Value investing and dividend investing are commonly looked at as two separate investment strategies. But value and dividend investing can go hand in hand. Both exist: undervalued dividend stocks, and dividend paying value stocks.
When we look at what the two most famous value investors, Benjamin Graham and Warren Buffett, say about dividends, we will understand why some investors may be confused when it comes to the topic of dividends.
For Benjamin Graham, dividends were an absolute must1. For him, investing in non-dividend paying companies requires a substantial reason.
If we now look at Warren Buffett – one of Graham’s mentees – we will be surprised and confused that Berkshire Hathaway – the company of which Warren Buffett is CEO and chairman – does not pay any dividend despite vast cash reserves.
But this difference between Graham and Buffett is not the only contradiction for a value investor. When we look at the research, we can see that bodies of research came to similar conflicting results.
In this chapter, we will look at dividends, share repurchases, and how dividends make sense for a value investment strategy.
Excess Cash
Dividend investing – like value investing – is an investing discipline itself. Nevertheless, it shares some characteristics with value investing2. The fundamental idea behind dividends is that companies pay parts of their profits back to their owners.
Instead of paying dividends, the management of a company can also decide to use the profits otherwise, for example by retaining the earnings to make investments or to buy back their shares. For the investor, it is therefore important to know how a company uses its free cash flow.
Free cash flow describes the remaining cash after capital expenditures have been subtracted from the operating cash flow. In other words: the remaining cash after all necessary expenses for supporting the company’s operations and maintaining its capital assets have been made.
The company has to use its excess cash intelligently to increase shareholder value. To do so, it has two options: either the excess cash is reinvested into the business, or it is paid back to the shareholders of the company by paying dividends or by buying back shares.
If an investor finds a company with an excess of cash, this does not guarantee he will benefit from the investment. More important is that the management of the company can make more profitable investments with it or decides to return the excess cash in appropriate amounts to its shareholders via dividends or share repurchases. That is one reason why a competent management is more critical for investors than the simple fact that a certain business pays a dividend.
Dividends from an Investor’s Perspective
Vanguard is one of the largest investment companies in the world. They experienced that dividend-paying stocks are today of broad interest for investors around the world3. This increased the demand for dividend-paying stocks.
Miller-Modigliani Theorem
An increased demand for dividend-paying stocks shouldn’t exist according to the well-known Miller-Modigliani Theorem, which is an influential economic theory named after Franco Modigliani and Merton Miller.
Miller and Modigliani4 argued that dividends are irrelevant for investors because investors do not care whether their returns come from dividends and an appreciation of the stock price combined or from an increase in the stock price alone – as long as the return is the same. The theorem assumes an efficient market with an absence of taxes, bureaucracy, and so on. The theorem would imply that investors are acting rationally, and that dividend policy has no effect on how efficient a company can create additional returns for its shareholders.
That investors do not act entirely rational is shown by Dong, Robinson, and Veld5 who instead of looking at theories and quantitative data went out to investors and asked them about their opinion on dividends. Their results indicate that investors are not – as Miller and Modigliani suggested – neutral towards dividends, but that investors prefer stocks which pay dividends over no dividend payments at all.
A comparable approach was deployed by Chiang, Frankfurter, Kosedag, and Wood Jr6 who surveyed chief financial officers of publicly listed funds. Depending on their economic intention, investors were put in different categories. More traditional or conservative investors did show a higher favorability for dividends than growth-oriented investors.
The Dividend Puzzle
Already in 1976, the researcher Black7 argued with his famous Dividend Puzzle that an investor’s bias for either dividend or non-dividend paying stocks will, in the end, lead to a disadvantageous portfolio for him. If an investor believes that non-dividend paying stocks should not be held – or the other way around – he will “end up with a less well-diversified portfolio, than he would otherwise have.”
Dividends as an Indicator
That dividends are still a puzzle for investors is portrayed by numerous and often contradicting studies. Since Miller and Modigliani earned their respect with their theorem and Black subsequently opposed by showing that dividends are not quite that simple, much research followed on this topic.
Dividends as an Indicator for Future Success
Investors might be inclined to use dividends as an indicator for the future success of a company, as several researchers have shown that dividends might be correlated to future success.
