Dividends are good

The next section of chapter 29 examines the practice of retaining profits to build up the business.  The issue here is that if you owned the business you could take 100% of the profit because the profit is what is left over after everyone else has been paid.  However, most companies will retain part of the profit on the basis that it will enable management to build up the business and maintain the dividend rate in future.

I briefly discussed dividends when establishing my stock screening criteria (See "Selecting Stocks - Take Two" from January 2009).  Based on the premise that the value of the unpaid amount is added to the company value (because a share is a portion of the company), I said I preferred companies that don’t pay dividends because individuals receive a 50% deduction on tax due on capital gains (ie the change in the share price) and it is paid only when you sell (if you are not classified as a day trader by the ATO and hold the shares for over a year) but pay full tax on income (ie the dividend) and pay it annually.  (At least that is my understanding, tax law is always changing and I could simply have it wrong).  Also, there are no brokerage charges associated with reinvesting your dividends if they are just retained by the company (although this is not an issue if the company offers a dividend reinvestment plan).

Graham and Dodd question the practice of retaining earnings (ie withholding dividends) on the basis that:

1. if two companies are similar in all respects except the size of the dividend paid, the one with the higher dividend will have the higher share price.
2. withholding profits lowers the return.
3. it rarely succeeds in maintaining the dividend rate in terms of $ per share.
4. any increase in share price generated by withholding dividends will not necessarily compensate the shareholders for the dividends withheld – particularly if you take into account the interest that would have otherwise been earned on the funds.  I had a go at trying to test this using the data I’ve complied for the NAB, but given the volatility of the share market, seven years is too short a period.
5. they believe a study would show that the earning power of a corporation does not expand in proportion with the dividends withheld, although they are assuming the company is retaining the majority of the earnings, say 70% to 90%.
6. individuals in charge of companies have a vested interest in withholding dividends – they will want to retain the cash in the company where they have control over it and they will want to increase the size of the company for self aggrandizement and to generate a higher salary.  They may also withhold dividends to depress the share price so they can purchase more shares or to minimise their tax bill.

In relation to point 3, I have replicated an exercise Graham and Dodd performed on United States Steel, in my case using figures for National Australia Bank over the period 2003 to 2008:

Sum of earnings per share for the period:    $14.455

Dividends paid to shareholders                   $10.380

Dividends withheld:                                  $  4.075

In 2009, after earnings fell to $1.975 per share from $2.373 per share the year before, NAB reduced its dividend to $1.46 per share from $1.94 per share the year before.  With over $4 per share “saved up” in the previous six years (and more if I went back further), there seems little justification for reducing the dividend. I scanned through the annual report to find any discussion on how NAB determines the amount of the dividend and found nothing.

Graham and Dodd’s conclusions are:

• Any dividend not paid out loses value for the investor.
• The major proportion of earnings should be distributed and any earnings withheld should be justified by management.
• You should look for both an adequate return and an adequate dividend when investing.

And the winner is ... dividends!

In Chapter 29 of Security Analysis, Graham and Dodd make the comment “Until recent years the dividend return was the overshadowing factor in common-stock investment”. (These words come from the 1940 edition of the book.)

To illustrate this they present two tables, one for American Sugar Refining Company (ASR) and one for Atchison Topeka and Santa Fe Railway Company (ATSR). Each table shows for a number of years, the price range of the stock, the earnings per share and the dividends per share.

ASR had quite volatile earnings, for example going from $18.92 per share in 1911 to $5.31 per share in 1912, but maintained a constant dividend of $7 per share over the period of the table (1907 – 1913). According to Graham and Dodd, the volatility of its share price was low, suggesting that it was the dividends driving the price rather than earnings.

The table for ATSR covers the years 1916 to 1925. The dividend paid was $6 per share each year except for the last when it rose to $7 per share. Earnings per share, while exhibiting some volatility, had a general upward trend. The price range again was relatively steady and level, but jumped in the final year when dividends were raised. So again, dividends seem to be driving the price.

I decided to undertake a similar exercise on a current ASX listed company. I chose National Australia Bank Limited (NAB) because I thought a long established bank would have steady dividends but volatile earnings and because, due to accidents of history, I own some (a very little some) NAB shares.

Instead of replicating the tables, I created two graphs: one plotting earnings per share against closing price on the day the full year results were announced and one plotting dividends per share for the year against closing price on the day the full year results were announced.

Here’s the graph of earnings against closing price for the years 2003 to 2007 inclusive. Closing prices were taken from Yahoo’s finance site, which only goes back to 2003. The R-square figure of 0.163 is a measure of how well the movement of earnings per share affects the closing price. A R-squared of 1 would mean that a change in the earnings per share would result in the exact same change in the closing price. A R-squared of 0 would mean that a change in the earnings per share would result in absolutely no change in the closing price. A R-squared of 0.163 is very low suggesting earnings per share has little influence on price.





What I see when I look at the graph is a squiggle – it folds back on itself. In this case I think the R-squared is meaningless and earnings do not directly affect the share price.

In contrast, when I look at the graph of closing price against dividends per share for the same period, things are a bit clearer. Each rise in dividends paid has lead to a rise in the share price. The R-squared of 0.664 suggests a reasonable correlation. So although there are not many data points here and no doubt a statistician would draw no conclusions from this, it would appear dividends directly affect share prices and earnings do not.




The impact of dividends could also be seen in the market reaction to Qantas’s decision to cut its interim dividend for the FY2010 half year despite the profit result being in line with company guidance. Its share price fell 8% in one day.

You may be wondering why I only took the graphs out to 2007. It’s because 2008 is when the global financial crisis hit and things went awry. When I extend the graphs out to 2009, it all goes horribly wrong.





Now both graphs are squiggles. So from this I conclude when it all goes wrong, it all goes wrong and hopefully when it happens again, I will have already switched my portfolio into cash.