The Dividend Puzzle - or why the Dividend Emperor may have no clothes!

Thursday, May 31 2012 by
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The Dividend Puzzle  or why the Dividend Emperor may have no clothes

Dividends are a real mystery to researchers. In 1976, Fischer Black (yes, the same Black as in Black-Scholes!) wrote a seminal paper looking at corporate dividend payments entitled "the Dividend Puzzle". He concluded:“The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don’t fit together”. 30 years on, there's still a lot of intense head-scratching going on in the ivory towers. Why all the confusion? Well, while investors are quick to praise the merits of a dividend-paying stock (especially of late!), the thing that stumps academics is that dividend payments should, by their very nature, have a negative expected return. This is for two main reasons...

Why Dividends Baffle The Brains

Firstly, dividend payment tend to lead to double taxation of income - dividends are paid from after-tax profits and yet investors must pay income tax on dividends. That's also at a higher rate than capital gains, in most markets. The issue here is not just the immediate value destruction, but also the lost compounding of those taxes over time. Charlie Munger of Berkshire Hathaway gives an example of a 10% per annum investment that pays taxes every year versus an investment that pays taxes all at the end. Mr. Munger explains:

“you add nearly 2 percent of after-tax return per annum from common stock investments in companies with tiny dividend payout ratios.” 

Secondly, a dividend distribution is essentially just a partial liquidation of the company. If a company has just paid X million in dividends, then its enterprise value has decreased by a corresponding X million. As Modigliani & Miller showed back in the 1960s, regardless of how the firm distributes its income, its value is determined by its basic earning power and its investment decisions. No value has been created by the dividend payment, nada. Indeed, as just mentioned, value is likely to have been destroyed due to the tax effect. As Cameron Hight has written:

"I was sitting beside an economist on a flight to New York City while writing this article and I asked the question, “How much money do you have if a $10 stock pays you $1 dividend?” He said, “$11, the $10 stock plus the $1 in dividend.” In actuality, you still have $10 because the price of stock declines by the…

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36 Comments on this Article show/hide all

Edward Croft 7th Jun '12 17 of 36
2

In reply to post #66371

Unless I've mistaken your analysis, if you held an equal weighted portfolio of your hypothetical portfolio your portfolio would look like this.

Start: Equity Position £100, Cash Position: 0
End: Equity Position: £100, Cash Position: £3

I'm fairly simple, so I'd apply Occam's razor to presume that whole return has come from the dividend - I couldn't care less what's happened to the individual equities. It's the dividend that's the reason for the cash jangling in my pocket after all.

I do understand that you are talking about the danger of weighting your portfolio to solely high yield - but dividends in general don't tend to liquidate a company's capital! A paper by Rob Arnott showed that high payout ratio stocks actually out grow the rest of the market.

Almost every bit of research I have read recently - including the Soc Gen Quality Income index that I wrote about last week indicates that both high yield and high quality stocks have outperformed the market index over the last 12 years - and high quality income stocks have massively outperformed. It's in bull markets that income stocks underperform growth, but there's not much evidence of a bull market springing into action as yet. In fact all the evidence suggests that the sideways market will continue for a fair while longer.

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SteMiS 7th Jun '12 18 of 36
3

I'm fairly simple, so I'd apply Occam's razor to presume that whole return has come from the dividend

But it hasn't. It's come from the dividend of A, plus the capital gain of B, less the capital loss of A.

Thinking it has come from the dividend alone means that you would pick share A, the High Yield share, to invest in (assuming you are not an index investor buying equal weightings of A and B) and would therefore make no return.

The point I'm making is that it is NOT true that 90% of the return on the stock market has come from dividends and 10% from capital gains.

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emptyend 7th Jun '12 19 of 36

In reply to post #66371

The market returns 3% over the period and this appears to be entirely due to dividends. That however is a misinterpretation and chasing dividend yield would lead to underperformance for an investor (in our case a 0% return). The entire stock market return in our example actually comes from the capital gain of the growth stock (B). It only 'appears' to come from dividend return.

The reason for this is that overall capital gain or loss for the stockmarket over a period is the net of gains and losses amongst its constituents. On the other hand there are no negative dividend payers (no companies, as far as I know, actually take dividends off shareholders). So net dividend return is always going to be positive. That doesn't mean dividend payers are delivering positive total return or that there is correlation between dividend payment and positive return.

Very well put!

I'm fairly simple, so I'd apply Occam's razor to presume that whole return has come from the dividend

But it hasn't. It's come from the dividend of A, plus the capital gain of B, less the capital loss of A.

