New Zealand investors have a longstanding obsession with portfolio income, and their bias is exacerbated in a low interest rate environment.

Meeting a specific cash flow need is an important element of portfolio management. But there are better ways to meet that need than investing specifically for dividends. In many cases, taxable investors with a cash flow need are better off minimising portfolio income.

Investors drawing down on their portfolios (e.g., retirees) need cash flow, but it can comprise of two components:

• Income (typically interest and dividend payments)
• Cash from the sale of securities

There are a number of factors to contemplate when determining how best to use these components of cash flow in order to meet a specific need. However, investors often gravitate toward income investments without properly considering all the relevant issues, which can result in a less efficient investment solution. The following discussion touches on some important aspects of the income versus cash flow distinction.

In summary, Bradley Nuttall shows that investing for dividends and high-interest is a tax-inefficient and risky method to meet investors’ cash flow needs. We show that several popular theories about dividends are not accurate, including:

1. High dividend yield helps you avoid eating up your investment base to generate cash flow,
2. Dividends offer protection on the downside and mitigate the drop in down markets,
3. High dividend yielding shares constitute a less risky investment because of the regular payments, and
4. Dividend yielding shares are worth more because they offer dividends.

We show that companies are valued based on their earnings. Whether those earnings end up in the left pocket (higher share price) or the right pocket (distributed as dividends) doesn’t matter from an overall value perspective.

Perhaps the best way to think of this is a scale. To increase one side of the scale, dividends, you must balance it by decreasing the other side of the scale, share price. This must be the case because they are both based on earnings. The more earnings distributed as dividends, the less earnings reinvested in the business (for future growth).

In short, what an investor gains as a dividend they lose in the value of their remaining shares. What does matter is the ability of a business to reinvest earnings (their investment policy) and the taxes investors pay as a result of which pocket the earnings fall into.

We show that investors should prefer taking capital gains as they are a more tax efficient means of raising cash. Further, we show that high yielding shares are often riskier. Thus, investing for yield can inadvertently lead to a riskier portfolio then is warranted by the client’s specific circumstances.

Do Dividends Matter?

Apple and Berkshire Hathaway (Warren Buffett’s firm) don’t issue dividends. Why are they so valuable if dividends are so important? Yet it only takes a cursory read of national newspapers to realise that dividends are the sacred cow of the New Zealand investment landscape. The emphasis on dividends stems from the notion that a high dividend yielding share constitutes a less risky investment because of the regular payments. Conventional wisdom is that the regular payment protects you on the downside because, if the share price declines, at least you have your dividend cheque. This perceived benefit leads many investors to emphasise dividends, regardless of whether they need cash flow. Those who are drawing cash from their portfolio are even more enthralled with high dividend yielding shares because, if the regular payments can meet most or all of their cash flow need, then there is no need to sell and "lock in" a loss if the share price declines.

While this logic attracts many investors, it is empirically flawed. Dividend payments are not created out of thin air. Rather, they come from a company’s earnings or assets. When dividends are paid, the distributions reduce the value of the company by the amount of the dividend.¹

Capital Encroachment and Downside Protection

Part of the conventional wisdom mentioned above, is that a high dividend yield may help you avoid selling shares to generate cash flow. However, a dividend distribution (assuming you don’t reinvest) is like the company selling your shares for you! With a dividend you may not have actually sold the stock yourself, but the economic impact is essentially the same as if you had.

Another common misconception is that dividends offer protection on the downside and mitigate falls in down markets. For example, if you own a share yielding 5%, your portfolio will be buoyed by this amount if the share price drops. However, consider that if the company did not pay a dividend, the price would have dropped less. You would obviously be out the cash from the dividend payment, but in both the dividend and no-dividend scenario, the total portfolio has dropped by more or less the same amount.

Investment Policy

A company's dividend policy should not affect the overall value of your portfolio. However, while dividends don't matter, what the company does with the cash in lieu of paying a dividend (i.e., its investment policy) does matter. The following passage from Nobel laureates Merton Miller and Franco Modigliani ("M&M") succinctly sums up the concept:

"Like many other propositions in economics, the irrelevance of dividend policy . . . is "obvious, once you think of it.". . . [Company] Values are determined solely by "real" considerations—in this case, the earning power of the firm's assets and its investment policy—and not by how the fruits of the earning power are "packaged for distribution."²

The dividend irrelevance proposition is one of the key findings of M&M. While more recent papers suggest that dividends can impact firm value, it is because of what paying dividends signals to investors, not the dividends themselves. The signalling, however, relates more to changes in dividend policy (i.e., the dividend is being cut, increased, or initiated) than to the dividend versus no-dividend decision.

Risk and Return

While M&M describe dividends as merely a form of "packaging" the fruits of a company's earning power for distribution, dividends are often erroneously thought synonymous with profits. This misconception leads to the view that high dividend yielding companies are more profitable and less risky than non-payers when, in fact, dividends are often not related to profits.

