Understanding dividends is important to understanding your investments. With dividend rates at an all-time low, some investors are worried that the markets are poised for a severe pull-back. In this article we examine dividend trends and offer our opinion about the importance of low dividend yields.
Firms have two basic choices for what to do with their earnings; pay them out to shareholders in the form of dividends, or spend (reinvest) them on activities or projects which will ultimately cause the price of their stock to go up (capital appreciation). Which choice they make is the subject of corporate finance, but their choice affects all their investors.
Historically, dividends have been an important component of investment returns on stocks. In fact, a whopping 41.5% of the investment return provided by stocks since 1926 has been attributable to dividends. Total return (10.9% average annual since 1926) is provided by the combination of income (from dividends, 4.5%) and capital appreciation (increasing stock prices, 6.4%).
In addition, dividend yield (annual dividend/market price) has been among the most consistent predictor of where the market is likely to go – up or down. Whenever the dividend yield has fallen to about 2.3%, the market has almost always experienced a dramatic price decline. In recent years dividend yields have been in a secular (OK, long term) decline, as market prices have risen, and dividend increases have failed to keep pace. The dividend yield for the market as a whole now stands at about 1.6%, so it is appropriate for us to question if this fact is significant.
In 1976 Fischer Black wrote an article which questioned why corporations pay dividends at all:
- A company that pays no dividends is more attractive than one that does, especially if capital gains tax rates are lower than ordinary income rates (as they are now).
- There are better ways for a firm to enhance shareholder value; buy back stock, or, replace common stock with bonds to get deductible interest expense (dividends are not deductible by the firm).
- Not paying dividends is a low-cost source of capital for the firm.
We concur with Mr. Black, and it may be that investors are gaining a sophisticated enough understanding of corporate finance to accept the basic truth of these arguments. Investors would make more money if corporations used the funds available to pay dividends for any of these other purposes.
Stocks are in a constant tug-of-war with bonds to see which can offer investors the best combination of risk/return, so it is natural to ask about the relationship of dividends and interest rates. With a current dividend yield of 1.6% from stocks and 20-year bond rates at 6.1%, it is implied that investors are expecting capital appreciation of at least 4.5% from stocks (6.1%-1.6%). Of course, stocks have more price volatility (risk) than bonds, so investors should get a risk premium for investing in stocks – perhaps 50% of bond yields, or 3% additional. Thus, as a benchmark, if investors can get a total return of 9.1% from stocks (1.6% + 4.5% + 3%), then they should prefer stocks over bonds. In addition, since the capital gains rate is lower than the rate investors will pay on income from bonds (in taxable accounts), then stocks offer tax advantages as well.
Our view is that it is time to shift the dividend paradigm; dividend yields are no longer the accurate predictor of overvalued markets that they once were. We applaud actions taken by corporations to utilize their earnings more productively for investors. As long as corporate profit growth remains reasonably strong and interest rates remain relatively low, the fact that dividend yields are historically low is of little significance.