How important are dividends to companies and investors?

Dividends are a highly debated topic and one side’s opinion can affect the other’s decisions. There are many theories as to how a company arrives at their dividend policy, typically dividends are paid out of the company’s profits, but there may be times when a company pays out on a loss. This is done from their reserves but is quite risky and usually done to keep shareholders happy but the company should have confidence that they will return to profit quickly.

Modigliani & Miller (M&M) proposed that a company’s dividend policy wasn’t actually important as it is the future earnings potential that affects share price. They argued that dividends were basically a residual after all positive NPV projects had been accounted for.

Imagine here that a company had 6 possible projects; four are legitimate investments as they have a positive NPV, meaning the returns are above the cost of equity. If the company makes profits of P¹  then it has the funds available for all 6 projects, however it should only invest up to point A as only four of the projects have positive NPV, the remainder should then be paid out as dividend. On the other hand, if profits were P² then only projects 1 and 2 should be invested in and no dividend paid. You could also argue that the company should then borrow money so that it can complete projects 3 and 4 as they are also profitable. Thus, dividend decisions are purely a financing policy according to M&M.

Furthermore, they argue that shareholders are indifferent to dividend policy because they can either create homemade dividends by selling some shares each year or if they are receiving dividends they don’t really want they can just reinvest and buy more shares each time.

The traditional view before M&M was that of the “bird in hand” argument meaning that people would rather have the money at the time because you couldn’t be certain on a company’s future performance. In this case the company’s dividend policy may well affect the market value of the company as if they pay a low dividend; investors could sell their shares and invest in a company that pays a higher dividend and therefore lowering the share price of the company paying less.

Now I’ve considered why dividends may not be relevant let’s look at why it might be seen as important. One reason is that the level of dividend may be seen by the investor as a signal of the company’s performance. High dividends can be seen as good news on a company’s performance/prospects and vice versa. Conversely, some investors could think quite the opposite. For example, high dividends could in fact mean the company didn’t have any positive investment projects and therefore plenty of profit left over, but this could be bad news for the company in the long term. If they are paying low dividends it may be a sign that the company has reinvested the majority of its profits into investments that will mean higher earnings in the future. Generally the market is short sighted with a focus on how the company is doing right now.

 

The Telegraph, 22.10.2014




The Telegraph, 22.10.2014

You only have to look at the FTSE 100 history to see this is true; in times when prices have dipped there has been an increase in the dividend yield. Companies here are trying to reassure the investor of the company’s performance and make up for a lack of capital gains. Therefore, if a company was ever going to cut dividends it would be particularly important to communicate why to the investor so that they didn’t see it as a sign of poor performance and look elsewhere to invest.

The clientele effect argues that shareholders have a definite preference when it comes to dividends or capital gains as some people require regular income to meet their liabilities. As mentioned before, M&M believe that these dividends can be ‘home made’ however this doesn’t consider the negatives such as transaction costs, the time needed and probably most importantly, tax.

Tax can be very influential to an investor’s preference for dividends or capital gains. For those on the lower income tax band of 20%, you will pay just 10% on dividends. However, you can earn up to £10,900 of capital gains tax free, afterwards this goes to 18% so it would really depend on how many shares you were going to sell. On the other hand, if you are a higher rate tax payer it is almost always better to go for capital gains as the tax rate of 28% is lower than the dividend rate of 32.5%.

From this I can gather that an investor will usually choose shares that meet their individual needs and thus if a company changes its dividend policy and no longer meets those needs there is a risk of investors switching to a company that does.

Overall, I believe that is clearly very important that a company carefully considers its dividend policy and the reasons behind it. This policy and its communication will have an effect on those investors concerned with dividends but I also think some aren’t interested in dividends at all. Some investors will only ever plan to have shares for a small period of time with the hope of a sharp increase in price. As a lower rate taxpayer I pick shares that have a history of paying a reasonable dividend because I will only be paying 10% tax.  As a young person I am more likely to buy and hold shares in the hope that in the long term they will provide large capital gains whilst providing some payments along the way.

