Enrich Your Future 30: The Hidden Cost of Chasing Dividend Stocks

Andrew Stotz 00:02
Andrew, fellow risk takers, this is your worst podcast host Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, Larry stands out because he bridges both the academic research world and practical investing. Today we're diving into a chapter from his recent book, enrich your future the keys to successful investing. Specifically, we are looking at chapter 30, the economically irrational investor preference for dividend paying stocks. Larry, take it away. Yeah,

Larry Swedroe 00:36
this is one of my favorite chapters, because it deals with, I think, one of the great anomalies, which is that, despite an overwhelming body of evidence, a lot of investors have a preference for dividends. Even though there's no economic theory to support it, there's no data to support it. And when you show the people the evidence and the data they have a confirmation bias, and ignore anything that you show them that doesn't agree with their preconceived notions. It's simply incredible to me that people can just ignore, you know, all the theory and the evidence because it doesn't happen to agree with their preconceived notions. So it's been long known for that, for behavioral reasons, people have a preference for dividends, even though it is completely illogical and easy to show. In fact, you're an academic, you teach classes, you know, one of the favorite activities of professors is writing papers that disprove what somebody else had written, right? Okay, so in 1961 Merton Miller and Franco Modigliani wrote a famous paper called dividend policy growth and valuation of shares, in which they showed empirically that dividend policy should be irrelevant to stock returns. That was now 64 years ago, and not a single paper has been written that shows anything but that no one has refuted it, and yet we get it. And it's easy to show people, as I describe in the book, because unless you think $1 is not worth $1 then you have to understand dividends are irrelevant. And it's easy to show. So I give an example. Let's say you have a stock that's worth say it's got $10 book value, okay? And it's trading at a at at $10 so it's trading at one times its book, and you have another company that's exactly the same, also as a $10 book, and trading at 10, both companies earn $1 a share, okay, If at the end of the year that one has paid a dividend. What has happened an investor, say, at 100 shares times 10, said $1,000 okay, the stock is still trading at 10 because it's trading at one time book, and therefore it's still worth 1000 but they got $100 in cash before taxes. Of course, in the US, many other countries, you have to pay taxes on those dividends. Okay? Now you have another company that earns the same dollar, but it chooses not to pay a dividend. So now it's trading at $11 or one time book, and you have the same $1,100 before taxes, but since you didn't receive any dividend, certainly for a taxable investor, you're ahead, and if you don't need the cash to live on, you're clearly better off not doing that. In addition to which, if you don't need the cash, okay, the company now has more capital which it can reinvest, and therefore should be able to grow earnings faster than the company that paid the dividend, as long as it earns its you know, cost the capital, so you're ahead from that perspective. Now, despite that simple logic that even if you needed the dividend, you could sell 100 Dollars worth of the stock at $11 so you don't even have to sell 10 shares. You sell nine, you know, point, oh, nine or whatever, and you end up at the same place. But for the taxable investor, okay, you're ahead because you have a your pay a tax only on the portion that's the gain, not the entire amount of the dividend. And so therefore you're ahead that way. And yet, despite that simple logic and simple math of this example, you have people who think that there's companies that pay dividends have like what's called Magic pants. You could take the dollar dividend out of one pocket, put it back in another, and think you're worth more, but it can't be. Your company's stock has to be worth less after the dividend is payment, unless you think $1 isn't worth $1

Andrew Stotz 06:05
simple. So there's, there's a bunch of different angles. I want to tell you a story about a Parliamentary Debate many years ago in Thailand, and they were grilling the finance minister for not distributing enough of the dividends from the state owned oil and gas company, and they said that, you know, you're disadvantaging the treasury of the country by not paying out more dividends. Now, where it became very interesting was nobody discussed on the floor of the parliament that the company was making a return on invested capital of 40% with a cost of capital, let's just say, let's just say 10% right? So they were creating value of 30% now you could have another argument saying they should lower the prices to the consumers, you know, to the to the population, but let's just put that argument aside and just say so here's a situation where, if they took the money out, and at the time, deposit rates were about 1% so they wanted to get the money out of the company and into the deposits, you know, of the finance ministry, and say that that would be better off for the population. What's wrong with that?

