Another battle in the neverending war between clarity and confusion….

A recent opinion piece in the Wall Street Journal starts off with a promising title, “Why Many People Misunderstand Dividends, and the Damage This Does.” June 7, 2020 . That is most certainly true. After nearly two decades helping to manage dividend portfolios, I can say that even institutional investors and pension fund consultants still seem to trip over the basic math of dividend investing. Unfortunately the newspaper article only adds to the confusion when the author, an academic, asserts that “Paying dividends doesn’t benefit investors, because a dividend of $1 simply reduces the stock price by $1—just as withdrawing from an ATM gives you cash in your pocket, but less in the account.” By the math of near-term total return—on the day that a dividend “goes ex-“—the author is completely correct.  But by the math of business valuation and long-term returns from stocks, the author’s assertion muddies the waters. In contrast to that one-day snapshot, businesses that can pay and sustainably increase their distributions over time will be worth more over time in the marketplace. Let’s take a simplified example where a company pays a dividend annually. Based on the company’s history, its current business conditions and the market’s expectations of its future cashflows, the company’s stock is trading with a 4% yield heading toward its dividend date. The expected dividend is $4 and the share price is $100.  On the “ex-dividend” day, the shares will likely open around $96. That’s as it should be and, unfortunately, where author’s line of argument ends, suggesting that dividends just detract from capital appreciation. On that day, perhaps. But over the long-term, the opposite is true. If the company is doing well and is on track to have enough free cash flow the following year to pay a $5 dollar dividend, and the market continues to price it with a 4% yield, the share price will move up toward $125.  The day the shares go ex-dividend, they will open at $120, and the process starts all over again. By just looking at the impact on the share price on the ex-dividend date, the piece seems to imply that dividends are a sign of investment weakness, not the strength that they are.

 

The author continues by asserting that stock buybacks are superior to the “fallacy about dividends” because they can be turned off and on as needed. While the author ignores the well-documented fact that buybacks don’t help shareholders at all, and may (or may not) help sharesellers, it is true that buybacks can be turned on and off quickly, as the current crisis has shown. Most large companies that had share buybacks have suspended them.  “By contrast, he continues, dividends are largely inflexible. Once a company pays a dividend, it is committed to continuing to do so going forward. That’s because if it cuts the dividend, the stock price plummets.” That is strongly stated. Dividends are approved by boards on a quarterly basis. If business conditions are bad, they cut or don’t just pay one. Often the stock market has anticipated that action; in other cases it is a surprise. Diligent investors seek out companies that can continue to pay and increase their dividends, and avoid those that cannot. Like the rest of life, that process involves making choices.

 

The author ends his piece with an argument for flexible rather than fixed dividends, allowing companies slack if they need to cut payouts during a crisis. That concept is not unreasonable in Europe where payout ratios are very high. In that instance, a company with a stated payout ratio of, say, 75%, will pay a lower dividend if profits are down in any given year. The lower distribution will be expected by the market because the company has been clear about its dividend policy.  If the company’s cashflow outlook over the next 5 years is attractive, then the income stream may still well be worth holding, even with the lower in-year distribution.  In the US, that argument is harder to make. Yields and payout ratios are low; share buybacks are preferred.  But even in the US, dividend-focused investors have the opportunity to maximize their cashflows though making choices about their holdings.

 

The author clearly knows all of these points, but the constraints of addressing an important and multi-faceted investment issue in a relatively short opinion piece ends up adding to the confusion about dividend investing. That is a shame. Please consult your financial advisor. And for additional discussions of the math of dividend investing, see the posts from Sept 7, 2019, July 28, 2019, and Sept 28, 2018.

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