Very profitable firms may not pay dividends (e.g. Apple, Berkshire Hathaway etc.). Conversely, some companies (or trusts) pay dividends (or distributions) in excess of profits. The latter case is unsustainable over the long run. Dividends must ultimately reflect a company’s ability to generate profits.

Furthermore, high dividend yielding stocks may in fact be riskier companies. Market efficiency suggests that the price, rather than the dividend, contains the information about the prospects for a company and its expected future cash flows. A high dividend yield (D/P) could be a reflection of a low price rather than a high dividend.

The dividend discount model (DDM) shows how a high yield can result from:

• A high required return,
• A low expected growth rate, (or)
• A combination of the two.

Dividend/Price (i.e. Yield) = Required Return - Expected Growth

So a business that does not change its dividend but has a new, higher, dividend yield must have a lower price. The price is lower for a combination of; an increase in the required return or a decrease in the expected growth rate.

Let’s say the higher dividend yield is the result of higher required returns. This would be a direct signal that investors consider the company a higher risk. High risk companies have low prices because investors consider the future prospects of the firm to be less bright. So in very simple terms, high yield shares can be a direct result of increased risk.

But isn’t it a good thing if high yield shares have higher expected returns? …Only if an investor is aware of the risk and has chosen it purposefully, not if they fell into taking that risk accidentally chasing dividends. Either way investors must understand that the increased return is compensation for risk, not a direct outcome of the dividend policy of the business.

On the other side of coin, dividends may be high not because the shares are risky but simply because growth prospects are low. Rational firms with low growth prospects often distribute dividends as there are few good uses for the profits if reinvested in the business. These firms would not expect any increase in returns as a result of their high dividend yields.

International Evidence

Sorting shares in the US by dividend yield does not produce significant differences in average returns. This may suggest that a higher dividend yield results from a combination of a higher required return and a lower expected growth rate.

Sorting by dividend yield does correlate with higher returns in international markets, similar to the sorting of shares by other measures such as book value and earnings. Therefore, a high dividend yield may be mostly attributable to increased risk, rather than as a result of low expected growth.

So, while many investors seek companies with high dividend yields because they want income from their portfolio, they must consider the risks they are taking to achieve that income.

However, there is another, much better, approach. It starts by recognizing that investors need cash flow, not income. Further, this method sets a portfolio’s risk as a deliberate target and does not bias the allocation of the portfolio unwittingly towards riskier companies.

Creating Cash by Selling Securities: Taxes, Costs, and Rebalancing

The alternative to meeting a cash flow need through dividend payments is to create "synthetic" dividends by selling securities. This approach is often deemed undesirable because selling may result in "locking in" a loss if the stock price has dropped. As discussed earlier, this view is not empirically sound, as the dividend payment amounts to "packaging" and doesn't necessarily change the underlying (pre-tax) value of the portfolio.

However, the tax impact of synthetic versus regular dividends may result in different after-tax values depending on the relevant tax rates applied to dividends and capital gains.

The highest marginal tax rate in New Zealand for individuals is currently 33%. Below we calculate the cash tax burden, as a percentage of the distribution, with imputation credits for taxes paid at the corporate level netted off for a tax payer on the 33% marginal rate.

* Assuming a fully imputed dividend from 1 April 2011 paid from profits taxed at the company tax rate of 28%.

Synthetic dividends are more tax efficient than ordinary dividends from New Zealand companies because generating cash flow from selling securities produces capital returns that are not taxed.

While generating cash flow from security sales is more tax efficient than dividends, any potential tax savings must be weighed against corresponding transaction costs incurred in a sale. There aren't likely to be any costs associated with receiving interest and dividend payments, but there may be transaction costs when selling securities. All else being equal, the priority should be to sell securities that trade without a direct transaction cost (e.g., most managed funds in New Zealand).

Further, this approach targets the specific amount of risk appropriate for the client so the client’s portfolio is not subject to losses beyond their comfort level. Since risk is the source of returns, this also provides a clearer understanding of what the returns of a portfolio should be. Lastly, the strategy invests in all underlying firms, not just those with high yields, so it is much more diversified, lowering overall risk.

A final consideration in the income versus cash flow decision is the implication for rebalancing. Generating cash flow from securities sales not only results in more efficient tax management, but also provides an opportunity to rebalance by selling assets that are overweight relative to their strategic target.

Bonds — Another Take on Income vs. Cash Flow

The income versus cash flow decision should be considered in other asset classes as well. In fact, one could argue that bonds are a component of the portfolio where this distinction is paramount because it is often where investors seek to meet their cash flow needs from.

The current low interest rate environment has prompted many income-oriented investors to pursue higher yielding bonds. But an increase in yield is not a free lunch, because yield is an inverse function of price. That is, bonds with higher yields are those trading at lower prices.