Larry Swedroe 07:20
Larry, well, it's pretty simple, if they needed cash flow, which is possible, the government could have sold some of their shares enough to generate whatever dividend they wanted to receive. Investors always have the option of creating a self dividend if they need it. So effectively, this is really important for people to understand when a company pays a dividend, and people don't think of it this way, but this is exactly what's happened. They're forcing you, as an investor, whether you like it or not, to disinvest and sell equity, if you will, in the company. Now you still have the same number of shares, so people don't think of it that way, but the company is worth less, or you have disinvested from that company when you may not want to do it. Now you can replicate that or undo it by dividend reinvestment, which a lot of people automatically do, but you still have to pay taxes on the dividend you receive, which makes it dumb from that perspective. So companies really have a choice. They could keep the cash and grow it. You know, if their return on capital is higher than the cost of capital, that's the logical thing. They could pay a distribution out. If they're unable to earn their return on capital, or if they believe their stock is really undervalued, then they could buy back the shares, and in effect, pay a dividend that way, by driving the price up, and if you need the cash flow right, then you could sell a few shares, putting you right back where you are. It really makes no economic sense to pay a dividend unless you're not earning your cost of capital.

Andrew Stotz 09:22
And it gets really clear when you look at this excessive level of value creation, right, where we're talking about 40% return on capital versus a 10% let's say cost of capital, where from, just from a pure business perspective, you want to have as much money in that company as possible to invest at that 40% rate until it starts to come down. And even if it came down to 30% use deal, even though additional investments have a lower value creation, the value creation is still huge. And so from a company perspective, you. Ultimately, they would never want to take any money out of that if you want to keep that compounding and growing. Would I be right in saying that absolutely

Larry Swedroe 10:08
in fact, while Microsoft investors have done great since they've started paying dividends, they've been worse off than if the company had used it either to buy back their stock, right, or reinvested in the company if they didn't have enough good uses, right? So either way, they would have been better off, because the company has continued to out earn it's cost the capital. Why do you think Warren Buffett has never paid a dividend from Berkshire Hathaway, because he referenced felt investors were better off by him keeping it and he's out earned this cost of capital. Now, there is one thing that we should know, or let's there are two points that we should make: if dividends or an indicator or an explanatory variable of equity returns, then it might make sense to own dividends. However, we have many models that have been developed as we've talked over the time we've been having our discussions, the first model of asset pricing theory was the CAPM, and the single factor was market beta, so that, of course, said, dividends don't matter. There's no dividend in the model. The second model was the farmer friends, three factor model, which was size and book to market again, dividends didn't matter. Then we added momentum, and we still don't have dividend. And then we added profitability and cash flow. And there are other factors that people have used hundreds and not one of them is dividends. Now if you look at value, dividends could be used to determine value in the sense that you get a high dividend yielding stock is a value company, and a low dividend yielding stock would be a growth company. You could use that metric. It turns out that there is a slight premium there, but it is by far the worst of all the value metrics you could use. So price to cash flow, price to earnings, price to book value, EBITDA, enterprise value, are much better explanatory models, so that should tell you again, dividends, dividends don't matter. All else equal. Now, the last thing I will say is this, that dividends can be used as signals by companies to shareholders. So companies, you know, increase their dividend, because we know companies hate to cut dividends because it sends the wrong signal about the future of the company. They're at risk in bankruptcy or whatever. So if they raise the dividend, they have to be highly confident they won't have to cut it in the future. So that could be a positive signal. But it turns out that companies with increasing dividends don't outperform companies with similar metrics of price to cash flow or other other metrics that matter. So even there, it may be a signal that it's a relatively safer investment, but that should tell you it's a lower expected returning, not higher expected returning investments.