 

 

 

Just how much can you diversify risk?

It’s no great secret that diversifying can reduce risk, but to just what extent? Portfolio theory developed by Harry Markowitz in 1952 suggests that holding a wide range of investments can help reduce the systematic risk. For this theory to work the rates of return, risks/standard deviation and relationships between the investments are considered. Various complex calculations and modelling are done to provide what is known as the “efficient frontier” of different assets that are allocated to provide optimum returns. However, in reality it’s reported that not even the experts are following through with their own advice!

“I should have computed co-variance of the asset classes and drawn an efficient frontier – Instead I split my contributions 50/50 between bonds and equities.” (Professor Markowitz)

So computer modelling aside what are the experts suggesting? It’s thought the vast majority of UK-based academics maintain a 60/40 split between equities and bonds, with just a couple of funds of each. Though as you can see below diversification isn’t just confined to the domestic market, diversifying internationally is also thought to provide benefits to your portfolio.





The y-axis here shows the risk as a percentage of the risk on a single share. Interestingly, holding international stocks can reduce that level of risk from about 33% down to about 15%, the problem I would have with this is that currency fluctuations can be volatile and so this does add to the risk. Also, it’s worth noting that any increase on 20 stocks doesn’t mitigate the risk further. In fact, it was said by a US analyst that anything over 10 reduces the ability to add value; however, I think that depends entirely on your risk appetite.

When deciding on a portfolio, one thing analysts can agree on is that the covariance between the companies should be low, for example if you invest in five airlines and there’s a major incident or oil prices spike then it’s likely the companies will all react in a similar way. Therefore, it is better to diversify across many different industries so that bad news for one could be offset by good news in another.

 

As you can see in the graph above, two perfectly negative correlating stocks can eliminate volatility and provide a healthy return. In practice it wouldn’t be as easy as this but do you really need to be trying to decrease volatility? It has long being thought that volatility is the investor’s worst enemy and investing on those stocks which just slowly but surely increase at a slow pace is the way to go. Nonetheless this changed in the aftermath of the financial crisis, these stocks that been labelled as placid and dormant were suddenly revealed to be extremely toxic and assets with low standard deviations lost all of their value. It’s these toxic securities that either do quite well or when the market turns will totally destruct, which then of course it is too late. It’s all too easy using the standard deviation method to describe these stocks as non-problematic and a “safe bet”.

An important part of a diversified portfolio is rebalancing, although you may start your portfolio with a certain percentage of domestic stocks, international stocks, bonds and cash, the mix will change over time.

This chart's hypothetical illustration uses historical monthly performance from April 1994 through April 2014 from Morningstar/Ibbotson Associates; stocks are represented by the S&P 500 and MSCI EAFE Indexes, bonds are represented by Barclays U.S. Intermediate Government Treasury Bond Index, and short-term investments are represented by U.S. 30-day T-bills. Chart is for illustrative purposes only and is not indicative of any investment.

Looking at the charts above, you can see that the breakdown of each investment has changed dramatically in those twenty years, with now over 80% being invested in shares. This means that stocks have had larger swings than bonds/cash and therefore going on historical data it is now subject to more risk because of this. Let's consider if the investments had been rebalanced semi-annually to their original levels and whether that lowers the risk at all.

 

Chart is for illustrative purposes only. The chart depicts observed historical risk based on the performance of broad diversified indexes named in the chart “How an investment mix can change over time.” A portfolio that is not diversified within asset classes may experience different levels of risk.

As you can see it levels out the risk and so if you were wanting a more cautious investment then it is definitely worth rebalancing to the original structure.