Numerous researchers891011 analyzed companies on an individual level where they found that companies which are currently paying dividends have a strong tendency for future earnings growth. Furthermore, researchers Nissim and Ziv showed that dividend changes are an indicator of the future profitability of the company. If a company is raising dividends, the next two financial years of this company will most likely be more profitable as well12.
The better performance of dividend-paying companies might be explained with a higher efficiency13. While growth companies tend to waste shareholders cash through overinvestment, overpriced repurchase programs, or overpriced acquisitions, high dividend paying companies are forced to use their cash more wisely as they cannot waste it.
In 2017, Vanguard Research analyzed dividend-oriented investment strategies14 and came to the conclusion that companies with high dividends and companies with a history of dividend payments have “produced higher returns with less volatility, than the global equity market, resulting in risk-adjusted returns.”
So, after all, dividends seem to be a useful indicator for future success? It is not that simple.
Dividends as a Useless Indicator
While some research indicated that dividends have a lot to say about the future performance of a stock, there is also a body of research claiming the opposite: a negative connection between dividend payments and future performance of a company.
In 1986, the researcher Oppenheimer15 showed that investors who follow Graham’s and Dodd’s investment advice, to select only companies with positive earnings and dividend payments, might be worse off, as they these companies pay a lower overall return on the portfolio than firms with positive earnings but who were not paying dividends.
Another researcher named James Ohlson made sense of this in 199516, by showing that when dividends are paid out today, it is reducing the future earnings of a company because they reduce the current book value.
In 1997, the researchers Benartzi, Michaely, and Thaler doubted that an increase in dividend payments says anything about future earnings17. They even claim that the opposite is true: companies which decrease their dividends are experiencing an increase in their earnings growth rate. However, the fact that a company increased dividends this year makes it less likely to experience a decrease in future earnings.
A 2005 study by Grullon, Michaely, Benartzi, and Thaler18 states that dividend changes do not contain any information about the future profitability of a company whatsoever.
This approves their earlier research19 where portfolios of companies who changed their dividends and those who did not were compared, concluding that companies with changes in their dividends “did not outperform those that do not include dividend changes.”
So, after all, whether a company pays dividends or not seems not to be a useful indicator for future performance.
Dividends from a Management Perspective
So far, we looked at dividends from an investor’s perspective. But dividends are just as an important tool for businesses themselves.
Black and Scholes argued in 197420 that dividend policy is not as important for individual investors as it is for the corporation itself. They found that corporations can make dividend decisions independent of the effect on the stock price, as this increase or decrease in the stock will vanish over time. Therefore, a reduction of dividends will result in a temporarily depressed stock price but a very attractive source of capital for the company. Therefore, a reduction or cut in dividends must not signal bad news but may be one of the cheapest financing options available.
In 2002, Fama and French21 showed a similar observation between the dividend payout of companies and their investment activity. Companies which are either more profitable or companies which have fewer investments are showing higher dividend payouts to their shareholders. On the other side, companies with more investments than average have lower dividend payouts in the long term.
Is it always the choice of the management to introduce, raise, or lower dividends?
That dividend policy is not solely a rational economic decision of a company’s management was shown in 1984 by the researcher Rozeff. He found out that in times when stock markets become riskier, investors demand higher dividends. Dividends are thereby acting as an equity risk premium. Therefore, the management might introduce or raise dividends when the market, in reality becomes riskier, mainly to please their shareholders.
Baker and Wurgler approved Rozeff’s finding in 200422, by showing that it’s not the decision of the management whether the corporation is paying dividends or not but rather the result of investor’s demand. When the share price of dividend paying companies is relatively high, managers tend to initiate dividends.
Then there is the catering effect, seemingly another large reason why companies introduce or raise dividends as shown by researchers Li & Lie in 200623: When the market is paying a large dividend premium, companies are more likely to increase their dividends – which then also turn out to be larger.
In other words, when investors are interested in dividend-paying stocks, companies will introduce or raise their dividend.
Increases or introductions of dividends may also indicate that a company is transforming from a growth phase to a phase of maturity. As the researcher Grullon and Michaely argued in 200224, dividends are introduced or increased when the number of positive net present value projects are declining and – as their capital expenditures are declining – their free cash flow is growing. Therefore, dividends are introduced or increased.
