Mar

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 1. Tax savings to the shareholder.  The shareholder receiving those dividends must pay taxes on them at a fairly high rate, and in that tax year.  If alternatively the corp uses that cash to repurchase its own shares on the open market or otherwise, the overhanging supply of shares decreases resulting in a higher price for all shares.  Thus the shareholder experiences a capital gain, which historically has been taxed at a lower rate.  Thus his after-tax return increases.  And he can choose the tax year.  Taxes deferred are taxes denied.

2. The shareholder receives the dividend at a time not determined by himself, and the odds are that it is not the most desirable time for him to receive that payment.  If the shareholder wants some cash, he can sell some shares when it is convenient and/or necessary for him to do so.  If you want some annoying experience with dividends, buy some HOLDERS (an early/anachronistic version of ETFs).  You will get dividend announcements several times a week and your accountant will be delighted with all of the work you have given him.

3. (Opinion) Corps that have cash available to pay dividends are not efficient investors of the capital entrusted to them.  By giving the shareholder a dividend they are saying effectively, "we do not have any good investment ideas; take the money because you probably can do better."  This is not to suggest that all corps should be acquirers of other companies, but they could put some money in R&D to either enlarge share or reduce expenses in the future.  And R&D expenses are tax deductible.

4. (Opinion) The payment of dividends is a public relations game to get investors to hold the stock for long periods.  The process lulls investors into not reevaluating their investment options as regularly or often as they should, which is not in the shareholder's best interest.  (N.B. That opinion is different from what the "buy and ignore" crowd will tell you.)

Thank YOU for your service to our country.

Stefan Jovanovich comments:

I think the point about the taxation of dividends belongs to an earlier time.  The taxable portfolios of individual investors (as opposed to IRAs, SIMPLE IRAs, 401(k)s, etc.) are not a significant part of the overall market.  Most of the shares owned are in the hands of tax-exempt institutions.  Most of the taxable investors are corporations; because of the dividends received exclusion their effective tax-rate on payouts from other corporations is - at most - 15%.  I would hardly want to quarrel with Bill's maths, but it could be argued that the advantage of having a cash payout diminished a 15% by tax could be a better return than allowing corporate management to hold on to the cash and then use it to speculate in their own company's securities.  There are very few Henry Singletons.

George Parkanyi adds:

The dividends-are-bad argument misses the point that dividends are not always static, and when companies keep increasing them regularly, after a while you can be earning a very high yield on your original investment in addition to the capital appreciation.  Companies can also squander money, and perhaps paying a dividend is a better choice than overpaying for some acquisition that blows up.  Dividends can also be good indicators of value where your primary objective is capital appreciation.  Look around you now.

I also would be careful using generalizations like "hope for the buy and hold crowd", implying they are a bunch of bovine followers.  A lot of people have gotten rich by holding on to companies that have grown and dramatically appreciated in value.  In addition to the appreciation, there are tax-deferral and transaction cost avoidance benefits.  In fact, it takes a LOT of discipline to be that patient, especially if you follow the markets regularly.

As for dividend-paying stocks, they're just another useful tool - not for everyone, but for many - in the arsenal of investment vehicles available to traders and investors.  Personally I think that quality companies paying dividends are going to rocket off the bottom first when things turn around because of the yield support and recognition of value, and many of us will be lamenting "How did I miss _________ at 6%?"

Phil McDonnell replies:

Dividends can be an important part of returns.  Most studies of long term stock market returns show that re-investment of dividends accounts for about half of the long term return.  So in the long term they are very important.

In the short term they may be less important.  If a stock pays a dividend of $.50 then it will probably drop and average of $.50 on the day it goes ex-dividend.  So there would seem to be no apparent gain.  But if the dividends are reinvested in the stock the investor is buying the stock a little bit cheaper after the ex-dividend event.

