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Should I buy dividend paying stocks?

October 13, 2011 - 0 comments

Why wouldn’t I hold dividend-paying stocks – they pay me while I wait for the market recovery. There is certainly a strong behavioural bias here, but the academic studies and math don’t support this premise.

Dividends are only part of the story when it comes to stock performance. The other is the potential for increase in value. Total return is key.

Consider what a dividend is – the company has made a profit and the board of directors decides to distribute its profits to the shareholders. Instead of paying a dividend, the Board could decide to keep the cash in reserve, reinvest it in the company through research and development or new fixed assets, pay down debt or buy back some stock. All of which should increase the value of the shares – thus returning profits to the shareowners in the form of capital gains. Paying a dividend is not the only option and may not be the right thing for management to do for the health of the company.

Now consider the math – if a company, whose stock is trading at $50, declares a $1 dividend, the value of the stock should decline by $1 since payment of the dividend will reduce the cash reserves of the company. If the dividend is not declared, the stock value would not change based on this criteria.

Over the years, the percentage of publicly listed companies paying cash dividends in the US has reduced from 66% in 1978 to only 20% in 1999¹. And those 20% likely represent 70% of the total market value. So if you focus only on dividend paying companies, you also focus on large companies. 

Something to bear in mind - there are a number of well-known companies which do not pay dividends – Google, Amazon, Apple and Berkshire Hathaway, to name a few. 

Similarly, if dividend-paying companies are perceived as being “safer”, why should they have a higher expected return? If the risk is perceived to be low, the return should also be expected to be relatively low. Risk and return are related.

Academic research supports the concept of value companies outperforming growth companies, over time, and smaller companies outperforming larger companies, over time  – recognition of the higher risks involved with small and value holdings.  

All of which draws me to the conclusion that PWL’s approach to portfolio construction, which includes exposure to various asset classes based on an allocation designed for our client, makes sense.

¹Fama, Eugene F., and Kenneth R. French. 2001. Disappearing dividends:  Changing firm characteristics or lower propensity to pay?  Journal of Financial Economics 60:3-43.

By: Kathleen Clough with 0 comments.
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