Merton Miller

In today’s low interest-rate environment, investors might be tempted to buy certain types of investments for the purpose of increasing their annual income. One possible choice is stocks that have high dividend yields. In the financial media, we often hear the expert du jour talking about how high yield stocks now provide a higher yield than US Treasury bonds without mentioning the substantially higher risk of stocks over bonds. This risk was keenly felt in 2009 when 14% of firms around the world eliminated their dividend, and 43% of firms reduced their dividend. Based on the work of Nobel Laureates Franco Modigliani and Merton Miller1, we know that company dividends are not a free lunch as some investors believe.

A company’s dividend policy is irrelevant to the total return received by its investors. Dividends are deducted from earnings which are normally re-invested back into the company. Even if the company pays no dividends, shareholders can create their own dividends by selling shares, especially since long-term capital gains are taxed at the same rate as qualified dividends, and only the gain component of the sale is taxable as opposed to 100% of a dividend payment. Furthermore, we observe that on the day a dividend becomes payable, the company’s share price decreases by the amount of the dividend, although this is somewhat obscured by the additional share price fluctuation resulting from the news of the day. Furthermore, while a dividend payment may be interpreted as a signal that company’s reported profits are genuine, a dividend yield that is significantly above the market or industry group average is often a sign of financial distress. For example, two years before it declared bankruptcy (and wiped out the common shareholders), General Motors stock had a dividend yield that was five times the average of the S&P 500.2

 



Despite the theory that debunks the idea that high-dividend stocks provide additional returns without additional risk, certain members of the investment community cling to this idea by pointing out that dividend-paying stocks as a group have had higher overall returns than the total market. They are correct, but only partially. It is true that if you sort all the dividend-paying stocks into five quintiles, the higher yielding stocks have had a higher total return for the past 83 years than the lower yielding stocks without substantially higher volatility. However, once we account for exposure to the risk factors of market, size, and value for equities as well as term and default for fixed income (because the highest-yielding stocks such as utilities behave similarly to long-term bonds), the excess return of high-dividend stocks is almost fully explained. Essentially, holders of high-yield stocks were merely paid for their acceptance of value risk and interest rate term risk, even if they were not aware of it. It is also worth noting that the “zero dividend stocks” category is dominated by growth companies which have a poor reward-to-risk ratio.

A fair question to ask is if those investors who are willing to bear the risk for the purpose of gaining the risk premium offered by value stocks should capture it by concentrating in high-dividend stocks? While there are several legitimate investment vehicles for investing in high-dividend stocks, the essential problem faced by investors is that these companies tend to be concentrated in certain industries such as regulated utilities and consumer staples. A portfolio built on these companies alone may not have the proper diversification required to capture the overall market return in any given year. Also, a shock to the economy such as a rise in interest rates may affect all of these companies in the same adverse manner. When formulating their multi-factor approach to portfolio construction3, Professors Fama and French considered several different methods of sorting for value, including dividend yield. They settled on the ratio of book value to market value as providing the most efficient manner of achieving exposure to value risk. In the 19 year period since the initial publication of their findings, nobody has proffered a winning argument for replacing book-to-market with dividend yield.


1. Modigliani, F.; Miller, M. (1958). "The Cost of Capital, Corporation Finance and the Theory of Investment". American Economic Review 48(3): 261–297.
2. http://www.thestreet.com/story/10261079/1/gms-dividend-squeeze.html
3. Fama, E.; French, K. (1992). "The Cross-Section of Expected Stock Returns”.  Journal of Finance, 47 (June 1992), 427–465.