Added to this are the benefits of dollar cost averaging. Specifically when the stock is generally at a low price more shares are purchased with the dividend.  When the stock is high fewer shares are purchased with that same dividend.  Over time this leads to an average price per share that is below the average price of the stock during the same period.

In looking at yields and total returns it is important to look at how the reporting institution does its calculation.  You would think that this is not important and that people like S&P report things on a consistent basis.  A good case in point is that the S&P index is a cap weighted index.  Big cap stocks like IBM, GE and XOM get far more weight than their smaller brethren.  But when S&P reports the earnings for the index, bizarrely, they do not use cap weighting.  The earnings are equal weighted.  Thus an earnings to index level comparison for the S&P is completely meaningless.  An example is that S&P calculates the equal weighted reported earnings as negative for the first time in history.  But if they were cap weighted the earnings would be positive.  If the operating earnings were reported on a cap weighted basis they would be 80% higher than the equal weighted earnings that S&P actually reports.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008


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4 Comments so far

  1. Steve Leslie on March 1, 2009 8:15 am

    his is an interesting study as to whether the dividend discount model works in today's world. I have heard recently how high the dividend on the S&P is historically, thus making the valuation of the market low. Perhaps Dr Zussman or the Doc Castaldo might enter into the discussion as to the historical aspects of this.

    25 years ago I owned Cleveland Illuminating and Gas companies for the dividends which could well exceed 7 and even 8 percent. This is for the most part an anachronism. These companies became holding companies. In Florida, FPL is a holding company. To my knowledge the only companies that pay out big dividends are REITs and limited partnerships. Are there others.

    I own shares of Microsoft and only once in the many years that I have owned it have they issued a special dividend to the shareholders. They allegedly generate 3 Billion a month in free cash flow, yet I never see it.

    If a company hoards its cash such as Microsoft has in the past, they do not get as high a valuation placed on it as some other companies.

    Of course if the companies hold onto the money instead of pay dividends this leaves them with the temptation to give the money to already overpaid executives and board members, instead of R&D, marketing, etc.

    On the other hand, if a corporation is doing the right thing (oxymoron?) they might retain their cash, plow it back into the business properly and judiciously, and all may prosper. This would of course work in a real world.

    In summary, I believe the number one reason why politicians like to craft tax law to double tax things is because they do not live in the real world. Instead they live in a very plastic, very insulated environment where they are never told no. Look at Hillary Clinton at election time, trying to pump her own gas or Nancy Pelosi feigning ignorance as to what the numbers on a Boeing signify and why she needed a 747 because that is what Dennis Hastert flew in. Of course we already know that 60 percent of politicians claim law as their prior profession. How many of them ever ran a business and now they run the largest business in the world. One which never has to show a profit. In fact the goal is to overspend at every turn because the repercussions are not felt for years out in the future and their main job is to get elected in the present.

    Thoughts for a Sunday morning.

  2. Rocky Humbert on March 1, 2009 11:44 am

    Dr. McDonnell's reply (regarding cap-weighting of earnings) references arguments in Jeremy Siegel's WSJ Op-Ed piece that "S&P Gets Its Earnings Wrong." see: http://online.wsj.com/article/SB123552586347065675.html

    There's been a fair amount of blog debate on Siegel's Op-Ed. Here's the primary source of information (S&P's own methodology): http://www2.standardandpoors.com/spf/pdf/index/Index_Mathematics_Methodology_Web.pdf

    Does this debate regarding the S&P's p/e and current yield miss the forest from the trees? Perhaps:

    1)The trailing p/e and dvd yield(however measured) is a useful benchmark of cheapness/expensiveness ONLY when the economy is in a "normal" condition. During a severe contraction the p/e SHOULD rise dramatically; otherwise stocks will price in a perpetual contraction. Likewise, during a boom, unless the p/e contracts, stocks will have priced-in perpetual prosperity (e.g. 1997-1999). (If an investor believes that we are in a perpetual contraction, it doesn't matter how "cheap" or "expensive" the S&P looks, he shouldn't buy it!)

