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Debunking Dividend Dogma

As anyone that regularly reads my posts knows, I believe there is a general misunderstanding of dividends in our industry (Institutional Investor Article, Article with Dr. Laffer, Mauboussin Article). My basic point is that you cannot create value by paying a dividend. At best, dividends are a zero-sum equation. And if you include taxes, dividends are actually a net drag to investors. Based on this fact, I believe that companies with excess cash should repurchase shares instead of paying dividends.

Two recent articles, “Buyback or Dividends?” by Stephen Taub in Institutional Investor and “Understanding Compounding: Berkshire’s Not-So-Hidden Dividend Contrarian Secret” by my friend Arthur Clarke, give additional evidence to support buybacks over dividends. “Buyback or Dividends?” summarizes a recent S&P article by Todd Rosenbluth by stating that companies with a disciplined buyback program outperformed dividend paying companies over the past three years. I don’t put much stock in these results because of the three year time horizon and assumption that a cash distribution policy is the primary driver of returns when, in reality, returns are much more complicated (see “A Mathematician Reads the Newspaper” or “How to Lie with Statistics” for a myriad reasons why this generalization of the study is inaccurate). That being said, I believe there are some salient points, including “What counts is the amount of company’s cashflow distribution, not whether it is paid out in dividends or buybacks” and the conclusion that the net effect of share value is zero. Matter cannot be created or destroyed and there is no reason to believe that dividends and buybacks are excluded from this physical tenet.

The more profound article is “Understanding Compounding” by Arthur Clarke. Some of the logic will be familiar to frequent readers of my articles because it is similar to a piece by Michael Mauboussin, but Mr. Clarke brings two very interesting analogies to bear. One, comparing dividends to the cashflow from a bond. This allows for easy compartmentalization of the dividend stream to calculate a Yield to Maturity which shows the deleterious impacts of taxes and poor reinvestment of cashflows. The second analogy is equating a dividend to a zero cost basis sell of shares. This is a great concept that brings home the impact of taxes on dividends. Both analogies contradict the fallacy that dividends are a good use of company cash.

For those of you still on the fence about dividends, I understand. Dividend dogma is powerful. Just ask the old baseball managers that roundly disregarded Billy Beane when he showed them a better way to pick players (Moneyball article). If you want to be enlightened, take some time and read these articles. Or better yet, analyze a dividend-paying company using Enterprise Value and I believe you will agree that a transfer of cash from one pocket to another does not create value.

About Cameron Hight

Cameron Hight, CFA, is an investment industry veteran with experience from both buy and sell-side firms, including CIBC, DLJ, Lehman Brothers and Afton Capital. He is currently the Founder and President of Alpha Theory™, a Portfolio Management Platform designed to give fundamental money managers the ability to create their own repeatable discipline to organize the complex process of portfolio management.
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