Dividends and Market Returns:
The compounding impacts of dividends have historically been significant in terms of market returns for long-term investors. The importance of these cash flows to investor returns can be seen across countries and industries.
However, over the last four decades the pronounced growth of stock buybacks has dimmed the lights on the importance of dividends. From 1972 to 1998 the dividend payout ratio of publicly listed U.S. companies declined from 22% to 14%. Over this same period, the ratio of share repurchases relative to earnings increased from 3% to 14%.1 As a result, the total cash payout to shareholders rose to 28% of earnings. It is important to note that, prior to 1971, buybacks were relatively rare. Wage and price controls imposed by the Nixon administration placed restrictions on dividend payments and induced a number of firms to consider share repurchases. Further impetus for repurchases came from the issuance of SEC rule 10b-18, which provided guidelines for firms that wished to repurchase shares in the open market.
Following the 2008-2009 financial crisis, Federal Reserve Zero Interest Rate Policy (ZIRP) put renewed emphasis on investable assets providing reasonable levels of absolute yield, leading investors to seek out investment strategies and products that focus on yield. Unfortunately, yield alone has not provided investors with superior market returns.
In general, firms with equivalent cash flows but different dividend yields reflect investor perception of the risk to future cash flows. Investors attach higher risk to higher yielding securities by discounting their future cash flows at higher rates. So, there is a relationship between dividend payouts and expected returns (Blume, 1980).
Do dividends matter?
The question of whether dividends matter has been the subject of much research attention over many decades. Academic scholars Franco Modigliani and Merton Miller examined a hypothetical firm that wanted to distribute a fixed amount of cash to its shareholders either by repurchasing shares or by paying a cash dividend, finding that neither option impacted the firm’s investment decisions or operations. Their study demonstrated that, in the absence of personal taxes or transaction costs, the choice between paying a dividend and repurchasing shares is a matter of indifference. However, most corporate managers believe that this proposition ignores market realities.
Given the tax advantages of stock buybacks, why do firms continue to payout so much of after-tax earnings in the form of dividends? The reason: it positively impacts stock returns.
|
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Impact of announced dividend increase = 2% |
( Aharonyand Swary, 1980) |
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Initiation of a quarterly dividend = >2% |
(Michaely,Thaler & Womack, 1995) |
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Reduction of a dividend = -9.5% |
(Healy and Palepu, 1988) |
Our own observations incline us to believe that dividend increases may impact the market to an even greater degree than these earlier academic works suggest. Dividends are seen as more than temporal increases to investor cash flows and therefore signal to the market positive longer-term expectations for operating cash flows. For example, following dividend increases, equity analysts have tended to increase their earnings forecasts more for low price-to-book firms than for high price-o-book firms, which often pay no dividends (think of the classic growing tech company as an example). In general, dividend increases generated only slight stock price increases for firms viewed as having favorable investment opportunities (i.e, higher P/B firms). Contrasting this, dividend increases resulted in much larger stock price responses for firms believed to have unfavorable investment opportunities. Hence, the payoff differential between stock buybacks and dividends tends to be imperfect.
The financial crisis and its aftermath have added layers of uncertainty to the investment puzzle. With investors seeking to mitigate risk, it appears the role of dividend policy has taken heightened importance. Dividend- growing stocks modestly outperformed the broader equity markets in the five years prior to the start of the financial crisis.
Post-financial crisis, dividend growth appears to be increasingly favored by investors.
Indeed, dividend growth has been a much larger determinant of equity returns in this new era of low benchmark rates and higher levels of uncertainty.
Overall, we believe that the combination of yield and growth, combined with strong underlying fundamentals, should provide investors with superior long-term returns relative to the broad equity benchmarks.
Changes in dividend payouts tend to have above average impact on firm value. Financial information that conveys favorable information to the market tends to increase stock prices, even when the decisions are potentially negative for the firm’s future profitability. Dividend increases in particular can diminish intrinsic values, but still generate positivestock price responses because they signal favorable information. As a consequence, dividend growth as a strategy can mitigate investment risk.
Footnotes
1 Grullon, Gustavo and Michaely, Roni. Dividends, Share Repurchases, and the SubstitutionHypothesis (April 2000).AFA 2002 Atlanta Meetings.
2 The Modigliani-Miller Theorem (M&M, 1961) posits dividend irrelevance.
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