Dividends really, really matter....

Friday, Feb 11 2011 by
13
Dividends really really matter

Why are dividends so important ? The academic literature suggests that dividends benefit investors over the long term in a number of different ways.

The first and perhaps most obvious is the actual regular dividend payment as a contributor to what are called shareholder returns but the magic of dividends doesn’t stop there – there is some evidence that a strategy of buying the right kind of dividend payers (progressive dividend payers with a decent balance sheet) will actually delivers better returns in and of itself i.e the market itself tends to prioritise the attractions of certain dividend payers and awards their shares a premium rating. The reason for this market preference is obvious in retrospect – dividends are easy to calculate and involve simple, hard numbers made in regular payments. But dividends also tend to be much more stable over time compared to earnings – annual earnings growth has historically been 2.5 times more volatile than dividend growth according to SG – while the discipline of making the regular dividend payout encourages a more focussed management, determined to conserve the financial resources of the firm. As Lapthorne at French investment babk SocGen reminds us “the retention of a too high proportion of earnings can encourage unnecessary mergers and acquisition (and often wasteful) investment in the pursuit of higher earnings growth”. As an example of this discipline and focus its worth noting that very few companies ever set their management teams a dividends target as a way of calculating their bonuses – the cynic might note how difficult it is too manipulate the dividends stats compared to earnings. 

Dividends by contrast are boring and steady. A study by French bank BNP Paribas looked at both US and European Dividend growth over the very, very long term. It found that US equities have not only risen consistently faster than inflation but have increased by a fairly steady 1.4% per annum in compound annual terms – an extra 1.4% every year, compounded makes a huge difference to returns data.

Sadly most investors don’t tend to focus on the boring old dividend payout – they’re much more enthused by the profits or earnings numbers. But these widely followed numbers based on cash profits are also hugely volatile - back in the middle of 2009 for instance various studies by leading investment banks pointed to a precipitous collapse in global stock market earnings…

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23 Comments on this Article show/hide all

emptyend 11th Feb '11 4 of 23
5

In reply to post #53783

Do you not think a lot more people would have held onto their Soco if they recieved a dividend?

Absolutely not. That is one of the most delusional ideas I've ever heard. I can't comment on the other one.

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Stockhound 12th Feb '11 5 of 23
4

A lot of people post these kinds of articles banging the table about how dividends matter. The truth is they are normally trying to sell you some kind of income fund.

The proportion of earnings paid out as dividends  (the dividend payout ratio)  has been falling for decades primarily as share buybacks have become a far more common way of returning money to shareholders. As long as buybacks are done at prices that are lower than intrinsic value then I'm all for it.

I would much rather a rational management team invested excess earnings in a tax efficient way back into the business (if there's a high enough ROE) than distributing them as dividends where I'd have to pay income tax on top of the corporation tax already paid on those earnings - who likes double taxation? It seems to me that the only people who should prefer a dividend are those that really do need the income to live off.

I believe in Norway there is no income tax on dividends, thus avoiding this double taxation -  I applaud that.

If I'm wrong on my thinking on this, please do let me know,  I'm certainly no tax expert and would appreciate the feedback.

 

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marben100 12th Feb '11 6 of 23
2

In reply to post #53796

I don't think people should be so scathing about dividends.

It seems to me that the only people who should prefer a dividend are those that really do need the income to live off.

But that is surely a high proportion of investors/savers? - either directly, or indirectly via pension funds.

As long as buybacks are done at prices that are lower than intrinsic value then I'm all for it.

I agree. However, "intrinsic value" is an ephemeral (though important) concept. Net result is that one can only judge whether buybacks really were below intrinsic value with the benefit of hindsight. Consider, for example, Rio Tinto (LON:RIO) 's recent announcement.

·      Final dividend of 63 US cents per share increases total dividends for 2010 to 108 US cents per share, up 20 per cent compared with previous commitment of 90 US cents per share.

·      Capital management programme announced, comprising a $5 billion share buyback by the end of 2012.

Rio's P/E currently stands at only 8, so you might think that the shares trade below intrinsic value and hence that this buyback is sensible.

However, the shares currently trade at 4623.5p... whereas Rio made a rights issue @ 1400p/share in 2009. What sense does it make from the company's POV to be issuing shares and then buying them back for 3x the price it issued them at?! I don't call that good business. It would seem much safer to return excess cash by way of a special dividend. There are tax efficient ways of doing this (e.g. capital shares) - and many investors can make dividends tax efficient in the UK by using iSAs.

