BNL Dividend Policy:
Should Investors prefer Dividend Yields or Capital Gains?
New Zealand investors have a longstanding obsession with portfolio income; a bias which is exacerbated in a low interest rate environment.
Meeting a specific cash flow need is an important element of portfolio management. However, there are better ways to meet that need than by investing primarily to achieve 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, which may originate from:
- Income (typically interest and dividend payments)
- Cash from the sale of securities
There are a number of factors to contemplate when determining how you might best use these components of cash flow to meet a specific need. However, investors often gravitate toward income investments before properly considering all the relevant issues, which can result in a less efficient investment solution. The following discussion addresses some important aspects of the income versus cash flow distinction.
In summary, Bradley Nuttall show that investing for dividends and high-interest to meet investors’ cash flow needs is a tax-inefficient and risky method. We explain how several popular theories around dividends are not accurate, such as:
- High dividend yield helps you avoid eating up your investment base to generate cash flow
- Dividends offer protection on the downside, and mitigate the drop in down markets
- High-dividend-yielding shares constitute a less risky investment because of the regular payments
- Dividend-yielding shares are worth more because they offer dividends
We argue 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 as 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 is necessary because both are 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 however, 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 demonstrate that high yielding shares are often the riskier choice. Thus, investing for yield can inadvertently lead to a riskier portfolio than is warranted by the client’s specific circumstances.
Do Dividends Matter?
Neither Apple nor Berkshire Hathaway (Warren Buffett’s firm) issue dividends. So why are they so valuable, if dividends are so important? 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, due to the regular payments. Conventional wisdom dictates 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 place their emphases on dividends, regardless of whether or not they actually need cash flow. Those drawing cash from their portfolio are even more enthralled with high-dividend-yielding shares; 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 feeling compelled to sell shares in order 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.
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 affect firm value, this is more a result of what paying dividends signals to investors, rather than the dividends themselves. This 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 ReturnWhile 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 to be 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). Conversely, some companies (or trusts) pay dividends (or distributions) in excess of profits. The latter case is unsustainable in 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
- A combination of the above
Dividend/Price (i.e. Yield) = Required Return – Expected Growth
So a business that does not change its dividend but instead has a new, higher dividend yield, must have a lower price. The price is lower for one (or a combination) of two reasons; 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 indicator that investors should 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 yielding shares can be a direct result of increased risk.
But isn’t it a good thing if high yielding shares have higher expected returns? Not necessarily – only if an investor is aware of the risk and has chosen it purposefully, rather than having fallen into taking that risk accidentally through 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 hand, 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.
Sorting shares by dividend yield in the US 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.
There is however another, much better approach. It starts by recognising that investors need cash flow rather than income. Further, this method sets a portfolio’s risk as a deliberate target and does not unwittingly bias the allocation of the portfolio toward 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.
|Eligible dividends from New Zealand companies*||5%|
* 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, as 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 are not 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 on selling securities that trade without a direct transaction cost (i.e., most managed funds in New Zealand).
Furthermore, this approach targets the specific amount of risk appropriate for the client, so that 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. As a result 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, as it is often from bonds that investors seek to meet their cash flow needs.
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, as 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 provides compensation for bearing this risk. There is nothing inherently wrong with taking more risk in your bond portfolio, as long as it is well diversified, low cost, tax sensitive, and prudently managed. However, many investors chase yield simply because it is ‘higher,’ without considering the fact that there must be an underlying reason for this. 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, 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, with a greater portion of your portfolio allocated to shares.
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 a 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 which is expected, such as a pay cheque.
Consequently, labelling effects influence mental accounting, which offers one explanation of why firms even pay dividends at all. If a company wants to distribute earnings to shareholders, it can choose either to pay a dividend or to 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 periodically need to sell shares in order 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 this: 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 its clients’ regular withdrawals from portfolios as an allowance, or as a pay cheque 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 the cash flow need in the most tax-efficient way.
The current low interest rate environment and New Zealanders’ obsession with income-oriented investments has led many investors toward riskier portfolios. But investors with a cash flow need should first consider their overall risk profile, as well as the impact of volatility and expected returns on their total wealth. Biasing a portfolio toward 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 in 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 flo.
- 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
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.