Thinking it has come from the dividend alone means that you would pick share A, the High Yield share, to invest in (assuming you are not an index investor buying equal weightings of A and B) and would therefore make no return.

The point I'm making is that it is NOT true that 90% of the return on the stock market has come from dividends and 10% from capital gains.

Yes indeed. Dividends merely pay a portion of the company value out to their shareholders.

Ed says:

Almost every bit of research I have read recently - including the Soc Gen Quality Income index that I wrote about last week indicates that both high yield and high quality stocks have outperformed the market index over the last 12 years - and high quality income stocks have massively outperformed. It's in bull markets that income stocks underperform growth, but there's not much evidence of a bull market springing into action as yet.

....but IMO that is falling into the trap of generalising from the peculiar circumstances of recent years. We have undoubtedly had:

a) falling interest rates

b) rising risk aversion

c) a desperate search for income

As a result, dividend paying stocks have done very well - but THAT DOESN'T MEAN THAT THEY WILL CONTINUE TO DO WELL - OR THAT THEY HAVE SOME SORT OF SPECIAL INTRINSIC VALUE - quite the reverse, in fact.....

I think you can look forward from here to a decade of UNDERPERFORMANCE from dividend-paying stocks! All these factors will eventually unwind.

What you want for the future is high quality growth opportunities - or undervalued ones. You DON'T want companies that are on the path to self-liquidation due to an excess of sucking-up to please the dividend junkies!

That said, of course, there isn't much evidence of a bull market springing into action as Ed says - but OTOH, you CERTAINLY aren't going to get rich by betting (in effect) on a further fall in interest rates from current levels.

ee

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Edward Croft 7th Jun '12 20 of 36
5

In reply to post #66375

I've actually historically thought that dividends were just too boring, and signified ex-growth stalwarts.  But I've been researching the subject for some time now and my perspective has completely inverted.   They are not stocks you prefer to own in a secular bull, but they most certainly are the stocks you want to own in a secular bear/sideways market such as the one we are currently enduring.

You've probably noticed a slew of dividend related articles hitting the site in recent weeks - we'll be packaging this stuff up as an e-book 50 pages or so in due course.  The reason for doing this is that we do indeed think there's an intrinsic value in high quality dividend paying low beta stocks. The market systematically underpays for them.  People (fund managers) in general tend to put their money on lottery tickets, growth stories, event possibilities etc etc in the hope that they can bag a 100% return in a year.  The market overpays for hope.  It underpays for boredom.   Systematic underpayment leads to outsized future returns at a steadily compounding rate.  As Buffett says "I don't look for hurdles I can jump over, I look for ones I can step over" - or something like that.

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emptyend 7th Jun '12 21 of 36
1

they most certainly are the stocks you want to own in a secular bear/sideways market such as the one we are currently enduring.

We'll have to differ on that. I have no dispute at all that, over the last 4 years or so, "solid" dividend-payers was the place to be - but IMO to continue with that trade you have to believe that rates will continue to fall ...and they clearly won't. Accordingly, I think investing in dividend-payers, aka low-beta stocks, will slowly lead to an attrition of shareholder wealth....

we do indeed think there's an intrinsic value in high quality dividend paying low beta stocks. The market systematically underpays for them.  People (fund managers) in general tend to put their money on lottery tickets, growth stories, event possibilities etc etc in the hope that they can bag a 100% return in a year.  The market overpays for hope.  It underpays for boredom.

I would broadly agree with that comment ACROSS THE WHOLE CYCLE - but we aren't looking at the whole cycle: we are looking at a point where interest rates have hammered down, bearishness has abounded and, IMO, dividend-paying stocks have been ramped to buggery by the hoardes of retail investors desperate for yield as interest rates have fallen. Accordingly, whilst I have some sympathy with the general premise that investors generally overpay for growth, I think we are now at precisely the point where one SHOULDN'T follow the crowds of the last 4 years and invest in low-beta dividend payers!

