The Free Dividends Fallacy

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Sarenco

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Excellent article in today's Irish Times on the irrational preference of investors for shares with high dividend yields:-

http://www.irishtimes.com/business/personal-finance/yield-hungry-investors-fall-for-free-dividends-fallacy-1.3134518


"Interest rates have been on the floor for years, prompting frustrated and yield-hungry investors to turn to dividend stocks. There’s a problem, however: research indicates many investors make costly errors because they don’t actually get how dividend investing works.

Do you? To test, state if the following statements are true or false:

(A) Dividend-paying stocks are less risky than non-payers;

(B) Like bonds, they offer free annual income as well as the potential for capital growth;

(C) Dividend stocks are an especially good investment when bond yields are low, like today.

Kudos to those who answered false. Those who didn’t may be guilty of what researchers call the “free dividends fallacy”.

Consider a company whose shares are priced at €1. It decides to pay its investors a 3 per cent dividend annually. On the date the dividend is due, the company will distribute €3 to a shareholder with 100 shares and the share price will drop by the amount of the dividend paid, to €0.97. What’s the difference between this and a non-dividend paying company whose share price remains at €1 throughout?

If the above investor with 100 shares wanted income, he could simply sell three shares – in essence, create a home-made dividend. It should make no difference whether he receives €3 in the form of a dividend or by selling shares – in both cases he is left with €97 of shares and €3 of cash. Investors who prefer high-yielding dividend stocks do not tend to think this way, indicating they may not be grasping dividend payouts trigger an equivalent decline in the share price."
 
Sarenco said:
Kudos to those who answered false. Those who didn’t may be guilty of what researchers call the “free dividends fallacy”.
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Or the researchers might be talking a lot of crap (in my opinion)!!! It is not in the interests of the shareholder for the company to retain earnings if it cannot deliver at least as good a return as the investor could get else were. There are some companies who are cash cows and it makes since to consider such stocks in an income generating portfolio. For example I invest in title insurance companies for their income - because they are required to be a mono line insurance company they have little opportunity to grow and retained earnings will not generate much of a return going forward, but they are excellent cash generators.
 
Jim2007 said:
It is not in the interests of the shareholder for the company to retain earnings if it cannot deliver at least as good a return as the investor could get else were
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Sure but that's not the point being made in the article.

If your cash rich companies simply bought back your stock you would be in the same economic position. Take taxes into account and you would actually be in a better position.

There is nothing magical about dividends as compared to capital gains - it's an irrational preference.
 
maybe im just stupid but ive heard this before and it makes no sense to me

the author of the piece claims that in the case of a stock which pays 3 dollars of a dividend , on ex dividend day when the price of the stock drops by 3 dollars , this makes the dividend a fallacy

he is to me simply using the natural price fluctuation of stocks as a way of pushing him his bogus point about dividends being of no real NET benefit , using the arguement to its full wide conclusion , if a stock which eventually reach three dollars were to remain at below the purchase price of say a dollar , for several years , it would be no use even it did get to three dollars at some stage

dividends to me are about being paid to wait for ( hopefully ) capital appreciation , houses also fluctuate in price , while the stock does reduce in price to account for each quarterly dividend payment , its not like it remains down or as if some of your original holding has been reduced in order to pay out the cash dividend
 
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galway_blow_in said:
his bogus point about dividends being of no real NET benefit
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No, that's not the point being made - I don't think anybody would suggest that dividends aren't a significant component of the total return on stocks.
galway_blow_in said:
dividends to me are about being paid to wait for ( hopefully ) capital appreciation
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That's just mental accounting. Just because you like to think of it like that doesn't make it so.
 
Sarenco said:
No, that's not the point being made - I don't think anybody would suggest that dividends aren't a significant component of the total return on stocks.

That's just mental accounting. Just because you like to think of it like that doesn't make it so.
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well i guess im just stupid then , is rent each month on a BTL the same ?
 
I am not sure I would answer False to (A). Take the dot.com bubble. Those stocks were quite the opposite of dividend paying. They were a punt on huge future growth. If they had dividend paying capacity they wouldn't have crashed so spectacularly.

But as a believer in the EMH I hold that all shares are priced fairly - at least in the sense that I haven't a clue how to pick the bargains and I suspect very few people do have a clue; those that have picked the bargains probably just lucky. Instinctively I believe that a dividend paying stock is less risky than a purely growth stock but, of course, the counter is that it has less upside potential.

Anyway the debate is only relevant in a pension fund context as a tax paying investor should seek to avoid dividend paying stocks.
 
Duke of Marmalade said:
I am not sure I would answer False to (A). Take the dot.com bubble. Those stocks were quite the opposite of dividend paying. They were a punt on huge future growth.
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That's true Duke but I think you might be guilty of confusing correlation with causation.

Berkshire Hathaway never pays dividends but I'm sure you wouldn't consider that to be a high risk stock - it certainly sailed through the aftermath of the dot.com crash.