Regards,

Mark

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Stockhound 12th Feb '11 7 of 23
2

In reply to post #53809

It has actually been well documented by Miller and Modigliani that in a scenario with no corporate taxes or brokerage costs dividend policy is irrelevant - unsurprisingly it's known as the 'dividend irrelevance theory'.

Their theory is that any shareholder can create 'homemade dividends' of their own liking. If you received a big dividend and didn't like it, you can buy more stock, if you didn't receive a dividend you can sell stock.

I guess there's just no correct answer for or against.  But In spite of this, the 'bird in the hand' of receiving the odd dividend on a variable reward schedule tends to make certain investors exceptionally defensive about them.

I certainly vie on the side of believing in 'homemade dividends' if a company has a good return on equity as they should keep the money for reinvestment.... that is unless the company is mature (having excess profits) or can't see any use for their excess cash (from disposal, windfalls etc).

What frustrates me is seeing companies paying out dividends but raising money at the same time - what's all that about? If you see an opportunity, why not just invest the money and not pay a dividend - saving fees and probably taxes? But they can't due to the clientele effect of having X number of pension funds as shareholders who would sell the stock if they saw the divi as unreliable.  Sometimes companies have their hands tied by the expectations of the finance industry.

Ramble and out!

 

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sirlurkalot 12th Feb '11 8 of 23
4

Total return really really matters. Not dividends.

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marben100 12th Feb '11 9 of 23
3

In reply to post #53813

Total return really really matters. Not dividends.

In principle and in the long run, yes. But, if you want a regular, reasonably reliable income there is a clear problem with the "dividend irrelevance theory". That is, that you will be forced to sell more shares at times when the market is weak and fewer when it is strong. This is the precise opposite of what you should be doing to achieve the best returns.

Investors should never lose sight of the fact that the whole point of investing is to achieve a return. There are two ways of doing that: either through dividends, or by relying on the market to offer you a better price (possibly by means of a takeover). The latter method is intrinsically less reliable than the first.... and the former appeals to the lazy, who just like to see that income keep on rolling in, and with a bit of luck & investing skill, growing - and without having to reduce their share in the business by selling. ;0)

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Fangorn 13th Feb '11 10 of 23
2

I think you're spot on Marben.

What EE forgets is that most investors don't have the intrinsic knowledge or the investing expertise to achieve the returns he has made over 15 years without, as he says, divis. It takes alot of skill, research,and some luck, to achieve such a superior performance on capital gain alone as he has done.

For the majority of investors I suspect the focus is on a mixture of the two, the dividend reinvestment approach is indeed a lazy man's dream but still dependent on some work to pick those stable blue chip companies. Over time dividend reinvestment compounded has led to significant returns. Isn't there a Barclays Gilt/Equity study that indeed shows the outperformance of a dividend reinvestment approach or that dividends make up 90% of the return over the long term? (I've not seen it in many years now.Does its premise still hold?)

Whilst I wouldn't focus all my savings on such an approach I certainly would have it as the foundation base to a diversified portfolio with a view to it ideally providing a reasonably guaranteed stable decent long term return(one in a million BP events aside for example) . With the foundation sorted I'd personally feel more comfortable taking more risk in the search of better capital gain orientated returns. But that's just me...

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emptyend 13th Feb '11 11 of 23
3

Total return really really matters. Not dividends.

 

In principle and in the long run, yes. But, if you want a regular, reasonably reliable income there is a clear problem with the "dividend irrelevance theory". That is, that you will be forced to sell more shares at times when the market is weak and fewer when it is strong. This is the precise opposite of what you should be doing to achieve the best returns.

Mark - SirL is completely correct on this one. 

In "the old days" when investors got a reclaimable tax credit on dividends and when it cost 1 or 2% or so in brokerage  for any retail investor to transact, then there was at least a half-reasonable case for preferring dividends if one needed income.....

.....but that ceased to be the case over 10 years ago!

If I need money to live off (which I have done now for the better part of a decade) then I simply sell enough shares to cover the next month or three. Cost? About 0.25% or less....

If one structures one's investments (as ALL "income funds" do!) to only hold stocks that pay a reasonable dividend, then one is de facto shutting oneself out from some of the biggest growth opportunities. And, in terms of total returns, that is likely* to be enormously value destructive.