If I had more time (I'm about to go away for a week or so), I'd suggest setting up a model portfolio of (say) 20 shares of each type of stock and comparing the performance over the next 2/3/5 years. I'm happy to have a pint on the likes of VOD, Reed, Imps, and  assorted insurers and food retailers etc underperforming a more growth-oriented FTSE350 group over that sort of term...

ee

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m8eyboy 7th Jun '12 22 of 36
1

Great comments. Especially from SteMiS and emptyend. I think dividends are pretty insignificant if you can identify really strong companies they will be paying a decent dividend now, or in the future. Either way you gain, from capital appreciation or income. As everybody has acknowledged dividends look particularly attractive during economic difficulties when growth seems unlikely and backtests of high yield portfolios show great things but I think you're driving looking in the rear-view mirror if you jump onto the bandwagon now. Perhaps they're a crutch for those who can't identify strong businesses because they give the impression of strength: If a company pays a good dividend then it must be in good health. Of course we know that isn't necessarily true, but it is true enough for many investors to rely on it.. I am one of those investors that finds it difficult to identify strength in a company, sustainable competitive advantages, moats, whatever you want to call them, but I'd rather refine my techniques for doing that than rely on a proxy, the dividend, that can be withdrawn at any time and tells me little about the future earning power of a company or its dividend paying power for that matter.

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marben100 7th Jun '12 23 of 36
2

The papers and stats that Ed has uncovered simply demonstrate a truth long known to value disciples:

The market consistently overpays for hope and underpays for certainty.

Don't forget that the SocGen analysis focussed on companies that are both growing and paying dividends. It is entirely possible to do both. It's not a simple either or.

Of course it's silly to focus only on dividends. But a company that is able to both grow and pay a sound dividend is an attractive proposition. IME (especially in current conditions) the market presents quite a number of companies offering good and growing income streams (due to growing underlying earnings). The prospect of rising interest rates doesn't worry me for such stocks: interest rates are unlikely to rise before market conditions improve - if they do, then I predict pure growth stocks will be hit even harder, as the economy will then be in a truly dire state. As long as the company can offer growth as well as a dividend, P/E expansion will apply to such companies too, when the market turns.

Given that it is not particularly sensible to try to predict when the market might turn (on a sustainable basis - no sign of that yet), surely it is sensible to own something that pays you to wait, rather than just waiting & hoping?

Mark

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emptyend 7th Jun '12 24 of 36

In reply to post #66380

The market consistently overpays for hope and underpays for certainty.

It might do it "consistently" - but that ISN'T the same as doing it "constantly"!

All I'm saying is that now is completely the WRONG time to be becoming a fan of the broad thesis (just as the exact right time was in 2006/7 in the run-up to the crash).

I agree completely with this though:

Don't forget that the SocGen analysis focussed on companies that are both growing and paying dividends. It is entirely possible to do both. It's not a simple either or.

Of course it's silly to focus only on dividends. But a company that is able to both grow and pay a sound dividend is an attractive proposition.

The reason dividend-paying stocks appear to have been more attractive is the collapse in interest rates. They aren't going to collapse again! The mantra below is therefore one that is fraught with danger:

surely it is sensible to own something that pays you to wait, rather than just waiting & hoping?

If dividends are being paid for out of strong earnings growth, then I have no problem with that idea. But it is earnings growth that is important - and NOT the payout per se!  Amongst dividend-paying stocks, the growth wheat will soon be winnowed from the no-growth chaff.

ee

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MadDutch 7th Jun '12 25 of 36
2

In reply to post #66377

IMO, dividend-paying stocks have been ramped to buggery by the hoardes of retail investors desperate for yield as interest rates have fallen. 

If that was true, the share prices would have been ramped higher, and the yields would have been pushed lower by your defined desperate demand for the shares. But prices of high yield shares are not higher.

I have a dummy portfolio in Sharescope to guide me in selectinghigh yield investments. I have researched the share graphs of the 20 highest dividend payers in the Footsie 350. Every single one of them has a share price below, and most of them considerably below their pre crisis peak. Except for 2, Amlin and Catlin, they have all been in downtrend over the last 5 years and the falling trend of most has recently accelerated. 

You are a master of common sense, so I am sad to tell you that I think your statement above is nonsense.

Mike. 

 

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MadDutch 7th Jun '12 26 of 36
1

In reply to post #66377

I think we are now at precisely the point where one SHOULDN'T follow the crowds of the last 4 years and invest in low-beta dividend payers!
ee, are you seriously telling us that we should not be buying National Grid and Scottish Southern Energy on more than 6% yields and many years of dividend growth?

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emptyend 7th Jun '12 27 of 36
1

In reply to post #66384

ee, are you seriously telling us that we should not be buying National Grid and Scottish Southern Energy on more than 6% yields and many years of dividend growth?

You imply that it has been one-way traffic. It hasn't.

With National Grid, the shares peaked at c.860p and then fell to 490p in the following two years - before recovering to the present 650p as interest rates collapsed.  It is a similar picture for SSE (LON:SSE).

