Value Investing And The Importance of Dividends

Academics and the investment community have long argued for and against the value of dividend policy and its effects on the share prices. Apparently, like with the mood swings regarding specific stocks or sectors on the stockmarket, so does the majority view regarding the importance of dividends change frequently and abruptly.

This post intends to shed some light on the subject of Dividends.

Are Dividends are an Important Component of Total Return?

 

This controversy exists, although statistics have shown that "(...) dividends are an important component of total return, which historicaly has averaged almost 11 percent a year for stocks. Of this amount, just about 4 percent reflects inflation over the years; 2 percent is due to real growth in stock values, and almost 5 percent, or just under half, is the result of dividend payments." (Thomas P.Au; p. 112)

In former times, when the stock market was sleepy, investors heavily leaned towards assets and dividends to derive to the intrinsic value of a particular stock. They did not rely too much ont reported income. Certain features of high yielding stocks attracted investors and "(...) the stockmarket showed a persistant bias in favor of the liberal dividend payers as against the companies that paid no dividend or relatively small one." (Graham, p. 490)

One of Benjamin Grahams requirement for selecting bargain issues is that the stock shows  "uninterrupted payments (of dividends) for at least the past 20 years (p.348)". "(...) (the) dividend record (is) one of the most persuasive tests of high quality (...) Indeed the defensive investor might be justified in limiting his purchases to those meeting this test.(p.294)"

A second requirement concerning the dividend yield is, that it should be at least two third of an AAA bond yield. The reason why the dividend yield requirement of Graham and Dodd is only two thirds of the AAA bond yield is " (...) (if) dividend grows (...), at some point the dividend yield on original cost will exceed the bond yield. (Thomas P.Au; p. 112)" 

Features of a Dividend Paying Stock

Imortant aspects of a dividend paying stocks are:

• one can be surer that earnings are real

• not subject to arbitrary accounting principles

• they represent best-guess estimate of distributable earnings as determined by the company's management and board of directors

• provide income, and hence, a means for the investor to redeploy funds without selling the stock.

• provides an up-front, tangible return

• income stream gives a high-yield stock something of a bondlike character

• in certain monetary circumstances a dividend paying stock has characteristics, corresponding somewhat to cash instruments as well as bonds. In times of rising inflation and interest rates, a dividend that grows at least as fast as inflation, will give the stock cashlike characteristics. In times of falling inflation and interest rates (which hurts earning growth), the dividend will give the stock bondlike virtues, as long as the payout is maintained

(Thomas P.Au; p.112/117)

Aforementioned reasonings make clear why dividends were given such an importance in former times. Nevertheless, gradually this changed. "(...) the dividend was no longer what it had been. Where it was once a solid measure of corporate accomplishment and a reward for patient investors, (...) dividends had become, for many companies, a sign that the board had no better use for corporate cash than to give it back to shareholders. While followers of the traditional value discipline looked upon dividends as a sign of stability, others saw in dividends all the marks of stagnation." (Tengler; p.18)

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The Two Paradigms on Dividends: Fisher vs. Graham

Mainly two paradigms exist concerning the appropriate amount of dividends that should be returned to shareholders. The Philip A. Fisher (Growth Investor) school of thought and the Benjamin Graham (Value Investor) one.

Philip Fisher's View on Dividends

Philip Fisher had the more determinate and aggressive stance concerning dividend payment. "(...) dividends begin rapidly to lose the importance that many in the financial community give them. (...) The opinion is sometimes expressed that a high dividend return is a factor of safety. The theory behind this is that since the high-yield stock is already offering an above average return, it cannot be overpriced and is not likely to go down very much. 

Nothing could be farther from the truth. Every study I have seen on this subject (...) indicates that far more of those stocks giving a bad performance price-wise have come from the high dividend-paying rather than the low dividend-paying group.  (...) by spending earnings not as dividends but to build a new plant, to launch a new product line, or to install some major cost-saving equipment in an old plant, the management might have been doing much more to benefit the stockholder than it would have been doing just by passing these earnings out as dividends. (....) 

An otherwise good management which increases dividends, and thereby sacrifices worthwhile opportunities for reinvesting increased earnings in the business, is like the manager of a farm who rushes his magnificent livestock to market the minute he can sell them rather than raising them to the point where he can get the maximum price above his costs. he has produced a little more cash righ now but at a frightful cost. (...) 

