Dividends do not create value

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The Puzzle of Dividends

Dividends do not create value.

If you do not agree with this view, I can immediately give two counterexamples:

Counterexample 1: Warren Buffett favors companies that deliver consistent dividend payouts, but why has Berkshire Hathaway never distributed dividends to shareholders?

Counterexample 2: China Evergrande distributed 90 billion yuan in dividends over five years, with a dividend payout ratio remaining above 50% before 2020, making it a typical high-dividend stock. Why did it still end up in bankruptcy eventually?

If you begin to doubt the value of dividends, I will show you two more facts:

Fact 1: After including dividend reinvestment to calculate the full return index, the CSI Dividend Index has recorded annualized returns of 6.86%, 8.23% and 9.46% over the past 5, 10 and 15 years respectively, outperforming the CSI 300 Index's 7.69%, 3.42% and 4.07% in the same periods. Half of the excess returns come from dividend payouts.

Fact 2: Since 2016, among the China Securities six factors, the dividend factor has the highest annualized return, surpassing the low-volatility, quality, growth, value and momentum factors.

The facts and data from both aspects actually point to the opening view, Dividends do not create value, but they help you identify high-quality companies that do create value.

In this article, I will thoroughly explain why dividends are a signal of good companies, and the real source of excess returns of the dividend investment style. If you think you have already understood these issues, the end of the article will also answer a question that many people care about: Is a high dividend payout of funds a good thing?

The answer is also negative.

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Dividends Are Identical to Selling Your Own Shares

Most people's first reaction to "dividends" is: it is a good thing. The company has made profits and is willing to take out money to distribute to shareholders, which shows it has a sense of responsibility.

Yes, you will have an extra sum of cash in your account, but at the same time, the market value of the stocks you hold will decrease by the exact same amount. Adding and subtracting, your total assets do not change at all.

But listed companies are not deceiving you either. There is really less of that sum of money on the company's books, and the money is transferred to the shareholders' accounts. However, the price of your stock will simultaneously "drop" by exactly that sum of money, which is called "ex-rights" in stock market terminology.

More than 60 years ago, Modigliani and Miller published a famous paper that proved in a tax-free and frictionless market, the value of a company has nothing to do with how much dividends it pays and how it pays dividends. The effect of a company paying dividends is exactly the same as you selling a small portion of your shares for cash. Dividends are something you could have done on your own originally, so they do not create extra value.

In the real world, dividends are also subject to tax, and you will lose a sum of dividend tax.

So many people pursue high-dividend assets, are they wrong?

Not exactly. Dividends do not create value, but they provide a "value signal".

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Three Signals of "Good Companies"

Dividend payout behavior can provide three signals of the characteristics of listed companies:

First, profits can be "manipulated", but cash is real.

A manufacturing company that generates impressive profits piled up by accounts receivable cannot come up with real money to pay dividends; a technology company that needs continuous investment to survive in fierce competition also cannot afford to pay dividends. Companies that can afford to pay dividends are most likely earning "real" money (of course there are exceptions, such as Evergrande, which will be analyzed later).

Second, being able to pay dividends continuously every year and maintain a certain dividend ratio shows that the company has sound financial status, stable business operations, and focuses on shareholder returns, which reduces the risk of holding shares in the long term.

Third, the management recognizes that there is no better use for the money remaining in the enterprise, paying dividends is an act of self-restraint that restrains enterprises from blind capacity expansion, reckless mergers and acquisitions, and irrational cross-sector expansion. In China, a market with extremely fierce competition, this avoids the risk of "self-destruction" for most outstanding companies.

Although dividends themselves do not create value, they provide value signals. Just like the college entrance examination, most of the knowledge you learn will never be used in your entire life, but getting high scores in the college entrance examination means you surpass most people in terms of intelligence and diligence. Therefore, "first academic qualification" provides employers with a more reliable "talent identification signal" than a master's degree.

The core constraint of signaling theory is "screening condition", also known as cost asymmetry: a signal is credible only when "the cost paid by the truth-teller is lower than the cost paid by the liar".

For example, "share repurchase and cancellation" can identify good companies better than "share repurchase for equity incentive", because share repurchase and cancellation will not affect the operation of good companies, but it will cause great harm to the cash flow of poor companies; if the repurchase is only used for equity incentives, since equity incentives are often used to replace bonuses as rigid expenditures, the difference in execution cost between good companies and poor companies is much smaller.

Maintaining dividends for a long time is a natural and easy move for good companies, which is even conducive to maintaining a high ROE, with very little cost (damage). But for companies with poor cash flow, this is equivalent to a fatal blow, so it is a good screening condition.

There is a very important reason: in the A-share market where conceptual themes are rampant and market value management is common, traditional industries often lack operating events that are both attractive and carry real value signals, so dividends have become one of the few valuable signals.

Therefore, buying high-dividend assets is not for the dividends themselves, and a higher dividend ratio does not mean a better company. Instead, the credibility of the dividend commitment endorses the investment value of the enterprise.

The signal significance of dividends is exactly the focus point for interpreting Evergrande's high dividend payout.

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Five Types of Dividend Stocks With "False Signals"

Dividends do not create value, they only provide value signals. Therefore, they can also be exploited to package bad companies into good ones.

Evergrande distributed 90 billion yuan in dividends, of which as much as 50 billion yuan may have gone to Xu Jiayin's family. With huge debts on one hand and high dividend payouts on the other, the essence is to transfer assets through dividends, while the image of high dividends also supports the stock price.

As long as a certain signal can provide identification value, there will inevitably be people who create "false signals", just like some people cheat in the college entrance examination, and some people forge academic qualifications.

