CHAPTER 2 HIGH DIVIDEND STOCKS: BONDS WITH PRICE APPRECIATION?

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CHAPTER 2

HIGH DIVIDEND STOCKS: BONDS WITH PRICE APPRECIATION?

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 four of the companies in his portfolio called themselves real estate investment trusts, 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.

If you are an investor who abhors risk, you probably prefer to invest your money in treasury bonds or safe corporate bonds, rather than stocks, because bonds offer a guaranteed income stream in the form of coupons. The trade off is that bonds have limited potential for price appreciation. A bond's price may increase, as interest rates go down, but most of the money you make on your investment must come from the coupons you receive over the bond's life. Notwithstanding your aversion to risk, you may sometimes be induced

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to invest in stocks by what seems like an unbeatable combination ? a stock that delivers dividends that are comparable to the coupons on bonds with the possibility of price appreciation. In this chapter, you will consider why some stocks pay high dividends, whether such dividends can be compared the coupons paid on bonds and the dangers that can sometimes lurk in these stocks.

The core of the story

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. The dividends you will receive from investing in stocks will generally be lower than what you would have earned as coupons if you had invested the same amount in bonds and this sets up the classic trade off between bonds and stocks. You earn much higher current income on a bond but your potential for price appreciation is much greater with equity. Bonds are less risky but equities offer higher expected returns. But what if you could find stocks that deliver dividends that are comparable to the coupons paid on bonds? There are two different arguments made by those who believe that such stocks are good investments.

q The Optimist 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 where the potential risk is low.

q The Pessimist Pitch: "Defensive Investments": This is the pitch that gains resonance in bear markets. In an environment where 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, there is a general flight to safety that 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 dividends) to low risk stocks (often stable companies that pay high dividends).

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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.

The Theory: 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 returns.1 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%. While there remain numerous adherents to this view, there are theorists who disagree by noting that a firm may signal its confidence in its future earnings by increasing dividends. Accordingly, stock prices will increase when dividends are increased and drop when dividends are cut. To complete the discussion, there are still others who argue that dividends expose investors to higher taxes and thus should reduce value. Thus, dividends can increase, decrease or have no effect on value, depending upon which of these three arguments you subscribe to.

Dividends do not matter: The Miller Modigliani Theorem The basis of the argument that dividends don't matter is simple. Firms that pay

more dividends will offer less price appreciation and deliver the same total return to stockholders. This is because 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 take 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.

You, as an investor, will also need to be indifferent between receiving dividends and capital gains for this proposition to hold. After all, if you are taxed at a higher rate on dividends than on capital gains, you will be less happy with the higher dividends, even

1 Miller, M. and F. Modigliani, 1961, Dividend Policy, Growth and the Valuation of Shares, Journal of Business, 411-433.

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though your total returns will be the same, simply because you will have to pay more in taxes. For dividends to not matter, you either have to no taxes or pay the same taxes on dividends and capital gains.

The assumptions needed to arrive at the proposition that dividends do not affect value may seem so restrictive that you will be tempted to reject it without testing it; after all, it is not costless to issue new stock and dividends and capital gains have historically not been taxed at the same rate. That would be a mistake, however, because the theory does contain a valuable 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.

Dividends are bad: The Tax Argument Dividends have historically been treated less favorably than capital gains by the tax

authorities in the United States. For much of the last century, dividends have been treated as ordinary income and taxed at rates much higher than price appreciation, which has been treated and taxed as capital gains. Consequently, dividend payments create a tax disadvantage for investors and should reduce the returns to stockholders after personal taxes. Stockholders should respond by reducing the stock prices of the firms making these payments, relative to firms that do not pay dividends. In this scenario, firms will be better off either retaining the money they would have paid out as dividends or repurchasing stock.

The double taxation of dividends ?? once at the corporate level and once at the investor level ??has not been addressed directly in U.S. tax law until very recently2, but it has been dealt with in other countries in a couple of ways. In some countries, like Britain, individual investors are allowed a tax credit for the corporate taxes paid on cash flows paid to them as dividends. In other countries, like Germany, the portion of the earnings paid out as dividends are taxed at a lower rate than the portion reinvested back into the firm.

Dividends are good: The Clientele and Signaling Stories Notwithstanding the tax disadvantages, many firms continue to pay dividends and

investors in these firms typically view such payments favorably. There are some academics and practitioners who argue that dividends are good and can increase firm value and provide at least three reasons.

2 In early 2003, President Bush presented tax reform that essentially exempted all dividends from personal taxes. After negotiations, a compromise bill was ultimately passed in May 2003 reducing the tax rate on dividends to 15% - the same rate that capital gains will be taxed at.

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q Some investors like dividends. These investors may not be paying much in taxes and consequently do not care about the tax disadvantage associated with dividends. Or they might need and value the cash flow generated by the dividend payment. Why do they not sell stock to raise the cash they need? The transactions costs and the difficulty of breaking up small holdings3 and selling unit shares may make selling small amounts of stock infeasible. Given the vast diversity of individual and institutional investors in the market, it is not surprising that, over time, stockholders tend to invest in firms whose dividend policies match their preferences. Stockholders in high tax brackets who do not need the cash flow from dividend payments tend to invest in companies that pay low or no dividends. By contrast, stockholders in low tax brackets who need the cash from dividend payments will usually invest in companies with high dividends. This clustering of stockholders in companies with dividend policies that match their preferences is called the clientele effect and may explain why some companies not only pay dividends but increase them over time.

q Markets view dividends as signals: Financial markets examine every action a firm takes for implications for the future. When firms announce changes in dividend policy, they are conveying information to markets, whether they intend to or not. By increasing dividends, firms commit to paying these dividends in the long term. Their willingness to make this commitment indicates to investors that they believe they have the capacity to generate these cash flows in the long term. This positive signal should therefore lead investors to increase the stock price. Decreasing dividends is a negative signal, largely because firms are reluctant to cut dividends. Thus, when a firm takes this action, markets see it as an indication that this firm is in substantial and long-term financial trouble. Consequently, such actions lead to a drop in stock prices.

q Some managers cannot be trusted with cash: Not all companies have good investments and competent management. If a firm's investment prospects are poor and its managers are not viewed as careful custodians of stockholder wealth, paying dividends will reduce the cash in the firm and thus the likelihood of wasteful investments.

