Homemade Dividends

Tuesday, September 3, 2013 8,732 views

At Index Fund Advisors, we often encounter investors who religiously adhere to the commandment, “Thou shalt not invade thy principal.” Whether the investor is a retiree who is living out of his portfolio or a foundation that is spending its endowment, the notion that only dividend or interest income should be used for withdrawals, while psychologically satisfying, is flawed, as we will explain below.

The first thing to understand is that when a company pays a dividend, it is not a free lunch for the shareholders. On the day that the dividend is paid, the share price will drop by the amount of the dividend, but this drop may be obscured by changes in the market price for other reasons.

If a company has accumulated excess cash after reinvesting all that it needs for its operations and setting aside whatever reserves it deems necessary, it essentially has two options:

1)    Pay the cash to its shareholders as a dividend

2)    Repurchase its shares

No matter which option the company chooses, its investors fare the same. Suppose that a company paid out 5% of its share price as a dividend. A shareholder who has $100 worth of stock would now have $95 of stock and $5 of cash. Now suppose that the company instead decided to repurchase 5% of its outstanding shares. If our hypothetical $100 shareholder were to sell 5% of his shares, he would again be left with $95 of stock and $5 of cash. When a company chooses to pay a dividend, it is simply replacing part of the value of its shares with cash. For taxable investors, this creates an immediate tax liability that would not occur with a share repurchase, unless the shareholder chooses to sell some of his shares.

As the well-known financial economist Ken French put it, “Investors should be indifferent to how they raise cash, whether through dividends and interest, or through the sale of shares—a method Merton Miller (1990 Nobel Laureate) called homemade dividends.” Please check out the six-minute video below for an illustrative explanation of this concept from Professor French.

 

As explained by Ken French, investors who only purchase high-dividend stocks or high-yielding bonds are potentially exposing themselves to unnecessary risks. The problem with high-dividend stocks is that they tend to be concentrated in a few economic sectors such as utilities and consumer staples. Owning only these stocks would mean giving up the benefits of a broadly diversified portfolio.  Perhaps an even worse approach is reaching for yield on bonds. As we have stated many times, there is no such thing as higher yield without higher risk, and the two ways that risk can be increased with bonds are to go out for longer maturities and to take on more default risk. In the case of longer maturities, an increase in interest rates will cause a sharper drop in the value of the bonds. If a high amount of default risk is taken, an economic downturn may lead to (You guessed it!) a high amount of defaults.

For an institution such as a foundation, a misguided spending policy can lead to problems down the road. For example, if the investment policy statement requires that 5% of the portfolio balance is to be spent and none of it can come from capital gains, then it is forced to buy very high-yielding stocks and bonds. Stocks that have a significantly higher current yield than their peers often have an underlying problem that the market has identified via the lower price and hence higher yield. This usually means that the dividend will be cut, thus lowering the yield to a normative level. If the institution decides to get its entire yield from bonds, it will likely wind up with a portfolio that has an overall lower expected return (even with the higher risk bonds it will be forced to hold) compared to a balanced 60% equity and 40% fixed income portfolio.

To summarize, imposing the artificial constraint of taking only dividends and interest while avoiding the taking of capital gains can lead to a sub-optimal portfolio. The effort to reach for more yield may cause investors to lose in the end.

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