Over a span of five to ten years, the best dividend results will come not from the high-yield stock but from those with the relatively low yield. So profitable are the result of the ventures opened up by exceptional mangaments that while they still continue the policy of paying out a low proportion of current earnings, the actual number of dollars paid out progressively exceed what could have been obtained from high-yield shares. Why shouldn't that logical and natural trend continue in the future? (pp.138)"

Benjamin Graham's View on Dividends

Benjamin Graham appeared to be more open minded and thoughtful on that subject. "In the past the dividend policy was a fairly frequent subject of argument between (...) minority shareholders and managements. In general (...) shareholders wanted more liberal dividends, while the managments (...) to keep the earnings in the business "to strengthen the company." They asked the shareholders to sacrifice their present interests for the good of the enterprise and for their own future long-term benefit. 

But in recent years the attitude of investors toward dividends has been undergoing a gradual but significant change. The basic argument now for paying small rather than liberal dividends is not that the company "needs" the money, but rather it can use it to the shareholder's direct and immediate advantage by retaining the funds for profitable expansion (...). 

There was always a strong theoretical case for reinvesting profits in the business where such retention could be counted on to produce a goodly increase in earnings. But there were several strong counterarguments, such as: The profits "belong" to the shareholders, and they are entitled to have them paid out within the limits of prudent management; (...) the earnings they receive in dividends are "real money", while those retained in the company may or may not show up later as tangible values for the shareholders. These counter-arguments were so compelling, in fact, the the stock market showed a persitent bias in favor of the liberal dividend payers as against the companies that paid no dividends or relatively small ones. (...) 

In the last 20 years the "profitable reinvestment" theory has been gaining ground. The better the past record of growth, the readier investor and speculators have become to accept a low pay-out policy. So much is this true that in many cases of growth favorites the dividend rate - or even the abscence of any dividend - has seemed to have virtually no effect on the market price (...) there seems to be something paradoxical about requiring the companies showing slower growth to be more liberal with their cash dividends. (...) these are generally the less prosperous concerns, and in the past the more prosperous the company there was the expectation of both liberal and increasing payments. 

It is our belief that shareholders should demand of their managment either a normal payout of earnings (...) or else a clear-cut demonstation that the reinvested profits have produced a satisfactory increase in per-share earnings. (...) Dividends are sometimes held down by relatively unprosperous companies for the declared purpose of expanding the business. (...) such policy is illogical in its face, and should require both a complete explanation and a convincing defense before the shareholders should accept it. (...) there is no reason a priori to believe that the owners will benefit from expansion moves (...) by a business showing mediocre results and continuing its old management. (pp.489)"

Fisher vs. Graham: The Clash of Cultures

I find those extracts from Fisher's and Graham's writings outstanding. It is a clash of two investment philosophies. It almost seems as they referred to each others theory directly and quarrel over it via their writings. Kind of a theoretical battle concerning the most prudent investment approach, going much further than just a dispute over the treatment of particular payout policies by companies in the valuation process. A grand clash of cultures. Growth vs. Value.

Fisher's approach appears very dualistic. As if the stockmarket universe just consisted of two type of companies. The outstanding businesses with great moat and growth and the cigarbut, net-net universe.

Gaham's approach seems to be more open-minded and manifold. It becomes apparent in the following statement:"The market's appraisal of cash-dividend policy appears to be developing in the following direction: Where prime emphasis is not placed on growth the stock is rated as an "income issue," and the dividend rate retains its long-held importance as the prime determinant of market price. At the other extreme, stocks clearly recognized to be in the rapid-growth category are valued primarily in terms of the expected growth rate over, say, the next decade, and the cash-dividend rate is more or less left out of the reckoning.(...) above statement may properly describe present tendencies, it is by no means a clear-cut guide to the situation in all common stocks (...) many companies occupy an intermediate position between growth and non-growth enterprises (p.491).

Personally, what else could we have expected, I am much more convinced by the arguments laid out by Benjamin Graham than by Phillip Fisher concerning prudent dividend policies.

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Fisher's Most Convincing Argument

I find Fisher's most convincing statement on dividends the following: "(...) the most important and least discussed aspect of dividends. This is regularity or dependability. (...) those who set wise policies (...) set a dividend policy and will not change it. They will stockholders know what the policy is. They may substantially change the dividend but seldom the policy. (...) in no case will the rough percentages govern the exact amounts paid out; this would make each year's dividend different from that of the year before. This is just what stockholder do not want, since it makes impossible independent long-range planning on their part. (...) As earning grow, the ammount will occasionally be increased to bring the pay-out up to the former percentage. (...) (p.120)" 

Those remarks by Fisher are very interesting. Not so much because of the importance of dependability and reliability (although important indeed), but rather because of an often overlooked feature that make dividends so crucial. That is, a liberal but prudent payout policy limits the discretionary cash available to management,  potentially spent on value destructive investments or the  pursuit of low-risk/low-profit venture. Thus dividends offer a form of self-governing financial discipline (automatic stablizer). Here the self- governing, e.g. non-discretionary aspect, which would be accomplished by Fisher's rule concerning the setting of the dividend policy by the company, is key.

