In an article about declining dividend yields in today's New York Times, a graph depicts the yield of the S&P 500 declining from over 4% in 1985 to under 2% in 2006. While the piece explained the decline in dividends and offered strategies for income-seeking investors, it didn't address an important question: Why should investors care about dividends?
This is a question that I've often been puzzled over myself, because there are so many good reasons not to like dividends and, as far as I can tell, few good reasons to support them. There is a widely-held belief among retail investors that dividends represent free money. Of course, any money that is paid out as dividends comes right out of the company and reduces the book value of the company and inhibits future growth prospects. Then there's the little problem that dividend income is taxed twice: first as income for the company, and then as income to the investor when the dividend is paid. Investors who need income from their stock (e.g. retirees) would be better off selling a portion of their shares each year than picking up dividend-paying stocks. People warn about the capital gains tax ramifications of that, but unless the stock has appreciated considerably, it will not be much of an issue. But if you receive a dividend (which comes directly out of the book value of the company), you must pay taxes on the entire amount.
By now, some of you are probably thinking about how dividend-paying stocks have provided higher returns historically, which is true. But as anyone who has read Freakonomics was reminded five or six times per page, a correlation does not necessarily mean there is a causal effect. Consider some of the common attributes of dividend-paying stocks: 1) they must have stable balance sheets to support the dividend; and 2) they are usually dependably profitable.
In other words, dividend-paying stocks have stable balance sheets, and dependable profitability, two characteristics that most twelve-year old's could probably tell you would make them good investments. That does not mean that the fact that they pay a dividend has anything to do with that. The preference for stocks that pay dividends may go back hundreds of years, to England, to the stock-jobbers of the pre-South Sea Bubble markets. The stock market was so rife with fraudulent businesses (one offering raised money for a "most lucrative" venture but declined to state what that entailed) that a dividend was seen as "proof" that a company was actually involved in some kind of business. In the post Sarbox world of today, I think we can put a little bit more trust in the financials of companies: we don't need them to send us cash to convince us that the business is real.
Then there's share buybacks, which I believe are great for investors. If you own shares in a company, wouldn't you rather be given a larger stake in the company than cash that you have to pay a tax on. To this end, I have this rule about dividends:
If you are a shareholder in a company you should absolutely, 100% of the time, always prefer a share buyback to a dividend.
For those of you who suspect I've been hittin' the town with Jeff Skilling, let me back up a bit. What is the reason that a company would buy back shares? Answer: The company has excess cash that is not needed for reinvesting in the business and the stock is undervalued.
"Aha!" you say, sure that you've caught me. "But what if the stock isn't undervalued? What if it's overvalued?" My response: Then why the heck do you own the stock? If you would prefer cash (taxable by the way) to a larger stake in the company, you should probably sell the stock and seek bargains elsewhere. There are far too many stocks to choose from to own ones that you think will provide less of a return than cash.
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Reader Comments (Page 1 of 1)
12-27-2006 @ 10:31AM
Austin said...
I think Zac has been hitting the eggnog.
12-27-2006 @ 9:54AM
Zac Bissonnette said...
Thanks for the comment. I can assure you that I wrote that post completely sober. ;) My point is this: a company that has an undervalued stock price and chooses to return cash to shareholders so they can pay a double-digit tax on it rather than repurchasing its own stock is not making the best use of shareholder equity. I don't really see how anyone can disagree with that: Why send people taxable cash when you can use it to repurchase its own undervalued stock.
And if the stock isn't undervalued, why buy it? Thanks again for reading/commenting.