Therefore, the following types of companies with high dividend payouts require special attention:

1. Enterprises with impressive book profits but poor operating cash flow

2. Enterprises with high liabilities but insist on paying dividends at a high ratio

3. Enterprises in strong cyclical industries that are at the peak of prosperity, but continue to pay dividends based on the profits at the peak

4. Companies where controlling shareholders are in urgent need of cash, and the enterprise continues to sell assets and significantly increase dividend payouts

5. Companies where the controlling shareholder holds a high proportion of shares and cannot reduce their holdings, and the dividends are continuously higher than the profits

In short, do not only look at past dividend payouts, you need to judge the sustainability of dividends in the next three to five years.

Therefore, I have always believed that for most ordinary retail investors, the research difficulty of high-dividend targets is no less than that of growth stocks, and it is better to hold dividend-themed ETFs.

On the contrary, companies that do not pay dividends do not necessarily have no investment value, and Berkshire Hathaway is an example.

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Berkshire Hathaway That Never Pays Dividends

Since Berkshire Hathaway paid a dividend of 10 cents per share in 1967, it has never distributed dividends again. Buffett even joked that if old shareholders send back that 10 cents one day, he will be very happy to accept it.

Why?

The reason is very simple, exactly as the title of the article says, dividends do not create value. When you buy shares of Berkshire Hathaway, you believe that your return on investment is lower than Buffett's, so the profits Berkshire Hathaway earns should continue to be reinvested, instead of "returning" the money to you.

Buffett's original words roughly mean: as long as every 1 dollar retained by Berkshire Hathaway can create more than 1 dollar of value in the future, it should be retained; when it can no longer achieve this, the money should be returned to shareholders.

Buffett believes that the core of making money from stocks is "compound interest", and dividends and compound interest are obviously at odds at the level of investment companies.

Therefore, "Buffett likes companies that pay continuous dividends" and "Berkshire Hathaway does not pay dividends" are not contradictory, they are two directions of the same logic.

Moreover, in 2018, Berkshire Hathaway removed the price cap for share repurchases, and may consider using more repurchases to replace dividend payouts. Share repurchase and cancellation is equivalent to helping you convert your dividend money into the company's stock, and then consolidate the shares, which can avoid a sum of dividend tax and is more beneficial to shareholders than dividend payouts.

The example of Berkshire Hathaway not paying dividends just answers the question at the beginning: does fund dividend payout make sense?

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Fund Dividend Payout Makes No Sense At All

From the perspective of value creation, the dividend payouts of listed companies and funds have two different implications.

On the one hand, from the perspective of capital allocation decision-making. Stock dividend payout means distributing part of the profits and retaining the other part for reinvestment, and the payout ratio reflects the management's judgment on industry opportunities. Since it is very difficult for enterprises to change their industry attributes, if there are no opportunities in the industry, there are no opportunities. If you force to look for opportunities when there are none, you will only waste the precious cash of the company for nothing.

Investing in a fund is the same as investing in Berkshire Hathaway, which means you trust that the fund's profitability is stronger than yours, and the fund can seek opportunities in any industry and any asset class. Fund dividend payout runs counter to the original intention of investing in funds.

On the other hand, from the perspective of asset allocation: company dividend payout converts operating assets into cash, and the attributes of the two are very different. However, the dividend payout of securities investment funds converts financial assets into cash, stocks and bonds have very strong liquidity, so the difference between the two is very small.

As the saying goes, if you like fund dividends, and you think that fund dividends after a sharp rise can lock in profits, then sell some of your fund holdings regularly, and treat it as a dividend distributed by the fund company.

Therefore, dividends do not create value, but the dividends of listed companies carry "information", while fund dividends carry no information at all; minority shareholders can use dividends to constrain the investment behavior of the management, but fund dividends have no meaning at all.

Of course, there is one exception. If you want to get cash income regularly in a certain form and cannot sell the fund, you can choose a fund that pays dividends regularly on a quarterly basis, which is equivalent to a small trust plan.

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Source of Excess Returns of High Dividend Ratio

Up to this point, the article has analyzed three correct signals brought by dividends and some false signals, as well as the difference between company dividends and fund dividends. Finally, we can solve the problem: where does the continuous high return of the dividend investment style in the A-share market come from?

The formula for dividend ratio is: Dividend Ratio = Dividend Per Share ÷ Stock Price. Why is the dividend ratio high? It is not only because the dividend amount is high, but the more important reason is that the denominator (stock price) has fallen sharply, so most companies with high dividend ratios are companies with low PE ratios.

Think about it, under what circumstances will the market push a company's stock price down to a level that is only a discount of its cash flow?

The answer is: when the industry has reached its peak, growth stops, and the valuation center moves down, the market is only willing to pay a very low price for its current cash flow.

Therefore, the group of companies with the highest dividend ratios are often the group of companies priced with the most pessimism by the market. The high return of the dividend investment style, in addition to selecting a group of stable companies, also comes from this point.

Why is the long-term return of the dividend investment style in the US stock market lower than that of the S&P 500, while the dividend style in China continues to outperform the index? Because in the A-share market, valuation factors play a more important role in long-term returns.

It is not because the quality of high-dividend targets in China is higher than that in the US stock market, but because companies with the growth investment style in China are overpriced as soon as they are listed, and have been in the process of de-rating; while the valuation of dividend stocks in the past has always been normal or even low, and there are very few new stocks listed in this category.

Therefore, the real reason why dividends do not create value but can continuously outperform the index is not the dividend itself, but the stock price valuation.

Moreover, some dividend stocks often come with a "low volatility" attribute. Low drawdown is a real operational "dividend" for retail investors who do not practice timing trading.

This article is from the WeChat official account "lig0624" (ID: sxgy9999), the author is Thought Stamp, 36Kr publishes this content with authorization.