*The only exception perhaps being in the event of a long-term bear market that would be expected to hit growth stocks harder because (putting the effect in fixed-income language) the duration of the expected cashflows on non-dividend growth stocks is is going to be rather longer than with stocks that pay a largeish dividend....hence the concept of "defensive" stocks.

As Stockhound says, M&M argue that dividends are irrelevant - but ONLY if there are no frictional costs, which there ALWAYS are, as his comment here indicates:

What frustrates me is seeing companies paying out dividends but raising money at the same time - what's all that about? If you see an opportunity, why not just invest the money and not pay a dividend - saving fees and probably taxes?

Not only is there no logical dividend-preference advantage for retail investors any more, but it has ALWAYS been the case that frictional costs can be substantial - as stockhound's comment indicates.  The only justification for companies paying dividends is that their management can foresee no likelihood of meaningful opportunities for growth....but there is no reason on earth for an investor to rationally prefer dividends or to hold (most*) dividend-paying stocks.

*Obviously if, for example, one particularly wanted to own tobacco stocks then dividends would come with the territory, because tobacco is generally ex-growth.

ee

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Isaac 13th Feb '11 12 of 23

ee,

What has your annual rate of return been the past 3 years with such an approach?

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marben100 13th Feb '11 13 of 23
1

In reply to post #53832

Hi ee,

If one structures one's investments (as ALL "income funds" do!) to only hold stocks that pay a reasonable dividend, then one is de facto shutting oneself out from some of the biggest growth opportunities.

Completely agree with that and I most certainly wouldn't advocate putting all of one's portfolio into yielding stocks.

Concerning the tax credit... the impact of that depends on your personal taxation arrangements. I think I'm correct in saying that dividends no longer affect a company's tax bill (ACT no longer exists) - so tax-neutral from the company's perspective. From the shareholder's perspective, if your income is NOT tax sheltered and you are a higher rate taxpayer then, yes, dividends are not at all attractive, which perhaps influences your view?.

So, bottom line AFAICS, is "horses for courses". Dividends WILL be an attraction for some shareholders but not for others. They shouldn't dominate one's thinking, but may have a role - and for many savers of modest means will have a role - especially at a time when inflation is high and bank interest rates on savings derisory.* A company that pays high dividends will be attractive to some shareholders but not to others. And I maintain that a business that does not pay dividends is inherently riskier (even in total return terms) than one with a sound track record of progressive dividends - and a business model that makes that track record sustainable.

*ISTM that the market has not yet recognised this, and that stocks such as Glaxosmithkline (LON:GSK) with a sustainable 5.7% current year forecast yield, and offering some degree of inflation protection, stand a good chance of showing a strong capital gain, as well as a good dividend. I suspect that that sort of yield on quality businesses will not be available for too long, unless interest rates rise very sharply, which I think unlikely, though modest rises may be on the way. For anyone interested in GSK, there is an interesting brief note here: http://www.morningstar.co.uk/uk/news/article.aspx?articleid=95622&categoryid=13

Best,

Mark

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Isaac 13th Feb '11 14 of 23

Mark

I hold a decent amount of GSK in my port. Worth adding that the company seems to be buying back a million shares a day, which makes a lot of sense given the low rating & increasing dividend. In particular love the Lucozade and Ribena brands that will continue to generate cashflow like a coca cola year in year out.

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marben100 13th Feb '11 15 of 23

In reply to post #53833

Isaac,

Short term returns (and I call 3 years short term) say very little about the validity of differing investment approaches. As you know my 3 year return has been been pretty good - but that had very little to do with dividend paying stocks and more a combination of extraordinary market pricing anomalies (companies trading way below NTAV, and arbitrage opportunities between linked companies) and exploration successes (i.e. some luck) .

Only the future will tell whether my decision to increase the proportion of high-yielders in my portfolio at this time proves to be a good one or not.

Best,

Mark

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Isaac 13th Feb '11 16 of 23

 

Mark

In the aftermath of the crisis a number of stocks found themselves in the Dogs not so much because they were robust businesses that wanted to be good to investors but because they were vulnerable businesses. 

These companies were forecast to pay high dividends but frequently ended up being unable to do so. For a while their yields looked good, then they either announced a cut in the dividend or the share price fell so far that they were booted out of the FTSE 100. Man Group is a classic example of the former and Home Retail Group of the latter.