Common sense suggests that higher yielding bonds have lower prices for a reason. They are deemed riskier by market participants, and their higher yield is compensation for bearing this risk. There is nothing inherently wrong with taking more risk in your bond portfolio, provided it is well diversified, low cost, tax sensitive, and prudently managed. However, many investors chase yield simply because it’s “higher” without considering there must be an underlying reason. Investors in finance companies should be the first to understand this lesson.

The fundamental question should be, “Am I taking this extra risk because I want increased risk exposure?” not “Am I taking this risk because this yield is higher than that yield?” If you answered yes to the latter then you’re setting yourself up for much more volatility than you really want and, in a cruel twist, will probably have lower returns for the exact same amount of risk than if you invested in safer bonds, but allocated a greater portion of your portfolio to shares.

Mental Accounting

A behavioural bias known as mental accounting may also prompt New Zealand investors to overemphasise income investments in their portfolios. Research in behavioural finance has identified the tendency for people to separate their money into different mental accounts.

An example of mental accounting, based on the intended use of funds, is putting money for a child's education in a low interest earning savings account while carrying a balance on a high interest bearing credit card. In this instance, the importance of the intended use of the money (i.e., education) means it is not used to pay off expensive debt, even when doing so results in a net economic benefit.

Another example of mental accounting, based on the source of funds, is spending "found" money, such as gifts or tax returns, to a greater extent than an equivalent amount of money that is expected, such as a paycheque.

Consequently, labelling effects influence mental accounting, and this offers one explanation of why firms even pay dividends. If a company wants to distribute earnings to shareholders, it can choose to pay a dividend or it can repurchase shares. These two alternatives have the same economic impact before taxes, but if dividend tax rates are higher than capital gains tax rates, taxable investors should prefer share repurchases over dividends. In this scenario, firms should never pay dividends. Yet, in jurisdictions where these conditions exist (e.g., the US), many firms do!

Meir Statman argues that investors prefer dividends because the regular payment provides a simple self-control rule: Live off the dividend, but don't touch the principal. The dividend becomes like an allowance, whereas, if firms repurchase shares, the investor would have to periodically sell shares to raise cash. The economic impact before taxes is the same, but there wouldn't be a designated amount to view as an allowance, and the share sales could be seen as a dip into principal.

However, the bottom line is: When you move money from your left pocket to your right pocket, you are no better off; and in some cases, a few coins can slip between your fingers for the tax authority to collect. So, in an attempt to take the mental accounting focus away from the perceived need for investment income to meet cash flow requirements, Bradley Nuttall positions clients’ regular withdrawals from portfolios as an allowance or as a paycheque of sorts. Our role is to ensure the overall drawdown rate is sustainable, that the risk in the portfolio has been considered, and to then take responsibility for meeting that cash flow need in the most tax-efficient way.

Conclusion

The current low interest rate environment and New Zealanders obsession with income-oriented investments has led many investors towards riskier portfolios. But investors with a cash flow need should first consider their overall risk profile and the impact of volatility and expected returns on their total wealth. Biasing a portfolio towards companies with higher dividend yields or bonds with higher yields to maturity is putting the cart before the horse, unless the decision reflects a risk preference rather than an income preference!

Once the overall asset allocation decision has been made on the basis of total portfolio risk and return, the income produced becomes a by-product. In many cases, taxable investors are better off reducing income and periodically selling securities to meet the balance of their cash flow need. However, mental accounting seems to be a powerful force preventing this approach. Satisfying the need for mental accounting comes at the expense of higher taxes or the desire for a portfolio that may not be appropriate for investors' risk tolerance.

Summary of Key Points

Portfolios should be designed to reflect risk tolerances while considering the impact of expected returns and volatility on sustainable drawdown rates and vice versa. Portfolio management then shifts to implementing the desired asset mix while reducing income for taxable investors.

• Here is a summary of the main reasons why:
• Investors have cash flow needs, not income needs.
• Cash flow can come from income and/or security sales.
• Dividend policy doesn't matter; investment policy does.
• High dividend yielding stocks may be more risky.
• Dividends do not protect you on the downside.
• Dividends do not prevent you from encroaching on your capital.
• Dividends can be a less tax-efficient way to generate cash flow.
• A higher yielding bond is a riskier bond.
• Supplementing income with security sales to meet a cash flow need creates regular opportunities for rebalancing.
• Mental accounting is a powerful bias when managing portfolios for investors with a need for cash flow.

Written by Brad Steiman, Ben Brinkerhoff and Scott Rainey

1. Certain studies show the price drop on the ex-dividend date is, on average, lower than but close to the amount of the dividend when controlling for market movement. 2. Merton Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of Business 34, no. 4 (October 1961): 411-33. 3. Eugene F. Fama and Kenneth R. French, “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?” Journal of Applied Corporate Finance 14, no. 1, (Spring 2001): 67-79. 4. There are generally no transaction costs to the investor for redeeming units of a fund in Canada. Transaction costs may be incurred within a fund if cash must be raised to meet redemptions.