Photo by Unsplash+ in collaboration with Ave Calvar
Editor’s note: Investors seeking cash to spend are often enamored with dividend-paying stocks. But as Larry Swedroe explains in his book “Enrich Your Future,” it’s important to look at all the math. Read another excerpt from his book here.
It has long been known that many investors, especially those using a cash-flow approach to spending, have a preference for cash dividends. From the perspective of classical financial theory, this behavior is an anomaly.
Providing you with a better understanding of the relationship between dividends and price changes will enable you to properly characterize the gains from each appropriately and avoid some of the negative consequences that can result from this anomaly.
Financial Theory
In their 1961 paper, “Dividend Policy, Growth, and the Valuation of Shares,” Merton Miller and Franco Modigliani famously established that dividend policy should be irrelevant to stock returns.
As they explained it, at least before trading costs and taxes, investors should be indifferent to $1 in the form of a dividend (causing the stock price to drop by $1) and $1 received by selling shares. This must be true, unless you believe that $1 isn’t worth $1. This theorem has not been challenged since.
Moreover, the historical evidence supports this theory as stocks with the same exposure to common factors (such as size, value, momentum, and profitability/quality) have had the same returns whether they pay a dividend or not. Warren Buffett made this point in September 2011.
After announcing a share buyback program for Berkshire, some people went after Buffett for not offering a cash dividend. In his 2012 shareholder letter he explained why he believed the share buyback was in the best interests of shareholders. He also explained that any shareholder who preferred cash can effectively create dividends by selling shares.
Despite theory, evidence, and Warren Buffett’s response, many investors express a preference for dividend-paying stocks. One fre- quently expressed explanation for the preference is that dividends offer a safe hedge against the large fluctuations in price that stocks experience. However, this ignores that the dividend is offset by the fall in the stock price—the fallacy of the free dividend.
The Math: Cash Dividends vs. Homemade Dividends
To demonstrate the point that cash dividends and homemade divi- dends are equivalent consider two companies that are identical in all respects but one: Company A pays a dividend and Company B does not.
To simplify the math, assume that the stocks of both companies trade at their book value (while stocks do not always do that, the findings would be the same regardless). The two companies have a beginning book value of $10. They both earn $2 a share. Company A pays a $1 dividend, while Company B pays none. An investor in A owns 10,000 shares and takes the $10,000 dividend to meet spending requirements.
At the end of year one the book value of Company A will be $11 (beginning value of $10+ $2 earnings − $1 dividend). The investor will have an asset allocation of $110,000 in stock ($11 × 10,000 shares) and $10,000 in cash for a total of $120,000.
Now let’s look at the investor in B. Since the book value of B is now $12 ($10 beginning book value + $2 earnings), their asset allocation is $120,000 in stock and $0 in cash. They must sell shares to generate the $10,000 they need to meet their spending needs. They sell 833 shares and generate $9,996.With the sale, they now have just 9,167 shares. With those shares now at $12, their asset allocation is $110,004 in stock and $9,996 in cash, virtually identical to that of the investor in Company A.
Another way to show that the two are equivalent is to consider the investor in Company A who instead of spending the dividend reinvests it. With the stock now at $11, their $10,000 dividend allows them to purchase 909.09 shares. Thus, they now have 10,909.09 shares. With the stock at $11 their asset allocation is the same as the asset allocation of the investor in Company B: $120,000 in stock.
It is important to understand that Company B now has a somewhat higher expected growth in earnings because it has more capital to invest. The higher expected earnings offsets the lesser number of shares owned, with the assumption being that the company will earn its cost of capital.
Taxes Matter
What is particularly puzzling about the preference for dividends is that taxable investors should favor the self-dividend (by selling shares) if cash flow is required.
Unlike with dividends, where taxes are paid on the distribution amount, when shares are sold, taxes are due only on the portion of the sale representing a gain. And if there are losses on the sale, the investor gains the benefit of a tax deduction.
Even in tax-advantaged accounts, investors who diversify globally (which is the prudent strategy) should prefer capital gains because in tax-advantaged accounts the foreign tax credits associated with dividends have no value. And finally, if dividends were throwing off more cash than needed to meet spending requirements, the total return approach (ignoring dividends) would benefit from not only the time value of not having to pay taxes on the “excess” amount of dividends but also dividends could push investors into a higher tax bracket.
There is another negative implication of a preference for dividends.
Diversification
Because about 60% of US stocks and about 40% of international stocks do not pay dividends, any screen that includes dividends results in portfolios that are far less diversified than they could be if dividends were not included in the portfolio design.
Less-diversified portfolios are less efficient because they have a higher potential dispersion of returns without any compensation in the form of higher expected returns (assuming the exposure to investment factors are the same).
These negative implications are why the preference for dividends is considered an anomaly.
