It’s been well-documented that stock prices tend to react positively when companies announce an increase in dividends. That’s in contrast to economic theory, which holds that companies should distribute earnings to investors when they cannot earn a rate of return in excess of their cost of capital; otherwise, they should reinvest in their business.
The explanation for the positive reaction to such corporate announcements is that managers are signaling good news about the future prospects for the company—the firm is becoming more mature and less risky, enabling it to take on more leverage or hold less cash reserves.
Policy & Returns Research
Haim Mozes contributes to the literature on the relationship between dividend policy and stock returns with his study, “Reinvestment and Global Stock Returns,” which was published in the Summer 2018 issue of The Journal of Investing. Mozes examined the relationship between a country’s aggregate dividends and its equity market returns. His data sample covered the period 1999 through 2016 as well as 11 developed and nine emerging markets.
Following is a summary of his findings.
- The change in the country-level dividend payout rate is negatively correlated with returns.
- In some countries, there is no significant relationship between changes in dividend payout rates and returns.
- There are no countries in which the change in dividend payout rates is significantly positively correlated with returns.
- The cross-country relationship between changes in dividend payout rates and returns is significantly negative.
- Although the signaling story might hold for individual companies, it does not hold for countries as a whole. Rather, at the country level, an increase in dividend payout rate represents a decrease in the country’s investment opportunity set and accordingly is interpreted by investors as bad news, and vice versa.
- Change in a country’s dividend payout rate is negatively connected to changes in analysts’ long-term earnings growth expectations for that country, supporting the bad news story.
- The change in a country’s dividend payout rate is positively correlated with that country’s change in its equity risk premium.
- Countries with lower dividend payout rates have had higher real long-term equity returns.
Mozes noted that his findings “are particularly relevant for the current low-interest-rate environment, in which investors are aggressively searching for opportunities to generate yield.” He added: “Countries with high dividend yields are not necessarily good investment candidates if those high dividend yields are generated by high dividend payout rates or by strongly increasing dividend payout rates.”
The implication of Mozes’ work is that, at least at the country level, investors interpret changes in dividend policy in the way economic theory would predict: Increases in dividend payout rates signify a reduction in a country’s investment opportunity set and so are interpreted by investors as bad news. The reverse holds as well.
This is in striking contrast to prior research showing that, for individual stocks, investors view dividend increases as good news, and such an increase leads to higher stock prices (and vice versa). The fact that increases in dividend payout ratios at the country level represent bad news is evidenced by the data showing the change in dividend payout rates is negatively related to the change in analysts’ expectations of long-term earnings growth.
Today’s yield-chasers should beware: Countries with high dividend yields are not necessarily good investment candidates if those high dividend yields are generated by high dividend payout rates and/or are accompanied by significant rises in dividend payout rates.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.