Andrew Stotz 13:44
And I have, I have two last questions. The first one is, imagine, you know, in a case, that you are the sole owner of a company, and let's imagine, for the sake of argument, that it's listed in the stock market, which can't really be, but let's just say that there's a market price set every day for your company, and and you decide that you want to, let's say, take cash out of the company. You can do a dividend, or you can sell your shares, let's say, and let's say you're willing to sell it to somebody, and they'll come in as a new shareholder, as an example. But the point is, is that let's now factor in that. Let's say you've got a 40% return on invested capital and a cost of capital 10% when you take that $1 out of the business, the price of the company is going to fall by $1 right? You're going to receive $1 and let's just say you're going to put it in, you know, three, 3% bank deposit, right? You've just, you yourself, individually, has just missed a huge opportunity, because that dollar in your account, your bank account, versus that dollar in the company, is. Just two worlds apart,

Larry Swedroe 15:01
so in terms of expected, but not guaranteed, return, correct? And then you haven't even considered tax implications,

Andrew Stotz 15:08
yeah, let's say forget tax for some I'm simplifying it. As for the simple minded guys like me and we do live in a

Larry Swedroe 15:15
world where most people pay taxes on dividends, right?

Andrew Stotz 15:19
Well, let, let's just say that the tax rate is equal for dividends and capital gains for right now and but

Larry Swedroe 15:24
even if you assume that, yeah, so let's say, in your example, the person takes a million dollars out in dividends, they pay a tax on the million dollars. Now let's say they take it out by selling shares. Okay, let's say the shares were trading at $10 a share when they bought it or made the initial investment. Their cost basis was $5 a share. Now, when you take the million dollars out, you're only paying tax on half a million dollars, which is the gain. So depending upon their cost basis, you're clearly you can't be better off with the dividend, and you could be much worse off. Imagine an investor, okay, who is sitting with a loss on their stock and says to himself, I don't want to sell my stock. It's at a loss, okay? But he takes the dividend, and now he's paying tax in the US, you know, pay the tax on that dividend when he could have, in theory, let's say, not taken the dividend, okay, and sold shares, he would get a tax loss, not pay any, get tax at all. Right, so why would you prefer to own the company that's paying the dividend? There's no logic to it, none.

Andrew Stotz 16:56
And let me just ask one last question about that, and that is when you take that dollar out. And again, we all know that, that, you know nothing is guaranteed. But what you can see is that highly profitable companies tend to remain above average from what I've my testing. So let's say that this company

Larry Swedroe 17:16
some period of period of time we talked about this, that companies that grow their earnings abnormally above the average tend to that rate of abnormal growth tends to revert to the mean at 40% per annum, so they tend not to keep going. And the best testament to that are companies like Kodak and Polaroid digital equipment. And we could go on and on and on, but yes, over the short term, profitability is persistent, but at lower and lower rates,

Andrew Stotz 17:52
and we know in, let's say, a discounted cash flow type of valuation, the earlier periods have a huge, you know, impact. So let's just imagine that, you know, this business can continue on at a very high level of value creation for the next 10 years. And so let's assume that now, when I've taken that dollar out of that business myself, I've missed a huge opportunity for that dollar, right? And so my question is, did I decrease the value of my business by $1 or did I decrease the value of my business by $1 with the potential? Because when we're valuing it, we are expecting this relatively high level of return. So am I taking out $1 or am I taking out $3 with that present

Larry Swedroe 18:43
present value, depending on what you do with it, because you could put the money and buy back the stock, in which case you would be out only the tax differential, and then you could present value that right? But your answer is in if you earn higher returns and put the money in your bank account or spend it, then you've given up way more than the present value of $1 because your cost of capital is below your return on so

Andrew Stotz 19:14
let's now go into the open markets. We see companies buying back shares all the time, and people see it as really good news. It's going to reduce the number of shares. You're going to have a slightly higher percentage ownership in the future. But if it's a very high returning company, is it really $1 comes out of that company and the share price falls by $1 all they've missed is $1

Larry Swedroe 19:42
Well, you got to remember that depends on what they would have done with the dollar. They have to think the stock is undervalued. Otherwise they'd be better off keeping the cash and reinvesting in the business. So they would be make management is making a judgment. That the stock is undervalued, or we can't use all of our capital and get a 40% return. There are only certain investments. Let's say we've got, you know, a trillion dollars in cash, like Apple might have or something, but in this case, they can only put 500 billion to work, and the rest investments would get a lower return than the cost of capital, then they would be better off buying their stock back

