Do Dividends Really Pay?

What benefits do dividend payments and dividend yields convey? The answers may sometimes be overlooked as market participants seek equity income or the perceived safety of dividend strategies. In 1961, Merton Miller and Franco Modigliani (M&M) theorized that dividend policy is irrelevant to company value.[1] Of course theories are models of reality and require simplifying assumptions. There is room for debate about the limitations introduced by M&M’s assumptions, but it pays to consider their theory because if dividend policy is even close to irrelevancy in the determination of company value, then it is not a fundamental driver of total return. In much of the leading research and literature on risk premia and factors, dividends and dividend yields generally have not been widely found to generate a return premium. Carry is closely related to yield and it originated in foreign exchange markets. It has recently been researched broadly to comprise other asset classes, including equities.[2] However, while equity carry is related to dividend yield, it is a forward-looking measure derived from the valuation of index futures. Most dividend growth or dividend yield strategies do not capture equity carry per se.

All of which is not intended to imply that dividend payments do not contribute to total returns; they obviously do. But they may behave more as a component, rather than a driver, of cash flows. Think of it this way—you are paid by your employer with direct deposit into two bank accounts, Bank A and Bank B. The key drivers of your pay include the health of your employer’s business and your job performance. Whether you get paid through Bank A or Bank B has no bearing on the amount of your pay. The banks serve as cash flow conduits, just like dividends and capital gains. In a theoretical world without market frictions, investors would be able to create dividend-equivalent cash flow by selling shares, as Exhibit 1 illustrates.

If dividends do not drive returns in and of themselves, why do investors seek them? The real world does have market frictions, and there turns out to be an array of potential behavioral, financial, and even legal reasons behind investors’ dividend preference. For example, it may be psychologically easier to receive dividends than to sell holdings, because one may avoid the regret of selling at a loss. There may be emotional reasons, or even legal ones for some types of trust accounts, to avoid an invasion of principal. Financially, there are no sales commissions for dividends, while there may be for selling shares (though many funds can now be sold without transaction fees). Finally, dividends may simply be more convenient. One does not need to plan or remember to transact in order to receive a dividend, while one generally would for selling shares (though many asset managers and financial service providers offer automated withdrawal services). In a nutshell, dividends seem to have potential benefits psychologically, in some cases legally, and in terms of cost and convenience. While M&M made a strong theoretical case for dividend irrelevance, in the presence of market frictions dividend preference becomes somewhat clearer.

Furthermore, even if dividends do not generally drive total returns, they may serve as economic signals. This explanation provides another, possibly theoretically stronger, footing for dividend preference. For example, growing dividends may convey financial strength, while high dividend yield may be correlated with value. Of course, financial strength is closely associated with the quality factor, and value is one of the most widely accepted factors. Therefore, by virtue of a signaling aspect, dividend strategies may offer access to risk premia.

One thing is certain, which is that one dividend strategy can be quite different than the next. Market participants should carefully consider the role of specific dividend strategies with respect to their portfolios’ investment policy and factor exposure. An important overall consideration is that all dividend strategies are somewhat less diverse than the broad market, because not all stocks pay dividends. Therefore, the best dividend strategies are those that compliment diversified portfolios in ways that contribute to desirable characteristics on a case-by-case basis. In my next post, I’ll pick up on dividend strategies again and provide a bit of a deeper dive.

[1]   Miller, Merton H. and Modigliani, Franco. “Dividend Policy, Growth, and the Valuation of Shares.” The University of Chicago Press. The Journal of Business. Vol. 32, No. 4. Pp. 411-433. October 1961.

[2]   Koijen, Ralph S. J., Moskowitz, Tobias J., Pedersen, Lasse Heje, and Vrugt, Evert B. “Carry.” Fama-Miller Working Paper. Nov. 1, 2016.

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