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Whether in a business school classroom or at some other point during your journey as an investor, you’ve heard it said. The concept is rooted in the influential Modigliani-Miller theorem. It has since morphed into the harshly named “dividend irrelevance theory.”
The argument goes like this: A company’s value (and stock price) is driven by its ability to earn a profit and grow its business. Its dividend policy is irrelevant at best. In some cases, paying dividends could hurt the stock.
Is it true? Let’s explore this idea further.
As a shareholder, you are a partial owner of a business. You want the management of that business using its investment capital and earnings in the best way possible. Now, management has a few choices of what to do with that capital. They can pay down debt, reinvest in the company, make an acquisition, buy back stock, or pay a cash dividend.
In theory, paying dividends could be detrimental. If a company can achieve a high return for shareholders by deploying that capital to grow the business or acquiring another one, it makes sense to do that in lieu of paying a dividend. And if a company has substantial debt, they could be sacrificing a healthier balance sheet and financial position by paying out dividends.
But there are no hard and fast rules here. This is why investing in companies with management that you believe to be excellent capital allocators is crucial. You are trusting them to do the right thing with your money.
And the right thing doesn’t always occur.
Think of a few acquisitions that have gone wrong. Here’s a doozy. AT&T (T) anticipates their spinoff of WarnerMedia to close in the second quarter of 2022. AT&T should reap $43 billion from the deal. A nice chunk of change. Except AT&T paid a whopping $85 billion to acquire Time Warner back in 2018. That’s not the excellent capital allocation we’re looking for.
What about buybacks? They can be an excellent way for companies to return capital to shareholders, especially if the stock is undervalued. At my firm, Stansberry Asset Management, our income strategy takes a ”shareholder yield” approach to selecting investments. Buybacks are a big factor in our decision making.
Still, this approach isn’t without its risks. The news of General Electric’s (GE) recently announced $3 billion buyback program caused involuntary shudders in many of its long-term shareholders. That’s because GE has historically been the poster child for when buybacks go wrong. Between 2012 and 2017, GE spent roughly $32 billion to repurchase its own shares at an average purchase price that was well above $200 a share, given where the stock was trading at.
The company’s debt ballooned. It was removed from the Dow Jones Industrial Average – an index it had been a component of since 1907. The stock has been a perennial underperformer ever since, and sits around $95 today. This is not the type of buyback we want to see.
What is best? Grow the business? Pay down debt? Buy back shares? The frustrating answer is one that applies to so many questions in the world of investing: It depends.
But here’s what I love about dividends – it is the only option that puts the control in your hands.
Think it’s a great time to buy the stock? Reinvest your dividends! Not sold on management’s expansion plans? Funnel those dividend payments somewhere else to spread out your risk.
Like some other academic ideas that pertain to investing – I’m looking at you, efficient market theory – the idea that dividends are irrelevant is plausible on paper.
But until we decide to permanently plug into the metaverse, we live in the real world. There, having some degree of predictability in your investment return is important. Having a say over what happens to the earnings of a company you own as a shareholder is desirable.
Oh, and making money is important too.
In a study examining 60 years of historical returns, Greenrock Research found that dividend payers in the S&P 500 outperformed the broader S&P 500 index by 2.2% per year.1
Over those 60 years, a $10,000 investment in the S&P 500 would have grown to $4.2 million. The same investment in the dividend payers would have grown your initial investment to $13.5 million.2
In the real world, dividends matter.
Michael Joseph, CFA is a vice president and deputy chief investment officer at Stansberry Asset Management. He is a member of the CFA Institute’s Practice Analysis Working Body and sits on the advisory board of the Arizona Council on Economic Education. He can be contacted at [email protected]
This report has been prepared by Stansberry Asset Management and is for informational purposes only. Nothing herein should be construed as investment advice, or as an offer to sell or the solicitation of an offer to buy a financial instrument. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
1High and Growing Dividends, Greenrock Research.
2Dividends Matter. SmartETFs.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
