High dividend strategies seem to go in and out of favor. Recently high equity yield strategies have been introduced as a novel way to escape the current low yield environment. If the best I can do is less than 1% on a Treasury, why not invest in an equity income fund that pays 3% as well as an opportunity for capital appreciation?
High dividend-paying stocks are particularly tempting when yields are low and stock prices seem to be stuck in neutral. Some have suggested that high yield equity strategies make more sense for retirees since they provide a stable income from high quality companies that are unlikely to drop in value. Dividend paying stocks have rebounded smartly following the great recession. So why not succumb to the dividend temptation?
Financial economists argue that dividends are irrelevant. A firm's profits can either be paid back to shareholders through dividends or can be retained for reinvestment. A number of ex-dividend studies provide evidence that payment of dividends reduces firm value by roughly the amount of the dividend.
The main defenses of paying dividends are (a) that the dividend signals a firm's future financial strength; (b) that once initiated, managers will be punished for reducing them; and (c) that they reduce managerial temptation to waste resources when too much cash piles up within the firm. Dividends may also be associated with bad firm prospects if they are a signal that there aren't any productive investments available within the firm or that the board of directors doesn't trust the CEO with excess cash. In terms of share performance, there really isn't much evidence to suggest that dividends are good or bad.
The other reason that dividends are seen as irrelevant is that anyone can create income from equity investments by selling a few shares. Dividends may best be viewed as a forced regular sale of one's equity portfolio. If a firm decides instead to retain its earnings, then it is up to the investor to decide when to sell shares in order to provide income. Taking capital gains gives an investor far more tax flexibility and is more tax efficient if dividends held in a taxable account are reinvested since the investor gains compounding benefit from tax deferral. And this assumes that dividends and capital gains are taxed at the same rate, as they have been since the Jobs Growth and Tax Relief Reconciliation Act (JGTRRA) was passed. The Act passed by one Senate vote in 2003 and will sunset at the end of 2012.
Dividend stocks do provide the psychological benefit of paying a regular income to retirees without forcing them to sell securities. There is evidence that retirees loathe chipping away at principal to fund current expenses, and high dividends can provide a regular stream of payments without incurring the loss of liquidity and legacy cost of an annuity. Since there is little to indicate that the tax rate on dividends will remain 15% in the face of increasing budget deficits and entitlement obligations, it is worth revisiting what happens to equity prices when tax rates change.
When taxes go down, prices go up. If investors in 2002 were willing to pay $100 for a share that provided a $2 dividend with a marginal tax rate of 38.6%, they'd be willing to pay more with a tax rate of 15%. The JGTRRA was originally written to expire in 2010, so any change in prices should have been tempered by the short-term net benefit to investors. Nonetheless, subsequent studies by Alan Auerbach of the University of California, Berkeley, and Kevin Hassett of the American Enterprise Institute (among others) found that prices of income stocks rose immediately after the passage of the Act.
If a temporary dividend tax reduction resulted in rising prices for high dividend yield securities, then the expiration of the JGTRRA and reversion to a higher (and presumably more permanent) dividend tax rate will result in an immediate decrease in the value of an income stock portfolio. This makes the dividend income strategy particularly worrisome for retirees. Not only is the use of income equity investments of dubious advantage relative to a low-yield portfolio, dividend stocks are most likely to suffer a significant loss in value if and when tax rates increase.