The structure of the business is also an aspect which determines the dividend yield. There are observable differences between companies with many business lines and those with a more focused operation. Companies who focus their operations on only a few business lines tend to pay lower dividends to their shareholders25.
Also companies of developed financial markets around the world which are more profitable and those who have large amounts of retained earnings have a higher affinity to pay dividends26.
Along with it, losses of a company are an important reason why companies reduce their dividends as the researchers DeAngelo, DeAngelo, and Skinner showed in 199227 in an evaluation of 607 companies listed on the New York Stock Exchange.
Bruce Berkowitz offers an interesting perspective by arguing that not every manager is one hundred percent honest with its shareholders. He says that financially unhealthy companies may use dividends to create an “inappropriately favorable picture of future cash flow”28 Which means that some companies use dividend policies to hide their real economic difficulties or exaggerate their economic situation.
On the other hand, what might a company which is not paying dividends want to demonstrate to its shareholders? According to Black29, it might indicate that a company has exciting and profitable investment opportunities, which it might miss if it paid dividends. If this is indeed the case, the shareholder would likely be better off with an attractive investment that might appreciate in value more than what he would have missed out on with a dividend.
But do all companies who – from a financial perspective – should stop paying dividends – do so?
An evaluation from 1990 of 80 companies on the New York Stock Exchange30 showed that especially companies who have a long history of dividend payments are reluctant to stop dividend payments – even if the financial position of the company requires it.
Fund manager and value investor Bruce Berkowitz comments in the 2009 edition of “Security Analysis”31, that – from his experience – many companies maintain dividends even in bad times, when dividends exceed free cash flow. The management’s intention is usually to express their long-term confidence in the business. So, investors should better know whether this is justified or not.
What is holding executives back from introducing dividends?
An in-depth survey of company executives32 showed that executives of companies which are currently not paying dividends are reluctant to introduce them because an introduction would mean that these companies are entering the conservative world of “inflexible dividend-payers.”
Apparently, for companies, dividends are sometimes a real dilemma.
A company may have profitable and value-creating projects at hand which they forgo because they would need to cut or decrease dividends. Now every normal person would ask themselves why. As researcher Fairchild explained: investors are “behaviorally conditioned to believe that dividend cuts are bad news”33. As a result, companies are forgoing profitable projects only to stick with current dividends.
The Agency Problem
Is it only the investor’s irrational demand for dividends, which is causing companies not to achieve their full potential – or is there more?
According to several researchers, the management of a company does not necessarily act in the best interest of its shareholders. This is called the agency problem.
The agency problem describes a conflict of interest between insider shareholders – such as majority shareholders in the board of directors – and outside shareholders.
The researchers Jensen and Meckling showed34 that conflicts between the interests of inside and outside investors lead to real agency costs. How high these agency costs are varies from country to country, depending on whether laws prevent the causes of agency costs or not.
Other researchers35 pointed to a suspicious observation that the denser the amount of insider ownership of a company, the lower the dividend payout – and vice versa.
In countries with fewer minority shareholder protecting laws, there is often one major shareholder controlling the entire company, or the company is run by controlling shareholders who most likely have different interests than the minority shareholders36. This has a significant impact on the dividend policy of such a company.
Share Repurchases
Instead of paying dividends, companies can also return excess cash to their shareholders by repurchasing their shares.
Share repurchases are a more flexible tool than continuous dividend payments.
In theory, a management uses share repurchases when it believes that the shares of a company are undervalued. This reduces the overall number of outstanding shares, and as a result, the shareholders then hold a larger part of the company without having to buy additional shares.
A reduction in outstanding shares also improves metrics such as return-on-equity, return-on-assets, or earnings-per-share, and thus appreciates the market value of the company.
Share buybacks do not immediately result in a tax burden for the shareholder. This is one reason why many investors and researchers37 believe that share repurchase programs – among with merger and acquisitions – are the better way for distributing excess cash to shareholders. Therefore – they argue –should share repurchases be accepted as an alternative to cash dividends.
And indeed are U.S. corporations using share repurchases as an important form of payout of excess cash, which they otherwise would have used to increase dividends.
Since regulations on stock repurchases were removed in 1983, repurchases have become a substitute for dividends – especially for younger companies – as researchers Grullon and Michaely suggest38. In fact, they may have become the primary form of payout with the company’s earnings determining the height of share repurchases39.