    2) The p/e and dvd yield do not reflect the permanent impairments to tangible and intangible equity during this economic contraction. Once equity has been destroyed, there may be a long-lasting reduction in the profitability of that enterprise (and the index). This is non-cyclical — and particularly relevant for leveraged enterprises (such as banks and insurance companies). In contrast, companies with a less-leveraged balance sheet should "bounce back," upon the resumption of positive nominal GDP growth. (Some studies show the Tobin Q-ratio to be currently attractive.)

    3)People like to point to Japan as the role model for the S&P over the next 10 years, however, those folks ignore the fact that RoE of Japanese companies has been consistently horrible for decades. If one believes that the RoE of the S&P over the past 50 years has been anamolous … and the RoE will be low single digits for the next 30 years, then the S&P is horribly over-valued. However, that judgement cannot be reached from looking at either the p/e or dvd yield (however one calculates it).

    4) The debt markets must return to equilibrium before any of these points are relevant. If one believes that we are in a new world where investment grade companies must pay 200-ish basis points over Treasuries to borrow, then any historical p/e or dvd yield analysis is irrelevant.

    Bottom line: investing in equities requires optimism and confidence in the long term profitability of American enterprise. It's usually been true that buying stocks when the p/e is low is better than when the p/e was high — but that's a rationalization for building confidence — since noone really knows how the world will look tomorrow.

  3. Jim Davis on March 1, 2009 8:13 pm

    Yes, we are all aware of the large contribution dividends have made to total return over the last X decades.

    Reality check. Even if you could make a case for dividends being a HUGE component of long term return, they are also equally dangerous as a distraction from careful portfolio management.

    The authors item #4 is 100% correct. I’d like a penny for every dollar that has been lost in this downturn by investors fixated on phantom (backward looking) ‘yield’. Like bulls distracted by the matadors red cape, they focused on yield, all the while their capital evaporating , another spear taken, and eventually even the yield disappearing into thin air.

    Holding for yield has to be at least as damaging to the portfolio as another amateurs excuse, not selling for tax reasons.

  4. Steve Leslie on March 1, 2009 9:52 pm

    Rocky's point 4 is the most important one here. The debt markets are the keys to everything. Until homeostatis is restored, banks resume lending to other banks,trusting each other, offering commercial paper, providing loans, extending credit appropriately and judiciously, there can be no confidence going forward. In my view the equity markets will face rough headwinds for some time as a result. Thus an analogy is that first must come the chicken and then the egg will follow. So in many ways we must create a new chicken.Use any analogy you are comfortable with if you are fowl friendly.

    Equity markets are all about psychology and confidence and there just isn't any confidence there yet. That is why we are at 7000 and not higher.

    This reminds me on a smaller scale back in the mid eighties when Drexel Burnam Lambert went kaput and overnight the market for high yield bonds or back then junk bonds ceased to exist. That market was frozen for sometime until other institutions notably Merrill was able to break it out. But it took time. many many months of time.

    As far as confidence, I would think a good time to look at a very dark and foreboding period was 1939-1941 when the future of our nation and the world economy was very much in doubt. Wars were abundant in Europe, Asia, as far south as New Zealand and in Northern Africa. Think about this for a moment. Wars real wars on 4 continents. However, in 1942 the markets began to recover, signaling that there was a future that was not clear at that time. Unfortunately a sobering fact is that 65 million worldwide had to die until peace was achieved and the healing could begin.

    Keynes words ring loudly "The market can remain irrational longer than you can remain solvent". After 6 straight months of declines and the worst February ever, after one of the worst years ever, truer words have not been spoken.

    Daniel Day-Lewis as Hawkeye said to Madeleine Stowe as Cora in the Last of the Mohicans "If you are captured try to stay alive, I will find you."

    Right now we have been captured by the horribly \misconfigured,corrupted banking crisis. Our job is to stay alive until we are rescued.

    The big question is who is on the horizon looking for us to rescue.

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