense (or the reduction in interest earnings) lower future returns?

Second, dividends do provide one benefit. They reduce what is called agency risk – the risk that a company will spend “excess” cash on bad investments, perhaps poor acquisitions designed to build “empires.” But you don’t need dividends to do that. Repurchasing stock, or paying down debt, accomplishes the same objective. And while some companies spend cash unwisely, many others, like Berkshire Hathaway (BRK.B) for example, have never paid a dividend – and I don’t think anyone would argue that investors would have been better off if BRK.B had paid dividends. On average, there’s no effect, or we would see the failure of the factor models to explain returns without using dividends.

Second, even in the current tax regime where qualified dividends are taxed at the same rate as long-term capital gains, they’re not as tax efficient as home made dividends. The first reason is that you are forced to take the dividend, even if you don’t need it. And taking dividends might push you into a higher tax bracket. The second reason is that a dividend is the equivalent of selling shares with a zero cost basis (you are taxed on the full amount of the dividend). With a self-made dividend, you can choose to sell the lot with the lowest cost basis, minimizing taxes as the tax is due only on the portion that is a gain, not the full amount.

It’s important to understand that I’m not making the case that dividends are bad (except for their relative tax inefficiency). Nor am I making the case that you should avoid buying stocks that pay dividends. It’s just that they don’t matter in the sense that they don’t add any explanatory power to returns. In other words, you can use screens such as low prices to value metrics (such as p/b, p/e, p/cf, p/s) and profitability metrics (such as ROE, or ROA) and produce a more efficient portfolio simply because you won’t be eliminating from your universe the 60 percent of U.S. stocks that don’t pay dividends and the 40 percent of international stocks that don’t. And since done properly diversification is the only free lunch, you might was well eat as much of it as you can.

Finally, the preference for cash dividends has long been considered an anomaly in finance. However, there are behavioral explanations for the anomaly. If you’re interested in these explanations you can read more here.Whatever the reason though, it seems that many people have a tough time understanding the dividend irrelevancy argument – I hope this article helps those confused.