Swedroe: Rethinking Dividend Strategies

May 08, 2014

Sensible Drawdown Approaches

Now let’s look at the withdrawal stage.

In a bear market for stocks, you’ll be meeting both your cash flow needs and the need to rebalance by selling the outperforming safer bonds, not your stocks. Thus, in bear markets, unlike those that rely on dividends for the cash flow who are in fact disinvesting from their equities, a total-return approach would avoid such sales.

We’ll also take this opportunity to provide two examples of why dividends reduce the value of a company.

Company A is deciding whether to pay a dividend. Instead, it chooses to use the cash it would have paid out to buy back its stock. In either case, the company’s future earnings prospects are exactly the same. However, under the buyback scenario, it has fewer shares outstanding. Thus, its earnings per share are now higher. Thus, since all else is equal, the company’s stock will trade at a higher price.

Alternatively, the company could choose to pay back some of its debt. In that scenario, its future earnings are also higher, because interest expenses are now lower. In addition, it would have a lower leverage ratio than if the company had paid a dividend. That makes it a less risky company.

Again, since all else is equal, both factors should result in a higher stock price. In fact, 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: An acronym of sorts for shareholder yield that includes net-debt paydown as part of the yield calculation. Net-debt paydown yield is measured as the year-over-year difference in the debt load of a firm, scaled by total market capitalization.

The authors found both that there’s no evidence that high-dividend strategies systematically outperform. They also found that SHYD was the top performer in virtually all subperiods, providing a much better explanation of returns. This supports the evidence from two other recent studies.

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.

For those interested in learning more about the differences between a cash-flow and a total-return approach (using homemade dividends when needed to supplement the interest and dividends generated by the investment portfolio), Vanguard’s research team has a paper on this subject.

Their recommendation, like my own, is to use a total-return approach, with the investor first deciding on an asset allocation that is based on his or her unique goals and objectives, and their ability, willingness and need to take risk. “This decision should be the investor’s highest priority.”

Investors should then stick to their plan, rebalancing along the way as needed.


Larry Swedroe is director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.


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