To repeat - interest rates cannot collapse again!

Buying stocks like these is just taking an interest rate exposure.....at the point in the cycle where there seems to be no good reason to do so, especially when risk-aversion is also close to a maximum.

You are a master of common sense, so I am sad to tell you that I think your statement above is nonsense.

Its not nonsense if you look at the last couple of years......hordes of retail investors have piled in to stocks like these as interest rates have fallen away on other assets. That doesn't make them "good investments" - it is reminiscent of the 2003-7 dash into bank shares, based on the chimera of "bargain" dividend yields!

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MadDutch 7th Jun '12 28 of 36
1

Not your best answer ever, ee!

You missed the fact that SSE and NG, the type of share that Mark is referring to above, shares which I describe as "dividend plus growth." SSE has an annualized share price growth of 8.6% per annum since the Millennium, and 9% since 1994. The dividend is an extra. 

The point I made above is a fact. I repeat; both SSE and NG have been in downtrend since the financial crisis started in 2007. That is why I say your statement above; "dividend-paying stocks have been ramped to buggery by the hoardes of retail investors desperate for yield"  …… is nonsense.

Retail investors have not ramped dividend stocks like SSE, or growth stocks either. SSE and Nat Grid have both fallen despite being income plus growth stocks, and therefore cannot have been ramped by the hoards of desperate retail investors, because their prices would be higher if ramping had happened. Furthermore, your hoards do not exist. 

I repeat; your statement is still nonsense. In fact, retail investors keep out of the market when it is low, and pile in when it is high, and you should know that better than me. I am not discussing the effect of 0.5% interest rates, I am refuting your accusation of ramping.

 

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LongbeardRanger 7th Jun '12 29 of 36
2


With National Grid, the shares peaked at c.860p and then fell to 490p in the following two years - before recovering to the present 650p as interest rates collapsed.  It is a similar picture for SSE (LON:SSE).



Mmm..and just in respect of SSE, I would note that the direction of travel in respect of the dividend payout is not good. SSE once had a commitment to dividend increases at RPI +4%..then it slipped to RPI +2%..and now they merely anticipate dividend increases that are "above RPI". Of course, if they can sustain inflation-beating increases at a starting yield of 6+%, investors are likely to do reasonably well.  All the same, this is a trend that would concern me if I had a position in SSE - as would the highly geared balance sheets of the likes of SSE and NG. Yes, they have stable revenues that should be able to support higher debt levels, but it wouldn't take much of a downturn in their fortunes for shareholders' returns to suffer substantially. I struggle to see the utilities in general as the low risk investments that they need to be in order for them to compensate for their relative lack of growth prospects.

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marben100 7th Jun '12 30 of 36
1

Well, must admit, I'm in ee's camp with stocks like NG. and SSE. Whilst they offer attractive looking yields, their quality of earnings looks pretty ropey to me: both have small gross margins (SSE's is considerably worse than NG's) and are heavily indebted. When interest rates eventually rise, don't forget that their interest bill will rise too. They could then struggle to pay divvies.

Much prefer something like Braemar Shipping Services (LON:BMS) . After a tough year (due to depressed shipping rates) they continue to yield 8.5%. Crucially, they have no debt, so despite only being a smallcap stock (though fully listed, not AIM), I'd consider their divvy somewhat safer than that of the two FTSE100 stocks mentioned. On a mid-term view, they're well positioned to take advantage of a rebound in global trade & have improved their operating geography (and customer offer) to support future growth.

They're strong enough to weather a short/mid-term economic storm and will do very well in the recovering market ee describes, IMO. They will not be found to have been swimming naked when the tide goes out!

Cheers,

Mark

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MadDutch 8th Jun '12 31 of 36

In reply to post #66393

Good morning Mark,
Braemar looks interesting but there is an aspect that worries me. From Sharescope; The PEG is average at 1.05. The P/E is OK at 9.5, and the divi is very high at 8.4%. My worry is the 1.3 times dividend cover, which suggests a divi cut following even a small reduction in profit. The IFRS results in Sharescope shows an aprox 30% profit fall for the year ending Feb 2012, from £13.2 million to £9.8m; probably the reason for the share price fall. The 2013 forecast is much the same and a recovery is not expected for 2 years. I want high yielders that have a strong probability of maintaining their dividend throughout a multi year Euro disaster.
Do you think it likely Braemar will hold its dividend? Your best guess will do nicely, I have a lot of respect for your views!
Mike

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marben100 8th Jun '12 32 of 36
1

Hi Mike,

Firstly, concerning BMS, profits are already highly depressed for the reasons stated above. This is one of those cases where just looking at one or two years numbers doesn't tell you the story. BMS has enough cash in reserve to maintain the divvy for 2-3 years, even if profits remain depressed.

