Last Thursday, I busted the myth that increases in dividend tax rates would lead to a mass exodus from dividend-paying stocks. (If you missed it, you can find out why here.)
Today, it’s time to turn my attention to the second-biggest myth being spread as gospel truth concerning dividend tax hikes…
Namely, the notion that companies are going to suddenly stop paying dividends and/or stop increasing dividends. And in their place, announce share repurchase programs because it will represent the most tax-efficient way to return cash to shareholders.
Total hogwash. I say that not based on my own opinion, but on market study after study after study…
The “Puzzling” Choice of Dividends Over Repurchases
When it comes to returning excess cash to shareholders, companies have two main options: pay dividends or repurchase shares.
As noted in “Payout Policy” by Franklin Allen and Roni Michaely from the Wharton Business School, “The optimal [corporate] policy is to pay no dividends. Equity holders are better off receiving profits through repurchases or selling their shares so that they pay capital gains taxes rather than the higher taxes on dividend income.”
Note how they said “optimal.”
The only problem, which Allen and Michaely go on to reveal, is that “most U.S. corporations have not followed this scenario.” Instead, they’ve paid out large amounts of dividends.
This puzzling behavior is known in academic circles as the “Dividend Puzzle.” And it’s not just a recent phenomenon, either. It’s been studied for almost 40 years. (For instance, by Black, in 1976. Yes, that’s the Black responsible – with his partner, Myron Scholes – for the Black-Scholes Option Pricing Model.)
So the first reason dividends aren’t in jeopardy is simply because corporations don’t care that much about tax rates. Not when they’re deciding between dividends or share repurchases as a way to return cash to shareholders. Dividends always trump repurchases.
Over 50 years ago, researchers noticed companies’ reluctance to cut dividends. (Lintner, 1956.)
Then, studies in the 1980s and 1990s quantified it. (Ghosh and Wooldridge, 1988. And Denis, Denis and Sarin, 1994.) They found that the average stock drops 6% on the three days surrounding the announcement of a dividend cut.
So, the second reason dividends aren’t in jeopardy is because of us. We hate dividend cuts. And we respond by bailing on shares.
Keep in mind, the studies noted the average price decline. From my experience, I can confirm individual price drops can easily reach into the double-digits, wiping out millions in market capitalization in a blink.
Understandably, such swift and severe penalties act as deterrents to executives considering dividend cuts.
It’s important to note, too, that the announcement of a massive share repurchase program won’t be enough to overcome investors’ natural reaction. Why? Because we’re not stupid.
We recognize that a dividend expresses a commitment. It’s a promise to pay us.
“Repurchases, on the other hand, involve no such commitment or risk. Firms sometimes announce programs but fail to repurchase any shares. Even if a firm completes a program, it is under no explicit or even implicit obligation to begin another new repurchase program.” (Jagannathan, Stephens and Weisbach, 2000.)
Or, put simply, a dividend is an unending commitment to pay shareholders, whereas a share repurchase program is merely an intention to pay shareholders. And only for a finite period of time.
Even if we take into account the tax savings, swapping out dividend payments for repurchases isn’t a fair trade. We know it. Executives know it, too. And they’re not stupid enough to try to pull a fast one on us.
The Timing’s All-Wrong for Repurchases
The last reason dividends aren’t in jeopardy is because now’s not the time for share repurchases.
- “Firms tend to announce [repurchase] programs following poor stock market performance.” (Comment and Jarrell, 1991. Stephens and Weisbach, 1998.)
- “A firm would be reluctant to use share repurchases as a means of distributing excess cash following a significant run-up [in prices].” (Dehghani and Chun, 2011.)
In case you pulled a Rip Van Winkle, we’re three-plus years into a bull market. So, prices are up. In a major way. That makes now the least likely time for companies to announce massive share repurchases.
The data backs me up here, too. Repurchases peaked in the third quarter of 2011 at $118.41 billion. And they’ve been falling ever since. Or as Standard & Poor’s analyst, Howard Silverblatt, recently said, companies are “holding back on aggressive buybacks.”
Bottom line: Forget “plausible” or “confirmed.” The myth that corporations are going to abandon dividends in favor of share repurchase programs has been busted, too!