Finally there are signs that the portfolio is regaining its defensive qualities. In November, when we last looked at the portfolio, the Dogs comprised Aviva, AstraZeneca, National Grid, Resolution, Royal Dutch Shell, RSA, Scottish & Southern-Energy, Standard Life, TUI Travel and Vodafone.

Since then, share prices at Shell, TUI Travel and Vodafone have increased. Their yields, which fall as the stock price rises, have come down and they are dropping out of the portfolio.

In their place we welcome British American Tobacco, GlaxoSmith-Kline and United Utilities. This means the Dogs include four insurers (Aviva, Resolution, RSA and Standard Life), three utilities (National Grid, Scottish & Southern and United) and two drug multinationals (AstraZeneca and Glaxo). Last but not least is cigarette manufacturer BAT.

The Dogs' newly defensive bias has already begun to benefit the portfolio's performance. Over the past three months the FTSE 100 has gained three per cent while the Dogs are up eight per cent. In 2007 we invested a notional £10,000 in the FTSE and the same in the Dogs. Today, the FTSE investment is worth £9,452 while the Dogs are worth £6,000.

The gap is still uncomfortably large but it is closing. It is worth bearing in mind however, that our calculations look at share prices only, on top of which investors have enjoyed some extremely handy dividend payments. Perhaps the Dogs are not such bad investor companions after all.



Read more: http://www.dailymail.co.uk/money/article-1356371/MIDAS-JOANNE-HART-Dogs-taking-steps-recovery.html#ixzz1DqnwHZa6

I think that article sums up why I don't believe in holding dividend stocks forever,. As soon as I feel GSK is more fairly valued I will be out......

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Isaac 13th Feb '11 17 of 23

7: Ignore volatility. Mr Woodford said: “In the short-term, share prices are buffetted by all sorts of influences, but over longer-time periods fundamentals shine through. Dividend growth is the key determinant of long-term share price movements, the rest is sentiment.”

http://blogs.telegraph.co.uk/finance/ianmcowie/100009449/10-tips-to-invest-in-equities-for-income-as-dividends-return/

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emptyend 14th Feb '11 18 of 23
2

In reply to post #53839

Concerning the tax credit... the impact of that depends on your personal taxation arrangements. I think I'm correct in saying that dividends no longer affect a company's tax bill (ACT no longer exists) - so tax-neutral from the company's perspective. From the shareholder's perspective, if your income is NOT tax sheltered and you are a higher rate taxpayer then, yes, dividends are not at all attractive, which perhaps influences your view?.

Yes - tax-neutral for a company but, as was pointed out, it makes no sense to both pay dividends and raise fresh equity - because of the costs of issuance etc. Pre-Brown investors used to get a tax credit in an ISA (I think), but these days there is no tax credit and there is also a flat rate charge on interest (at 20%), even within an ISA.

So, bottom line AFAICS, is "horses for courses". Dividends WILL be an attraction for some shareholders but not for others. They shouldn't dominate one's thinking, but may have a role - and for many savers of modest means will have a role - especially at a time when inflation is high and bank interest rates on savings derisory.*

*ISTM that the market has not yet recognised this

I think you are completely wrong on the idea that the market hasn't recognised this. ISTM that the "we can't get any yield anywhere else" trade has been one of the major market drivers for the last 18 months! What the market hasn't yet taken on board is that interest rates will soon start to rise and, as a result, this "dash for yield" will soon start to unwind!

A company that pays high dividends will be attractive to some shareholders but not to others. And I maintain that a business that does not pay dividends is inherently riskier (even in total return terms) than one with a sound track record of progressive dividends - and a business model that makes that track record sustainable.

On your point about relative risk, you are correct in theory (as I reflected in my comment about "duration" earlier).....cash flows are expected to occur sooner in dividend-paying stocks. However, it is a complete fallacy (though historically one that is extremely widely held!) that they are ACTUALLY safer in practice. In fact I think we have probably had more recent examples of this in the last three years than at any point in my lifetime........I refer you to all of the banks, BP etc etc etc . See this Daily Mail article from two years ago for more examples of companies that have been forced to pass or cut their dividends.

The concept of companies being able to offer high and progressive dividends relies upon them:

a) having some pricing power and

b) inflation

IMO, although we are clearly exposed to the risk of inflation at this point, I think this will mainly be reflected in corporate input costs and that relatively few companies (mainly towards the luxury end of the market which isn't reliant on the financial health of "the man in the street") will actually be able to see stable or growing margins in the next couple of years.