The tax treatment of different sources of stock returns is also relevant to pension vehicles - don't forget dividend withholding taxes.
 
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Sarenco,

I can show you a graph of global dividend index Vs. Euro Stoxx 50 over 5 years. It outperforms the latter, without factoring in dividends.
 
galway_blow_in said:
is the principal of receiving an income from investment property by way of monthly rent not the same as a dividend when it comes to stocks ? ( useless )
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Well rent and dividends are obviously both sources of income but the former is a legally enforceable promise (and in that sense is bond-like) whereas the later is simply an expectation.

Again, I didn't (and the article didn't) suggest that dividends (or rent for that matter) are a "useless" source of return. The point is that there is no logical reason to prefer one source of return (income) over another (capital growth).

I've often made the point on here that over the very long-term the expected real capital growth of real estate is effectively zero. It's the (net, after-tax) rental yield that really matters.
 
fistophobia said:
I can show you a graph of global dividend index Vs. Euro Stoxx 50 over 5 years. It outperforms the latter, without factoring in dividends.
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Five years is a meaninglessly short time frame in terms of stock market returns. Also, why would you compare one (relatively concentrated) regional index with a global index in trying to prove anything?

In any event, the long-term outperformance of value stocks (and the correlation between dividend stocks and value stocks) is dealt with in the article.
 
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read the irish times article again , i still dont get it

he claims the owner of the stocks might as well have just sold three of his stocks for three euro instead of taking the 3 euro cash payment , to me thats like saying you might as well sell the front and back door of your house for the same price as a years rent

so what if the stock drops for the period of dividend execution , its an entirely temporary situation , you still maintain your stock holding , even you owned a stock which paid no dividend , it would very often drop by several percent countless times during the year , provided you dont sell , what difference does it make ?
 
Sorry but I think it is an appalling article. Someone who knows a little sneering at those who know less.

Sarenco said:

Do you? To test, state if the following statements are true or false:

(A) Dividend-paying stocks are less risky than non-payers;
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Dividend paying stocks crystallise a partial return every 6 months. The Investor no longer has the full investment exposed to the market. This reduces risk.

Dividend paying stocks tend to be in mature stable industries. Utilities, not tech punts.

Sarenco said:
(B) Like bonds, they offer free annual income as well as the potential for capital growth;
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What on earth does "free income" mean. Do bonds offer "free income" ? No you paid for it in the purchase price.

Obviously the dividend paid out is not available for reinvestment in the business.

(C) Dividend stocks are an especially good investment when bond yields are low, like today.

This is probably a reasonable assumption. With cheap money available high risk, high potential stocks are well supported. If interest rates rise such stocks will suffer far more than the boring dividend paying stock.


Sarenco said:
Consider a company whose shares are priced at €1. It decides to pay its investors a 3 per cent dividend annually. On the date the dividend is due, the company will distribute €3 to a shareholder with 100 shares and the share price will drop by the amount of the dividend paid, to €0.97. What’s the difference between this and a non-dividend paying company whose share price remains at €1 throughout?
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This is just a statement of the blindingly obvious.

 
I think we must take the article as being addressed at the layman who after all hasn't a clue about these things. I think it's a bit condescending for us know alls on AAM to lambast it. The general thrust that, contrary to intuitive first thoughts, one shouldn't seek out high dividend stocks is valid.
 
cremeegg said:
This is just a statement of the blindingly obvious.
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I would have thought so but a lot of people don't seem to grasp the point - often to their detriment.

Incidentally, I don't think it's just investing novices that fail to understand the issue.
 
Duke of Marmalade said:
I think we must take the article as being addressed at the layman who after all hasn't a clue about these things. I think it's a bit condescending for us know alls on AAM to lambast it. The general thrust that, contrary to intuitive first thoughts, one shouldn't seek out high dividend stocks is valid.
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thats a fair point but an entirely seperate one to the one made in the article , take energy stocks right now, due to low oil prices , many energy stocks dividend yields have climbed remarkably high , this might seem like a huge plus but the yields are high because the stock price has dropped , a wall st guy named kevin o leary claims any stock with a dividend yield of over 3.5% smells funny to him

the author in the article dismisses dividends full stop
 
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Sarenco said:
I would have thought so but a lot of people don't seem to grasp the point - often to their detriment.

Incidentally, I don't think it's just investing novices that fail to understand the issue.
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i still dont understand it , i must be stupid , i have only a relatively small amount of money tied up in stocks but my choice is either a vanilla index fund or high ( 5% plus ) dividend yield stocks for the long term as i dont know enough to pick winners in the growth sector , my attitude is over a ten year period , most index funds will at best average 10% per anum total return , if my dividend stock is paying me 7% , i dont need that much capital appreciation over the decade to match said index

during bear markets , i still get the high dividend from the likes of the energy stocks where as the index fund is only paying around 2.5% while its capital value is down 20%
 
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