Fisher's Fallacy

Although Philip A. Fisher had seen many studies indicating that high dividend paying stocks tend to lag the market price- wise, I have seen studies that suggest that a (strong) positive linear relationship between a high payout ratio and subsequent (positive) earning momentum exists. So did a research by Robert Arnott and Clifford Asness (2003) find, that:

(...) Historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low. (...) Our evidence thus contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. (...) Our findings offer a challenge to market observers who see the low dividend payouts of recent times as a sign of strong future earnings to come (p.70).

(...) the relationship of current payout to future earnings growth is strongly positive.

(...) Unlike optimistic new-paradigm advocates, we found that low payout ratios (high retention rates) historically precede low earnings growth. This relationship is statistically strong and robust. We found that the empirical facts conform to a world in which managers possess private information that causes them to pay out a large share of earnings when they are optimistic that dividend cuts will not be necessary and to pay out a small share when they are pessimistic, perhaps so that they can be confident of maintaining the dividend payouts. Alternatively, the facts also fit a world in which low payout ratios lead to, or come with, inefficient empire building and the funding of less than- ideal projects and investments, leading to poor subsequent growth, whereas high payout ratios lead to more carefully chosen projects. The empire-building story also fits the initial macroeconomic evidence quite well (p.80). 

Conclusion

Nancy Tengler (2003) who developed a simple investment strategy called “Relative Value Discipline,” which provides a framework for investing in traditional dividend-paying value stocks, as well as undervalued growth stocks found that: "Over time (...) the dividend was a good indicator of a company’s own expectations of future earnings growth prospects and its overall business stability. (...) the companies we were investing in tended to have “dividend-paying cultures.” The fact is, most dividend-paying companies do not slash their dividends haphazardly in response to market conditions (...) 

Company boards pay close attention to their long-term cash needs, as well as to the capital needs of the company and the economic conditions. They set their dividend policies so that the dividend can remain a relatively constant percentage of earnings in good times and bad.(...) stable dividend policy provides reliable information about how corporate management views the firm’s prospects for long-term earnings, as well as an income stream that is important to investors.

The predictability of the income stream can be beneficial to investors, particularly in periods when the market is declining for longer than a few months, such as prolonged recessions.(...) on dividend actions by the Board; investors can observe what management expects in terms of future longterm earnings growth. 

Bear in mind that many mature dividend-paying companies set the dividend level as a ratio/percentage of long-term sustainable earnings power. By analyzing the dividend history of a company, it is possible to gain an understanding of the firm’s current and projected earnings growth rates.(...)The dividend growth rate relative to the earnings growth rate. These figures provide some signals about a company’s future plans, as well as its expectations about the future cost of capital. Declining dividend growth compared to earnings can signal management’s expectations for slower growth. Conversely, a dividend growth rate higher than earnings growth can signal management’s expectations of accelerated growth in the future. (pp.23)

I have witnessed the 1990 madness personally. I saw how the TTM companies used to reinvest both in product development and in infrastructure heavily. I heared the management's mantra that those investments would soon translate into higher growth and high total return for their investors, a much more attractive alternative to paying out dividends. Growth was king and dividends for old ladies.

I saw the investors bid up the P/E ratio of those stocks to levels never seen before. Earning growth seemed robust and investors (as they often do) extrapolated the earnings of the recent past indefinitely into the future.  On this (assumed) double-digit growth trajectory dividends were irrelevant. But tangible value never materialised for the shareholders.

Jason Zweig puts it this way: "(...) most managers are wrong when they say that they can put your cash to better use than you can. Paying out a dividend does not guarantee great results, but it does improve the return of the typical stocks by yanking at least some cash out of the managers' hands before they can either squander it or squirrel it away. (Intelligent Investor; p.506)

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Source:

Robert D. Arnott and Clifford S. Asness "Surprise! Higher Dividends = Higher Earnings, Growth"; Financial Analst Journal Journal; January/ February 2003; pp.70-78

Philip A. Fisher; Common Stocks and Uncommon Profits and other Writings; John Wiley & Sons (2003)

Benjamin Graham; The Intelligent Investor; Harper Business Essentials (2003); (with commentary by Jason Zweig)

Nancy Tengler; New Era Value Investing - A Disciplined Approach to Buying Value and Growth Stocks; John Wiley & Sons (2003)

Thomas P. Au; A Modern Approach to Graham&Dodd Investing; John Wiley & Sons (2004)


Disclaimer: Repost March 2014



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