If you MUST buy stocks that pay dividends, then keep a very close eye on their margins....but frankly I think it much safer not to chase the 2010 yield trade, especially at this point!

ee

 

 

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sirlurkalot 14th Feb '11 19 of 23
3

There is a case for buying dividends - as I've previously written I do so to use the 0% tax allowances since I have no other income. None of the other arguments in favour of dividend-paying shares on this thread persuade me. ee's quite right that it's barmy to both pay a dividend and have a rights issue.

I'd beware of Glaxo being on a bigher yield than in the past suggesting it would be an attractive investment - IMO it's gone ex-growth with a less attractive drug pipeline. Is Glaxo's long run earnings growth likely to match the UK market?

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emptyend 14th Feb '11 20 of 23
1

There is a case for buying dividends - as I've previously written I do so to use the 0% tax allowances since I have no other income. None of the other arguments in favour of dividend-paying shares on this thread persuade me.

I might just note that SirL's tax position is an extremely unusual one. There can be few people with zero income who have enough assets to make it worth (in effect) converting potential taxable capital gains into taxfree income.

I am broadly in a similar (asset rich, income poor) position, except that my income exceeds the zero tax band and virtually all my CGT liability is sheltered within an ISA....and I wouldn't dream of buying dividend-paying stocks unless I thought they also offered good capital growth opportunities.

I also agree SirL's caution over Glaxo.

Now all I need is some capital gains......  ;-)

ee

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Fangorn 14th Feb '11 21 of 23
1

I'm in a similar position, Asset rich, income poor, but unlike you EE don't have most of it sheltered within an ISA due to working overseas for so long. Only effectively started using my ISA allowance/Sipp upon returning in 2007. Income Tax rates of 16% however, where I was working, enabled a decent sum to be saved, and I didn't waste those bonuses being one of the few prudent individuals of my generation.

I currently split my investments into SIPP ( mainly income orientated eg Man group,Aviva, PSPI,Interserve), ISA's (Income orientated with the odd speculative investment compared to the majority of my holdings eg Aex(Unfortunately), AGQ), and then have a trading book element where I do most of my capital gains orientated stuff. eg BP and other oilies/miners and whatever value play takes my fancy.

Given I'm not currently working the risible amount in my SIPP means I will have to take more risks as I'm unable to put in more than the 3600 or so currently allowed. Which is a pain given my situation above.

 

p.s looking for some decent capital gains myself. 

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sirlurkalot 14th Feb '11 22 of 23
1

Whilst in the general population "people with zero income who have enough assets to make it worth (in effect) converting potential taxable capital gains into taxfree income" aren't frequent, I suspect amongst the most visible bulletin board writers there are a few in that position. Amongst the people I spend time with in real life it isn't an uncommon situation either.

I've got to the point of inventing a not-actually-existing positive low-ish income to state on tax returns, on which I pay tax, in order to access the health services of the country in which I reside, but I won't give details of that on a public BB.

In reality my buying dividends strategy has evolved on from converting gains into enough income to fill the lower tax bands, into partly being a profitable strategy in its own right. Carefully chosen and timed right, it isn't difficult to make the in-and-out over the ex-div date capital neutral, whilst receiving the div income.

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extrader 14th Feb '11 23 of 23
1

Hi fangorn,

As a returned 'expat' - altho a few years earlier than you - I'm broadly in your position ie not (currently) working and able therefore to pay in only the GBP 3.6 k p.a. into my SIPP.

In addition to the trading account that you refer to, I also have a couple of spread-betting accounts and use those selectively (well-capitalised relative to the size of position I occasionally take) to generate some income.

Some special dividends from eg EML, POL and URU have helped the switch from capital to income (with the added benefit of a capital loss in addition to allowance-using income).

The most useful element long-term, it seems to me , is however the ISA, given the reasonable amount you can invest each year, the range of instruments you can invest in and the flexibility- at some point - re eventual withdrawal.

Returning briefly to 'nos moutons', I'm very much in the capital growth priority camp - the only dividend-payers I've been interested in recently have been the distressed bank debt (RBS, B & B, NRK etc), where it's a moot point as to whether coupon or capital gain has been/will prospectively be of greater significance..........

GLA

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