But it is not necessarily a question of one or the other.
Dividends and share repurchases are often used by two different kinds of companies at different times. Dividends are used and paid by firms with “higher ‘permanent’ operating cash flows, while repurchases are used by firms with higher ‘temporary’, non-operating cash flows”40.
Investors should nevertheless be cautious with share repurchases as a substitute for dividends, as repurchases may be reissued to employees, executives, or newly acquired companies and thereby minimizing or obliterating the anticipated payout41.
So, when should a company buy back shares or not?
I think Warren Buffett emphasized42 beautifully that companies should buy back shares only if this is possible at a substantial discount to a carefully calculated intrinsic value of the company. According to Buffett, repurchases above intrinsic value decrease shareholder’s wealth.
Investor’s on Dividends
In this chapter, we will move our focus from a theoretical perspective onto the perspective of real-life value investors. How are value investors assessing the importance of dividends?
We will look at four different value investors:
- Benjamin Graham
- Warren Buffett
- Seth Klarman
- Martin J. Whitman.
Benjamin Graham on Dividends
In his two books Security Analysis and The Intelligent Investor, Benjamin Graham extensively expressed his opinion on dividends. We should still have in mind that Benjamin Graham developed his investing style in the early 20th century. It is important to read his suggestions with caution as whether it is still applicable today. Or as Howard S. Marks emphasizes it43: The value of Benjamin Graham’s teachings do not lie “in its specific instructions, but in its common sense.”
While not every detail of Benjamin Graham’s opinion on dividends might still hold true in today’s business and investment environment, his reasoning will still give an investor a critical hint.
Benjamin Graham’s opinion was that dividends are an indispensable criterion for investors. He openly criticized public companies who retain the majority or all of their earnings. For Graham, it was not only crucial that a company pays a dividend , but also that it shows a continual history of dividend payments. Continuous dividends were the first investment criteria of a good investment he was looking for44.
Benjamin Graham agrees that it is beneficial for the shareholder when the company withholds some earnings for the future growth of the company. However, he also makes clear that future earnings are uncertain, and he doubts whether the future growth will compensate the stockholders appropriately regarding the compounded dividends withheld.
Benjamin Graham also criticized that dividend policy is – from a legal perspective – only a managerial function. Thus, shareholders usually have no influence and decision power over their discontentment with the dividend policy. Graham calls this an unrestricted corporate decision power, as the board of directors typically consist of executive officers and their friends. The management will always try to retain as much excess cash as possible in the business to simplify their financial problems and to expand the business solely for the reason to increase their salaries or bonuses45.
It is interesting to compare Graham’s decades-old critique with the agency problem, which was proven many years after the initial publication of Security Analysis. As a reminder, the agency problem indicates that large insider investors tend to have control over companies and thus can shape the dividend policy according to their interest.
Benjamin Graham also had a distinct opinion over the height of dividends – which should be as high as feasible. According to Graham, a high dividend rate is essential because retained earnings tend to lose “part of their effective value for the stockholder” over time46. He strongly advocates that stockholders have the right to get their earnings of their capital disbursed. Therefore, the management of a company should always seek the approval from its shareholders before they retain or reinvest earnings.
In his book The Intelligent Investor, Graham warns his readers of growth stocks who partially pay no dividends at all. He accentuates that when companies do not pay a dividend of around two-thirds of earnings, shareholders should demand a clear proof from the management that the reinvested earnings have produced a “satisfactory increase in per-share earnings”47.
Warren Buffett on Dividends
Warren Buffett is not only the world’s most famous investor of all time, he is also known as the best-known value investor. He frequently acknowledges Benjamin Graham as his biggest influence on his investment success, even though Buffett’s investment philosophy deviates considerably from Graham’s teachings.
According to Gleen Greenwald, his investment approach may be classified as contemporary value investing. One big difference between Buffett’s approach and Graham’s teachings is that Graham always emphasized the importance of a diversified portfolio. However, Buffett argues that risk decreases with the amount an investor studies his investment, and thus a smaller portfolio is less risky for the value investor48.
