INVESTMENT FABLES: HIGH DIVIDENDS

INVESTMENT FABLES: HIGH DIVIDENDS
Sam's Lost Dividends

Once upon a time, there lived a happy and carefree retiree named Sam. Sam was in good health and thoroughly enjoyed having nothing to do. His only regret was that his hard-earned money was invested in treasury bonds, earning a measly rate of 3% a year. One day, Sam's friend, Joe, who liked to offer unsolicited investment advice, suggested that Sam take his money out of bonds and invest in stocks.

When Sam demurred, saying that he did not like to take risk and that he needed the cash income from his bonds, Joe gave him a list of 10 companies that paid high dividends. 'Buy these stocks,' he said, 'and you will get the best of both worlds: the income of a bond and the upside potential of stocks.' Sam did so and was rewarded for a while with a portfolio of stocks that delivered a dividend yield of 5%, leaving him a happy person.

Barely a year later, troubles started when Sam did not receive the dividend check from one of his companies. When he called the company, he was told that they had run into financial trouble and were suspending dividend payments. Sam, to his surprise, found out that even companies that have paid dividends for decades are not legally obligated to keep paying them. Sam also found that 4 of the companies in his portfolio called themselves real estate investment trusts (REITs), though he was not quite sure what they did. He found out soon enough, when the entire real investment trust sector dropped 30% in the course of a week, pulling down the value of his portfolio.

Much as he tried to tell himself that it was only a paper loss and that he could continue to receive dividends, he felt uncomfortable with the knowledge that he had less savings now than when he started with his portfolio. Finally, Sam also noticed that the remaining six stocks in his portfolio reported little or no earnings growth from period to period. By the end of the third year, his portfolio had dropped in value and the dividend yield had declined to 2.5%. Chastened by his losses, Sam sold his stocks and put his money back into bonds. And he never listened to Joe again.

Moral of the story: High dividends do not a bond make.

When you buy a stock, your potential return comes from two sources. The first is the dividend that you expect the stock to pay over time, and the second is the expected price appreciation you see in the stock. Two common arguments are made in favor of dividend-paying stocks (especially as opposed to fixed-yield bonds)...

Optimistic Pitch: 'You have the best of both worlds': In this pitch, you are told that you can get the best of both bond and equity investments when you buy high dividend stocks. Summarizing the pitch: These are stocks that deliver dividends that are comparable and, in some cases, higher than coupons on bonds. Buy these stocks and you can count on receiving the dividends for the long term. If the stock price goes up, it is an added bonus. If it does not, you still earn more in dividends than you would have earned by investing in bonds. In fact, this story is bolstered by the fact that many stocks that pay high dividends are safer, larger companies for which the potential risk is low.

Pessimistic Pitch: 'Defensive investments': This is the pitch that gains resonance in bear markets. In an environment in which investors have seen their equity portfolios wither as the stock market declines, stocks that pay high dividends offer solace. Summarizing this argument: Even though these stocks may lose value like other stocks, investors holding on to them can still count on receiving the dividends. In fact, during crises, a general flight to safety occurs across all markets. While it manifests itself immediately as a shift from stocks to government bonds, it also shows up within equity markets as investors shift from higher-risk stocks (often high growth companies that pay no or little dividend) to low-risk stocks (often stable companies that pay high dividends).

These sales pitches have the most appeal to investors who are not only risk averse but also count on their portfolios to deliver a steady stream of income. It should come as no surprise that older investors, often retired, are the most receptive audience. But are there fables imbedded in these pitches?

THEORETICAL ROOTS: DIVIDENDS AND VALUE
Can paying more in dividends make a company a more attractive investment? There is a surprising degree of disagreement about the answer to this question in corporate financial theory. One of the most widely circulated propositions in corporate finance---the Miller-Modigliani theorem---states that dividends are neutral and cannot affect return.
How, you might wonder, is this possible? When a company pays more in dividends every year, say, 4% of the stock price rather than the 2% it pays currently, does that not increase the total return? Not in a Miller-Modigliani world. In this world, the expected price appreciation on this stock will drop by exactly the same amount as the dividend increase, say, from 10% to 8%, leaving you with a total return of 12%.