Andrew Stotz 20:27
and again, going back to this somewhat persistence of value, making additional value in the company. And now let's now look at another company that's earning for the next 10 years the cost of capital. That's fine. You know, it's not bad, because you've cost of capital has the risk, risk factored into it, but one's got the cost of capital. I can see if you're earning the cost of capital that you take $1 out, it's worth $1 but it's harder for me to see that $1 coming out of a highly profitable company is $1 No,

Larry Swedroe 21:03
it's not in present value. It's in terms of expectations. It's worth more. So it would not make sense. That is why Nvidia and Apple and Microsoft either pay no or very low dividends. So there's a trade off. No, they're increasing shareholder value by retaining that capital.

Andrew Stotz 21:24
So there's a trade off between the fraction that you own in the company rising because of the number of shares falling and the value creation that the company's missing by that money not being in the company at

Larry Swedroe 21:39
the pens again, because then let's say you're only able. In that example, let's say you're apple and you got a trillion of excess cash, you may not be able to invest a trillion at above your account. Which, which? We only, there's only a certain amount of investments, understanding that we'll meet that criteria. Companies always face that decision, right? What's my cost of capital and does that investment exceed that cost of capital? If it doesn't, then I should probably not make it.

Andrew Stotz 22:13
So does this imply that there, when highly profitable companies do share buybacks, their share prices should go down.

Larry Swedroe 22:21
No again we you have to the question management, hopefully is looked at the analysis and said, We're better off buying the shares than to keep that extra cash right, because we have put our cash available in all the investments that we think, on a risk adjusted basis, exceed our cost of capital, this other cash, we're better off. We think our stock is undervalued, and we'll buy that stock back.

Andrew Stotz 22:52
Yeah, and this isn't, this chapter is not really about buybacks, but you as you say, there's another factor, and that's what's the share price. You know, the share price is super low and the returns are super high. Yes, makes sense. One last thing on this topic. That's my last question, I promise. And then you'll get on with your rest of your evening. If the market, if investors are truly irrational in their preference for dividend, how can we as rational investors capitalize on that or take advantage of that? There's

Larry Swedroe 23:25
a there's a paper, I think it's a brand new one. I just read. It might have been somebody sent it to me or whatever, but showing that, at least before costs, let's say, let's take the high frequency traders can clearly exploit it, and because they show that stock prices tend to rise in the month before they pay the dividend, because dumb retail investors overvalue dividends, and then they tend to revert back after the dividend gets paid. So if your costs are very small and trading and you can front run the dumb retail money, you might be able to do that. I don't

Andrew Stotz 24:13
know if at home before they're buying it, before the dividends announced. Yeah, no, they

Larry Swedroe 24:18
know it's coming, but you know, let's say it's expected, but let's say the dividend is paid on March 30, that and they know from history. I'm just now making this up because they didn't read the whole paper in detail. I just read the summary of it, the abstract and the summary. Let's say the dividend retail investors start buying two weeks before a lot of stock brokers tell people what a great strategy. We're going to capture five dividends in just a little over a year. So we'll buy the stock so the high frequency traders come in, say on March 13, buying, knowing dumb retail money. Comes in on March 15, they push the stock up, and then on March 29, or 30th, they sell and push the stock right back down to where it was before. Now again, I don't know if it holds up after, but it certainly tells you you shouldn't buy a dividend paying stock in the month it's about to pay a dividend. You'd be better off Owning the market for that 30 day period.

Andrew Stotz 25:28
Well, I want to thank you, Larry, for this discussion, and we went into a lot of interesting stuff. I know it's valuable, and I'm looking forward to the next chapter. And the next chapter is chapter 31 the uncertainty of investing, where you talk about risk and the difference between risk and uncertainty. For listeners out there who want to keep up with all Larry's doing, follow him on X Twitter at Larry swedro, and you can also find him on LinkedIn. This is your worst podcast host, Andrew Stotz, saying, I'll see you on the upside you.