Looking at the Evidence

Over the last few decades, researchers have explored whether buying stocks based upon their dividend payments is a good strategy. Some of these studies look at the broad

3 Consider a stockholder who owns 100 shares trading at $ 20 per share, on which she receives a dividend of $0.50 per share. If the firm did not pay a dividend, the stockholder would have to sell 2.5 shares of stock to raise the $ 5 that would have come from the dividend.

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question of whether stocks with higher dividend yields deliver higher total returns. If the dividend story holds up, you would expect stocks with high dividend yields to also earn high returns. Others take a more focused approach of looking at only those stocks that have the highest dividend yields. One example is the Dow Dogs strategy, where you buy the 10 stocks in the Dow 30 that have the highest dividend yields. In recent years, a third strategy of buying stocks that have the biggest increases in dividends (rather than the highest dividends) has also been tested. In this section, the empirical evidence that has accumulated on all of these fronts will be presented.

Do higher yield stocks earn higher returns? The dividend yield is usually computed by dividing the dividends per share by the

current stock price. Thus, it is defined to beDividend yield = Annual dividends per share / Current Stock price

However, there are variations in how the annual dividends per share are computed, leading to different estimates of the dividend yield for the same stock. Some use the dividends paid in the last financial year, others use dividends paid over the last four quarters and there are some who use expected dividends per share over the next financial year. If higher dividends make stocks more attractive investments, stocks with higher dividend yields should generate higher returns than stocks with lower dividend yields.

Over the last four 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 based upon their dividend yields and examine returns on these portfolios over long periods. In Figure 2.1, the average annual returns ? these include price appreciation and dividend yields ? are computed on ten portfolios created based upon dividend yields at the beginning of every year from 1952 and 2001. Looking at sub-periods, the highest dividend 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. During this period, the lowest returns were earned by the firms in the intermediate dividend yield classes. Between 1971 and 1990, the lowest dividend yield stocks earned a higher annual return than the highest dividend yield stocks. Between 1991 and 2001, the advantage shifts back to higher dividend yield stocks. Over the entire period, higher dividend yield stocks generate a slightly higher annual return than lower dividend yield stocks.

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Figure 2.1: Returns on Dividend Yield Classes - 1952 - 2001

Average Annual Return

20.00% 18.00%

Highest dividend yield stocks

Lowest dividend yield stocks

16.00%

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%

Highest 2

3

4

5

6

Dividend Yield Class

7

8

1991-2001

1971-90

1952-71

9

Lowest

Data from Ken French at Dartmouth. The stocks were categorized into classes based upon the dividend yields at the beginning of each year and the annual returns in the following year were calculated. This figure represents the average annual return over the period.

What are you to make of this shifting in advantage across periods? First, you should consider the volatility a cautionary note. A strategy of investing in high dividend yield stocks would have delivered mixed results over the sub-periods, working well in some periods and not in others. Second, you could look at the periods where high dividend yield stocks did best and try to find common factors that may help you fine-tune this strategy. For instance, high dividend stocks may behave much like bonds in periods of high inflation and rising interest rates and lose value. This would explain why they underperformed the rest of the market between 1971 and 1990.

In a test of whether high dividend stocks are good defensive investments, you can see whether high dividend paying stocks hold up better than non-dividend paying stocks during bear markets. Using data from 1927 to 2001, the returns on highest dividend yield stocks (top 20%) were compared to returns on the lowest dividend yield stocks (bottom 20%) in bull market years (where total market return exceeded 10%), bear market years (where total market return was negative) and neutral years (where total market return was between 0 and 10%). The results are summarized in Figure 2.2:

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Figure 2.2: Are high dividend yield stocks better defensive investments?

30.00%

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%

-5.00%

-10.00%

-15.00%

Bull

Neutral

Bear

Highest dividend yield stocks Lowest Dividend Yield Stocks

Data from French. These are the average annual returns on high dividend yield and low dividend yield stocks in bull market years (stocks up more than 10%), neutral market years (stocks up between 0 and 10%) and bear market years (stocks down for the year).

There is little evidence for the claim that high dividend stocks are better defensive

investments, especially in bear markets. Between 1927 and 2001, high dividend yield stocks

actually delivered more negative total returns than low dividend yield stocks during bear

markets.

The Dividend Dogs An extreme version of a high dividend portfolio is the strategy of investing in the

"Dow Dogs", the ten stocks with the highest dividend yields in the Dow 30. Proponents of this strategy claim that they generate high returns from it, but they base this claim on a comparison of the returns that you would have made on the strategy to what you would have made investing in the Dow 30. For instance, a web site dedicated to this strategy () claims that you would have earned 17.7% a year from 1973 to 2002 investing in the ten highest dividend yield stocks in the Dow, a much higher return than the 11.9% you would have made on the rest of the Dow.

Not only is this comparison an extraordinarily narrow one ? after all, there are several thousands stocks that are not part of the Dow - but it can be misleading. Many of the Dow Dog stocks are riskier than the rest of the Dow 30 stocks, and the higher returns they make could be just compensation for the higher risk. In addition, any investor investing

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