From the November 2012 issue of Research Magazine • Subscribe!

Dividend Limits

High dividend strategies seem to go in and out of favor. Recently high equity yield strategies have been introduced as a novel way to escape the current low yield environment. If the best I can do is less than 1% on a Treasury, why not invest in an equity income fund that pays 3% as well as an opportunity for capital appreciation? 

High dividend-paying stocks are particularly tempting when yields are low and stock prices seem to be stuck in neutral. Some have suggested that high yield equity strategies make more sense for retirees since they provide a stable income from high quality companies that are unlikely to drop in value. Dividend paying stocks have rebounded smartly following the great recession. So why not succumb to the dividend temptation?

Financial economists argue that dividends are irrelevant. A firm’s profits can either be paid back to shareholders through dividends or can be retained for reinvestment. A number of ex-dividend studies provide evidence that payment of dividends reduces firm value by roughly the amount of the dividend.

The main defenses of paying dividends are (a) that the dividend signals a firm’s future financial strength; (b) that once initiated, managers will be punished for reducing them; and (c) that they reduce managerial temptation to waste resources when too much cash piles up within the firm. Dividends may also be associated with bad firm prospects if they are a signal that there aren’t any productive investments available within the firm or that the board of directors doesn’t trust the CEO with excess cash. In terms of share performance, there really isn’t much evidence to suggest that dividends are good or bad.

The other reason that dividends are seen as irrelevant is that anyone can create income from equity investments by selling a few shares. Dividends may best be viewed as a forced regular sale of one’s equity portfolio. If a firm decides instead to retain its earnings, then it is up to the investor to decide when to sell shares in order to provide income. Taking capital gains gives an investor far more tax flexibility and is more tax efficient if dividends held in a taxable account are reinvested since the investor gains compounding benefit from tax deferral. And this assumes that dividends and capital gains are taxed at the same rate, as they have been since the Jobs Growth and Tax Relief Reconciliation Act (JGTRRA) was passed. The Act passed by one Senate vote in 2003 and will sunset at the end of 2012.

Dividend stocks do provide the psychological benefit of paying a regular income to retirees without forcing them to sell securities. There is evidence that retirees loathe chipping away at principal to fund current expenses, and high dividends can provide a regular stream of payments without incurring the loss of liquidity and legacy cost of an annuity. Since there is little to indicate that the tax rate on dividends will remain 15% in the face of increasing budget deficits and entitlement obligations, it is worth revisiting what happens to equity prices when tax rates change.

When taxes go down, prices go up. If investors in 2002 were willing to pay $100 for a share that provided a $2 dividend with a marginal tax rate of 38.6%, they’d be willing to pay more with a tax rate of 15%. The JGTRRA was originally written to expire in 2010, so any change in prices should have been tempered by the short-term net benefit to investors. Nonetheless, subsequent studies by Alan Auerbach of the University of California, Berkeley, and Kevin Hassett of the American Enterprise Institute (among others) found that prices of income stocks rose immediately after the passage of the Act. 

If a temporary dividend tax reduction resulted in rising prices for high dividend yield securities, then the expiration of the JGTRRA and reversion to a higher (and presumably more permanent) dividend tax rate will result in an immediate decrease in the value of an income stock portfolio. This makes the dividend income strategy particularly worrisome for retirees. Not only is the use of income equity investments of dubious advantage relative to a low-yield portfolio, dividend stocks are most likely to suffer a significant loss in value if and when tax rates increase.

Advisors should overweight dividend securities if they believe that dividend stocks will provide risk-adjusted excess performance within a sheltered account. In a taxable account, they only make sense if the greater performance of high dividend investments outweighs the tax inefficiency of forced withdrawals. In order to explore the performance of diversified investments in high dividend securities, I asked David Blanchett, head of retirement research for Morningstar Investment Management and doctoral student in Personal Financial Planning at Texas Tech, to estimate the total return on the fund category traditionally associated with dividend payouts (large cap value) sorted by magnitude of dividend and excluding index funds.

Each year between 1995 and 2011, we re-sort all funds within this category into groups of five based on dividend yield and hold those funds through the year. If higher dividend funds outperform then we might feel more comfortable defending a high yield equity fund strategy.

They don’t. The top dividend yield quintile underperformed the bottom quintile between 1995 and 2011 by 1.94% per year during this period. Most of the underperformance occurred during the growth stock boom of the late 1990s which tended to punish dividend payers, but there is no consistent performance advantage in the 2000s. This result mirrors a number of more thorough analyses in the finance literature that compare the performance of firms sorted by dividend.

New York University Professor Aswath Damodaran documents dividend stock myths in his 2004 book Investment Fables, in which he shows how the highest dividend stocks underperformed the lowest dividend stocks even during bear markets in the 20th century, and that a taxable equity investor who held stocks whose dividend yield was twice the market average would have ended up with about half the wealth of a taxable investor holding equities with half the average dividend yield. 

So the unfortunate retiree who invested $100 in a fund with a $2 dividend will likely see his portfolio fall in value following a dividend tax rate increase. He will also see his net dividend income drop from $1.70 to something lower ($1.60?, $1.30?). The double injury of reduced shared prices and lower net returns following a tax increase is further compounded by the possibility that firms will cut dividends if tax rates go up.

Between the firms that started paying dividends following the JGTRRA and firms that increased their dividends, Berkeley professors Raj Chetty and Emmanuel Saez found that total dividends rose by about 20% after the Act. Presumably, taxable shareholders of firms with good corporate governance were able to convince companies to increase dividends during a window of lower tax rates. These same taxable investors would then be inclined to talk firms into reducing dividends once they become a less attractive form of net payout. University of Chicago professor Eugene Fama and Dartmouth professor Ken French found that the percentage of American firms paying dividends fell from 67% in 1978 to 21% in 1999 during a period where share repurchases held a strong comparative tax advantage to dividends.

 I happen to have a soft spot for dividends. All well-run firms eventually should pay their profits back to investors (even companies that are acquired by other firms eventually will need to repay investors). A firm sensitive enough to its taxable investors that it is willing to raise its dividends in response to a drop in tax rates is certainly worth supporting. Suggesting that dividend stocks are a good alternative to a non-dividend paying equity portfolio, particularly for retirees, might be setting investors up with more portfolio and income risk than they bargained for.

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