Angels, Pinheads, Capital Gains and Dividends

A Middle Aged Dispute

Medieval scholars have a reputation for disputation on the most abstract and rarefied of theological questions, the “how many angels can dance of the head of a pin” problem.  Of course, this is now a byword for particularly pointless, time-wasting debates.

Modern investors have their own equivalent conundrums, such as “does market growth come from dividends or capital growth?”  Just like its Middle Ages counterparts it turns out that the answer is neither obvious nor unimportant. 

Dividend Fallacies

Although it’s true that medieval philosophers delighted in debating abstruse theological questions, the angels-pinhead problem wasn’t one of them.  This was invented far later as a means of poking fun at the whole, peculiar process.  Strange questions such as “can a bishop who is raised from the dead return to his office?” weren’t practically useful but they did teach generations of scholars how to reason logically, and helped the eventual development of scientific reasoning.

Logical reasoning is, unfortunately, often absent when investors start thinking about the dividend / capital gain problem; it’s far easier to accept the received wisdom.  Take, for example, this quote from Ibbotson and Brinson:

"Note that nearly all of the real return over the period comes from the reinvestment of dividends."

This is often translated into the idea that the majority of growth from stockmarkets comes from dividends, rather than capital appreciation, and therefore that you should invest in higher yielding dividend stocks.  Unfortunately this is a logical fallacy with which those medieval theologians would have had great sport.

Dividends or Capital Growth

This meme drops out of long-term analysis of market growth that separates out capital appreciation and dividends.  Studies like the Barclays Equity Gilt Study show that if you don’t re-invest your dividends you end up with no real capital growth: hence the idea that dividend paying stocks are the best vehicle for longer-term investors.

This, of course, is a nonsense.  If inflation is running at 5%, capital appreciation at 5% and returns from reinvested dividends at 5% then your return is generated from all three components – capital appreciation plus reinvested dividends minus inflation equals 5%.  You can’t just separate dividends out, you could equally argue that the majority of gains come from capital appreciation.  And this would be equally wrong.

Reinvestment of Earnings

It isn’t that hard to work your way through the logic of this.  The growth of a stock’s price is driven by earnings appreciation, and if a firm doesn’t pay any dividends then this will be the sole source of an investor’s return.  With no dividends to pay the company will reinvest its profits into itself, with the aim of continuing to grow earnings.

If, on the other hand, a company pays out its entire earnings as a dividend – unlikely, to be sure, but let’s keep those angels dancing – there’s no obvious reason why the company should be able to grow its earnings in real terms.  So the capital growth for an investor will be zero unless, of course, they reinvest their dividends back into the company.  Which will, over time, lead to capital appreciation.

Of course, there are all sorts of simplifications in this analysis – the relationship between earnings and share prices is inexact, to say the least. However, the standard way of calculating total shareholder return is given by the combination of price appreciation and reinvested dividends (TSR = (Price at end of period – Price at beginning of period + reinvested dividends) divided by Price at the beginning of period).

Meme Problems

Hence, reinvested dividends help drive shareholder returns and the less of them you invest the lower your eventual returns. The difference is just the amount you invest.  The meme that investors make the majority of their money from dividends is not true: reinvesting dividends simply means that the entire growth of your investments is captured in your overall returns.

In essence what drives portfolio growth is just two things: how much you invest and share price appreciation,   where share price appreciation is at least partially dependent on retained earnings being reinvested by firm management.  100% dividend reinvestment just ensures that you're not withdrawing money from your investing “account".  

Equally, if you invest in a non-dividend paying stock then you don’t have the option of withdrawing earnings in the form of dividends and, in theory, you would see growth equivalent to reinvesting dividends into dividend payers.  The debate, often framed in terms of dividend paying or non-dividend paying stocks, is a false one: the real rate of capital accumulation is really dependent on how profits are reinvested, both by corporations in themselves and by individuals with dividends.

Rappaport's Rap

So a portfolio of non-dividend payers could perform as well, or as badly, as a portfolio of dividend payers with dividends invested, but probably better than the same portfolio with dividends spent.  At the market level the statement that overall returns depend on the re-investment of dividends is true, but also misleading, because it makes it sound like there's no growth from non-dividend paying stocks. As Al Rappaport puts it in Dividend Reinvestment, Price Appreciation and Capital Accumulation (abstract only):

“It is wrong to justify the choice [of older, dividend paying companies] on the grounds that you can accumulate more dividend-financed shares in older companies than in newer companies. First, this reasoning presumes that investors fully reinvest dividends.  Second, it fails to acknowledge tbat superior returns for investing in additional shares depend entirely on price appreciation.”

In fact, Rappaport estimates that people investing directly in stocks re-invest less than 10% of their dividends, and spend the rest, which is a sure-fire way of not achieving the "market" returns, whatever they really are.

Bird in the Hand Fallacy

Unfortunately we also run into the brick wall of investor psychology. Many investors prefer dividend paying stocks because of the bird in the hand fallacy, the idea that the certainty of dividends now is worth more than the possibility of capital gains later. This is simply wrong, as Aswath Damodaran discusses in this presentation on Returning Cash to the Owners: Dividend Policy: the correct comparison is between price appreciation today versus dividends, as paying dividends results in a reduction in the stock price, although this is also an imperfect relationship.

On the other hand, good reasons for paying dividends involve addressing specific investor profiles.  The dividend tax clientele hypothesis argues that there are certain groups of people who will prefer dividends for personal reasons, often relating to their tax situation.  In Direct Evidence of Dividend Tax Clienteles the researchers concluded that:

“We show that tax-neutral investors and investment funds tilt their portfolios towards dividend paying stocks and that business and individuals tilt their portfolios away from dividend-paying stocks.”

This, of course, is letting the tax tail wag the investment dog, but it’s the kind of response you’d expect to this kind of incentive.  Because groups of investors tend to be attracted to the types of stocks with dividend policies they favour corporations are careful about changing these policies – leading to another set of peculiar behaviors by corporate managements. These include paying out dividends that the company can't afford, or paying out dividends when they could produce a better return by re-investing it themselves.  In reality managements need to look at whether they can generate sufficient free cash flow to cover their requirements for reinvesting in the business and to pay dividends.

Free Cash or Bust

A corporation paying out more than its free cash flow is a suspicious investment, no matter how high the dividend yield is.  The erroneous meme that most capital appreciation comes from dividends can persuade gullible investors into just such investments.  In the end what matters for investors is how well earnings from their stocks are reinvested..

Of course, as we saw in Dividends Keep You Anchored, investors have different problems with non-dividend paying stocks: they find it hard to value them.  If you end up paying twice as much for the same level of earnings it’s highly unlikely you’ll make the average market returns.  So for most people investing in dividend paying stocks is probably the best approach, as long as the dividends are sustainable.  Just make sure you re-invest your earnings and avoid getting lured into debates about  the number of dividends you can keep dancing on the head of a pin.

Related reading: Michael Mauboussin provides a more detailed treatment of this issue in The Real Role of Dividends in Building Wealth.

Related articles:

• Dividends Keep You Anchored
• Buyback Brouhaha
• Don't Overpay for Growth

The bird in the hand fallacy added to The Big List of Behavioral Biases.