Regarding dividends, an even more striking difference becomes clear. According to Benjamin Graham, companies should only be allowed to retain earnings and not pay dividends when the management offers a precise explanation. However, Berkshire Hathaway – of whom Warren Buffett is the chairman and chief executive officer – does not pay any dividends at all.
In his letter to shareholders of Berkshire Hathaway in 1984, Buffett expressed that excess cash should only be retained if there is a valid and arguably profitable possibility to reinvest the money. His rule is that “for every dollar retained by the corporation, at least one dollar of market value will be created for owners.”
For Warren Buffett, dividends only make sense when they can generate higher returns outside the company – thus he does not always agree when shareholders cheer over an increase in dividends49.
Warren Buffett wrote an extensive statement in his 2012 letter to shareholders explaining under which circumstances it is feasible for a company to pay dividends to its shareholders and when it is not. This had the background that more and more shareholders of Berkshire Hathaway demanded the introduction of dividends – especially considering the large amount of excess cash Berkshire Hathaway held – and is still holding.
According to Warren Buffett, there are several ways how a profitable company can deal with excess earnings, and the first and most important thing the management should do is to “examine reinvestment possibilities offered by its current business.”
The management should always seek possibilities to expand the business, become more efficient, competitive, and attractive. In this regard, Warren Buffett argues, Berkshire Hathaway has a remarkable advantage because its businesses are operating in many areas of the economy.
If the possibilities of reinvestment are exhausted, the second way is to look for attractive acquisitions which make shareholders “wealthier on a per-share basis than they were before the acquisition.”
The third-best way to deal with excess cash are share repurchases at a conservatively calculated price below the company’s intrinsic value. Warren Buffett sees a sell-off policy – at least in the case of Berkshire Hathaway – as the better option to dividends.
Buffett says that dividends have two significant disadvantages: first, they force a cash-out policy on investors, and secondly they have adverse tax consequences for shareholders.
Benjamin Graham demanded a precise explanation by the management why a company does not pay dividends. Let’s agree that Warren Buffett did a good job by delivering a clear explanation to Berkshire Hathaway shareholders that he is absolutely confident that for every dollar invested, Berkshire Hathaway can generate more than one dollar in return. Which is a satisfactory explanation why he refuses to pay dividends.
We should also keep in mind that Berkshire Hathaway is not a company in the classical sense, as it is operating more as a large investment holding corporation with hundreds of investments in daughter companies and stocks.
Seth Klarman on Dividends
Compared to Buffett, Seth Klarman is following a more conservative value investing approach, closer to what Benjamin Graham taught.
In his book “Margin of Safety” he strongly advises50 to never buy businesses simply because of their dividend yield.
For him, dividends are not a must-criterion but instead, he puts the quality of the company in focus.
So whether a business pays dividends or not is secondary.
Martin J. Whitman on Dividends
Martin J. Whitman is a value investor and the co-founder of Third Avenue Management – a value investment firm.
Whitman calls the assumptions of Modigliani and Miller “utterly unrealistic”51.
Now if we recall, the Miller-Modigliani Theorem says that – for an investor – it does not matter whether he receives his returns via dividends or an appreciated share price alone, as long the return is the same.
In his opinion, management usually never supports the interests of the shareholders – especially not the interest of the smaller investors, which Whitman calls the ‘outsiders’. When it comes to Whitman, the interests of these outsiders are represented by the management only as far as the law requires it. This – again – heavily influences the dividend policy of a company as well.
To understand Whitman’s take on dividends, it is interesting to hear – what he believes – makes an attractive investment. According to him, it is necessary that the investor can either in the future gain control over the business or that he has the outlook that his investment becomes convertible into cash.
This is the reason the average investor – who with most certainty won’t overtake the entire company – should always pay attention to a decent dividend or a capital appreciation over time.
How important dividends really are, depends solely on the objectives of the investor. Some investors prefer securities with a combination of appreciation potential and cash returns as a hedge against inflation. On the other side, investors who hold securities with limited appreciation potential must demand dividends. Then there are investors who try to avoid taxes at all costs and thus dividends are counterproductive for their objective.
Moreover – according to Whitman – higher dividends do not necessarily make an investment more attractive. If one of two companies with the same earnings power pays fewer dividends, this company might retain more of its earnings and thus is in a better position in the future. As a result, the company with lower dividends might end up being the better purchase.
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