This theory assumes that a firm's value comes from the investments it makes---plant, equipment and other real assets, for example---and whether these investments deliver high or low returns. If a firm that pays more in dividends can issue new shares in the market, raise equity, and make exactly the same investments it would have made if it had not paid the dividend, its overall value should be unaffected by its dividend policy. After all, the assets it owns and the earnings it generates are the same whether it pays a large dividend or not. For dividends to not matter you must also be investing in an environment where taxes are the same on dividend income and capital gains.

The Miller-Modigliani theory is not supported by all practitioners... but it does have an important message for investors: A firm that invests in poor projects that make substandard returns cannot hope to increase its value to investors by just offering them higher dividends. Alternatively, a firm with great investments may be able to sustain its value even if it does not pay any dividends.

DO HIGHER YIELD STOCKS EARN HIGHER RETURNS?
Over the last 4 decades, researchers have tried to examine whether higher dividend yield stocks are superior investments. The simplest way to test this hypothesis is to create portfolios of stocks according to their dividend yields and examine returns on these portfolios over long periods. Data from Ken French at Dartmouth University shows that the highest yield portfolio earned an annual return of about 16% between 1952 and 1971, about 3% more than the returns on the lowest dividend yield portfolio.

In a different version of the dividend story, stocks that have increased their dividends over time are viewed as better investments than stocks for which dividends have been stagnant or gone down. One set of studies examined the stock price reaction when a company announces an increase or a cut in dividends. The consensus from this research is that stock prices increase about 1% when dividends are increased and drop about 4.5% when dividends are cut.

SUSTAINABILITY OF HIGH DIVIDENDS
While investors may buy stocks that pay high dividends as substitutes for bonds, there is one significant difference. A conventional bond offers a promised coupon; in other words, when you buy a bond with a coupon rate of 8%, the issuer contractually promises to pay $80 a year for the lifetime of the bond. While issuers can default, they cannot arbitrarily decide to reduce this payment. In contrast, a company does not contractually promise to maintain or increase its dividends. Thus, a company that pays a $2 dividend this year can reduce the dividend or even eliminate it if it so chooses. While investors may view this action with disappointment and sell the stock (causing the price to drop), they cannot force the company to pay dividends.
So, a stock with a high dividend is only attractive if the dividends can be sustained. How does an investor know whether dividends are sustainable? There are three common approaches. The first and simplest one compares dividends to earnings in the most recent period to see if too much is being paid out. The second approach modifies the first one to allow for the fact that earnings are volatile. It compares dividends paid to normalized or average earnings over time to make the same judgment. The third approach tries to measure how much the company could have paid in dividends, allowing for the reality that companies often cannot pay out their entire earnings in dividends when they have to reinvest to grow.

Some conservative investors and financial advisors suggest that you avoid firms that pay out more than a certain percent of their earnings---two-thirds (or a payout ratio of 67%) is a commonly used rule of thumb. If you can find stocks that are able to meet your target dividend yield by paying just 50% or less of their annual earnings, this would be considered a healthy and sustainable situation. It is also wise to consider cash flows in addition to accounting earnings when assessing the sustainability of dividends.

SUMMARY...LESSONS FOR INVESTORS
Stocks that pay high dividends have historically delivered higher returns than the rest of the market, and stocks that increase dividends see their stock prices go up. On the other hand, stocks that pay high dividends grow earnings far more slowly (thus delivering less in price appreciation) and are often unable to sustain dividends in the long term. Therefore, a savvy investor will always consider growth potential and payout sustainability in addition to simply looking at current dividend yields when building a stock portfolio.

LOW PE 'CHEAP' STOCKS...
... to be continued.

Sage@wallstraits.com
Credits: Much of this article is extracted from Investment Fables by Aswath Damodaran, 2004.
POSTED :20 Jun 2005

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