Personally I believe that market volatility can help investments, giving investors access to "cheap" stocks and the potential for large gains. However, it is entirely dependant on the individuals circumstances, if you are retired and hoping to live off the income from an investment then naturally your appetite for risk will be fairly low. On the other hand as a young professional who has other sources of income, taking a risk on a volatile stock might be worth it for a larger pay off. Dividends vs. capital gains is something I will be discussing in my next blog and assessing just how important each of these are.

I don't think it's necessary to work through complicated formulaes to try and achieve the perfect portfolio but it is certain that diversifiation can help reduce fluctuations. For a successful portfolio it would seem around 10/15 stocks across different industries is suffice, preferably with some negative correlation and an effort to rebalance at least annually. 

 

 

 

Just how efficient are capital markets?

Efficiency of the markets is a topic continually discussed, debated and researched with no real conclusion. Nothing proves this more than the fact that two economists with contradicting theories were both awarded the Nobel memorial prize for Economics in 2013. Eugene Farma and Robert Shiller were both commended for their work on market theories but what exactly is “efficiency”?

Market efficiency is simply how well the current price reflects information, be it public or not, and how quickly the market responds to new information. The red line on the diagram above shows a perfectly efficient market where on the announcement date the price reflects the news instantly. However, sometimes markets can react before the official announcement, for example there may be a leak or people with insider information may react and Line 2 shows this change in price before the event. Sometimes markets can overreact to news and Line 3 shows this with a period of deflation afterwards as the market moves back towards efficiency. On some announcements there may be a slow reaction in the market, this is shown by Line 4 and sometimes the market is continually inefficient, as shown by Line 1.

The most widely accepted theory thus far is that of Fama’s (1970) weak-form efficiency which claims that prices reflect all past movements and future movements cannot be predicted by looking at the past. So does this mean that all those city analysts are a waste of money if the markets can’t be predicted? One man who would disagree with is Warren Buffet who has become one of the most successful traders of all time; surely it can’t all just be good luck?

Fama also described stock market efficiency as semi-strong and strong:

Semi-strong efficiency will not just reflect all historic information but the publicly available information as well and the market will react quickly and rationally to new information. This theory also supports that abnormal returns cannot be made by studying information publicly available because the market has already taken into account this information. This hypothesis was supported by earlier evidence in the 60’s and 70’s.

Finally, strong market efficiency would reflect all information, whether it was available to the public or not, so that even ‘insider dealers’ cannot make abnormal returns. This is a “theoretical” ideal but is not often seen in the market.

One of the main themes of Shiller’s theory is that of “rationality”. This is particularly interesting as it considers investor’s decisions when they react to particular news, be it good or bad. For example, bad news to one person may not be bad news to another and this is how market can either overreact or underreact. Shiller compared share price to earnings over a long period of time and found that there were sharp peaks in 1929, just prior to the Wall Street crash and in the late 1990’s before the technical bubble burst. It’s hard not to ask why these irrational ratios weren’t spotted at the time, but as Shiller explains, in a boom so many people are benefitting from higher prices and earnings that nobody is going to burst that bubble.

Kendal (1953) came up with the “random walk” theory, this states that price movements are independent of each other and they will always reflect known information, only changing when new information is released.

So considering all these theories what does efficiency mean for the average investor? If the market is efficient then no abnormal returns will be made unless by chance or if you have access to information that has not been made public. There are also consistent patterns that contradict the efficient market theory such as the effects of the time of day and month.

An interesting example for looking at market efficiency is Tesco, on 22^nd September 2014 news came out about how they had overstated profits by £250m.

We can see here that the major change in price happened before the markets even opened on the Monday, therefore before the majority of people will have even heard the news. This would point to the market being semi-strong efficient as for those seeing the news on Monday morning; the price already reflected this, pointing to an early leak in information.

Overall, I believe it is hard to come to a definite answer to this question. I believe human behaviour can affect the markets and we can never 100% say how people are going to react to certain information. Therefore, I believe markets will never truly be efficient based on the fact people don’t always react in a rational way.