In an era when fewer firms pay dividends, what do payouts tell us about returns?
Dividend payments have been on a systematic decline since 1972, and the percentage of firms paying a dividend has declined from 63.8 percent in 1972 to 30.4 percent in 2011. The question is now, What does paying dividends tell us about possible returns?
Even after controlling for firm characteristics, companies have become less likely to pay dividends. The decline in dividend payments, as noted, has spurred many researchers to address the question of whether dividend yields continue to predict returns.
For example, the study “On the Importance of Measuring Payout Yield: Implications for Empirical Asset Pricing” found that the dividend yield does a poor job predicting future returns in a sample that runs from 1972 through 2003. In addition, the 2003 study “Predicting the Equity Premium with Dividend Ratios” found that that dividend yield has little predictive ability out of sample.
The authors of the 2012 study “Enhancing the Investment Performance of Yield-Based Strategies” found that by expanding the definition of dividend yield to include three alternative measures of dividend yield, the explanatory power of the dividend yield could be improved. The three alternatives were:
- PAY1: Dividends plus share repurchases.
- PAY2: Dividends plus net share repurchases.
- SHYD: Shareholder yield that includes net-debt paydown as part of the yield calculation. Net-debt pay down yield is measured as the year-over-year difference in the debt load of a firm, scaled by total market capitalization.·
The following is a summary of their findings:
- The addition of net-debt paydown to the PAY2 yield (dividends plus net share repurchases) improves investment performance.
- There is no evidence that high-dividend strategies systematically outperform. Three-factor alphas are statistically insignificant over most subsamples and point estimates vary wildly.
- Over the 1972-2011 period, firms with the highest SHYD measures earn an average monthly return of 1.3 percent and a statistically significant three-factor alpha of 0.25 percent per month. This compares favorably with the simple dividend yield strategy (DIV), which earns an average 1.18 percent monthly return and has a statistically insignificant alpha of 0.17 percent per month.
- PAY1, PAY2 and SHYD have outperformed the simple dividend yield strategy in three out of the past four decades.
- SHYD is the top performer in virtually all subsample periods.
- They also found that within yield categories, lower payout percentage firms outperform higher percentage payout firms.
The bottom line is that the addition of net-debt paydown in the yield metric is a robust improvement to high-yield investment strategies.
With that said, it’s important to note that the concept of share buybacks being a good thing has been around for a while.
Similarly, considering an effective yield by combining buybacks with dividends is also pretty well established. It’s also worth noting that one can think of these metrics as quality, or profitability, indicators—higher yield with lower payout should lead to sustainable and even increasing payouts.
And quality/profitability has now been well documented as a factor that provides added explanatory power to the Fama-French three-factor (beta, size and value) model—and mutual funds and ETFs are now available that incorporate the quality factor into their fund construction rules.
There’s one more point worth mentioning—for taxable investors, having a company buy back shares, or pay down debt, is more tax efficient than paying dividends.
Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.