Once normality returns to shipping rates, I expect their profits to rebound strongly. You'll than have the "double-whammy" of rising EPS and multiple-expansion. The current multiple of 8 will, in due course, be seen for what it is: a depression-era phenomenon. Of course, things could get worse over the next 2-3 years - and I make no short-term price predictions - but I am confident that this is a quality business, with long-term staying and earnings power. The biggest long term risk is that smarter private equity investors will recognise the same thing and it will be privatised before shareholders see their long-term rewards.

Note this from their latest IMS (issued in January):

Over the past few months activity in the Shipbroking division has increased. The Group has seen good levels of spot chartering business particularly in deep sea tankers and in capesize bulk carriers. The specialised tanker chartering desks are also performing well, having secured long term contract business and good prospects of increasing their transaction volumes in the new financial year, beginning 1 March. Our second hand sale and purchase and demolition business has been more active than in the summer, stimulated by the fall in the value of middle-aged ships in most sectors. Overall Braemar's markets are entering a new phase where principals are adjusting their operations to fit market conditions, and this greater certainty should be positive.

[though conditions may have deteriorated again since then, with the current global slowdown]

I expect there to be a trading update at the AGM on 20th June, which I intend to attend.

The contrast with NG and SSE is that when the corner is eventually turned, I can see those two businesses running into trouble in the face of rising interest costs, whereas BMS will be powering ahead. It'd be worth checking the nature of SSE & NG's borrowings and maturities on bonds that I would guess form a significant portion of their debt.

Disclosure: BMS is one of the larger holdings in my porty.

Cheers,

Mark

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marben100 8th Jun '12 33 of 36

In reply to post #66402

PS, just to illlustrate what I mean, in 2-3 years time when (one way or another!) the current economic crises are likely to have been resolved, I can easily see their EPS growing to 60p+. With a market multiple rising to, say, 12 that gives a target SP of 720p: a nice double-bag+ from where we are now - and I'm getting a juicy dividend whilst waiting! Considering that in 2009 they earned 56p/share on revenues 10% below where they are now, a 60p EPS target doesn't seem too ambitious.

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Edward Croft 8th Jun '12 34 of 36
2

These are great charts from a recent SocGen note.

Their definition of 'quality' is basically global larger caps with a Piotroski F-Score >= 7 as well as a low bankruptcy risk using Merton's distance to default model.  We don't have that but a good proxy would be using the Altman Z-Score.

Quality stock bubble?  Been around a long time no? 

Add in a higher yield aspect  (basically a >4% yield) and you get this:

Frankly I'm interested in the behavioural reasons for this kind of outperformance.  No matter how you slice it, boring quality stocks with low betas and dividends do outperform global equities.  Whether that can last I don't know.

There are an increasing number of funds allocating money to 'quality' portfolios.  I've seen GaveKal launch one amongst others.  SocGen is marketing ETNs based on these portfolios.  So yes, it may be that this trade gets crowded.  But I'm skeptical that market participants are going to go wild for the kinds of dull stocks that make up these portfolios.

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Murakami 9th Jun '12 35 of 36
1

There's a good writeup & set of comments on this thread on the ExpectingValue blog this weekend - see: http://expectingvalue.com/aroundtheweb/friday-reading-29

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kenobi 29th Jun '12 36 of 36

In reply to post #66390

With National Grid, the shares peaked at c.860p and then fell to 490p in the following two years - before recovering to the present 650p as interest rates collapsed. It is a similar picture for SSE (LON:SSE).er

One thing to consider about NG,  the price fell to 490,  at the time of a share issue,  to fund future expansion.  A particularly good time to have got in,  as the earnings grew and even after a 30% capital appreciation over a couple of years the divi is still 6% +   suggesting a total return of 40-50 % over a time where other shares haven't done well.   However these returns cannot be expected to continue into the future.  There will be much downward pressure on the price increases that utilities will be allowed to impose.  you can expect life to become tougher for the utilities,  and as has already been quoted SSE,  is predicting lower returns,   I would guess NG will return much less too.   Thats not to say that having a little bit tucked away in high yield isn't a good strategy though,  as mervin king might be right and we might not be half way through yet !

K

 

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