Dividend Paying Stocks and Survivorship Bias

Survivorship Bias

One of the most important concepts in all of investing is “survivorship bias”.  Per wikipedia:

In finance, survivorship bias is the tendency for failed companies to be excluded from performance studies because they no longer exist. It often causes the results of studies to skew higher because only companies which were successful enough to survive until the end of the period are included.

You should view any sort of “theory” on stock selection such as value, small-cap, growth, or dividend payers (generally part of the “value” spectrum) as a “sales pitch”.  When someone tries to sell you on something, they will use whatever data that is available to support their pitch.

The data that is generally available is in the stock market “raw” data.  You can see the price changes, the dividends, and compare these against your selected group or theory in a variety of ways.

Valuing Dividends

In general, it is more difficult to determine total stock returns (i.e. how successful your proposed theory is) when you include dividends.  It is easy to look at the “price” of a stock from 10 years ago and the price of that same stock today and said it “went up 25%” or “went down 25%”.  Or, if you owned that stock and are looking for it, that the stock doesn’t exist in the index any more (it went bankrupt, merged with someone else, or went private).  Even large and sophisticated investors sometimes forget to include dividends in their calculations.

Dividends are harder because they are payouts to shareholders and then you need to determine what happened with those dividends.  For my trust funds, for example, the dividends are received in cash.  Then we take the cash and re-invest it periodically, in our case annually.  Thus you don’t earn a “return” on that money, other than interest (which used to be significant, but now can essentially be modeled at zero since interest rates are so low) during that time.

For most models used by analysts, dividends paid are assumed to be re-invested in shares.  Thus if you receive a dividend of 2%, you essentially now own 2% more in shares, and you also earn dividends on those shares going forward, as well.  To make it a bit more complicated, there are taxes that you have to pay when you receive those dividends, so you may want to reduce the effective value of those dividends by 15% (the current taxable rate) or closer to 30% if that exclusion is taken away when the tax laws are changed in 2013.  Here is a wikipedia article that reviews the taxation of dividends for individuals.

Dividends are important.  Per the “dividends aristocrats” methodology used by the S&P 500 and found  here,

Since 1926, dividends have contributed nearly a third of total equity return while capital gains have contributed two-thirds. Sustainable dividend income and capital appreciation potential are both important in determining total return expectations.

For our own portfolios, dividends have brought in a substantial portion of total return.  The impact is largest on our biggest funds, portfolio 1 and 2, since they have more stocks and a longer time frame to accumulate dividends.

How Companies Decide on Dividend Policy

In order for a company to pay out dividends, they must be profitable.  Dividends need to be paid out of profits, or they are essentially a “return of capital” where they are giving back their investors their money received.  While this is not always technically true (you can issue debt and leverage up and then pay yourself) it is a solid rule of thumb that a company must be profitable to pay dividends.

Since a company must be profitable, many start ups are immediately disqualified as dividend-payers.  Once a company is profitable, however, many “growth” companies decide to plow profits back into the business rather than returning it to shareholders (in the form of dividends).  For example, Microsoft did not pay dividends for many years, Amazon pays no dividends (but there is an open question of how profitable their model really is, anyways, regardless of their stock price), Google pays no dividends, and Apple recently starting paying a dividend in 2012.

Thus we’ve already “narrowed” potential dividend paying companies into a smaller subset 1) those that are profitable 2) those that don’t define themselves as “growth” companies (broadly speaking).

Once companies decide that chasing growth isn’t the answer, and they then decide that they want to pay dividends (rather than buy back stock, although it isn’t always  an either / or question), they start notifying investors (and physically paying the dividend).  Investors then incorporate the dividend cash flow into their expectations, and the company is loathe to change these expectations (to reduce dividends once declared).

From the perspective of “expectations”, then, a dividend payer is viewed favorably if they pay the regular dividend they declared, along with continuing to raise their dividend regularly.  A general class of investor seeks out these sorts of stocks, and these investors are usually quite loyal (these stocks can become “widows and orphan” stocks), as defined in Investopedia:

A stock that pays high dividends and is generally considered to carry low risk.

Dividend Policy and Historically Low Borrowing Rates

Today companies can borrow debt at historically low interest rates.  For instance, ITW recently borrowed for 30 years at 4.1%, an historically low number for them and unprecedented in the 2008 stock meltdown when debt could hardly be raised by anyone at any price.  Note that this is for 30 year debt; the equivalent (risk free) yield per the US treasury is 2.8%, for a difference (risk premium) of 1.3%, which is incredibly small.

The equivalent 10 year yield for the US treasury (see table here) is about 1.7% – if you add on the 1.3% premium that ITW pays over the US treasury rate, that is a 3.0% rate.  Why is this rate important?  It is important because the 10 year debt issue would be a roughly reasonable comparison against the dividend rate that ITW is currently paying, which is about 2.6% (the 30 year duration is too far out to be a valid comparison to current dividend policy).

When you factor in the negative tax effect of ordinary income treatment, an adjusted 3.0% interest yield (10 year plus ITW’s risk premium) would receive about a 30% effective tax rate, while that 2.6% dividend payment would be at 15% (see above).  On top of that, the dividend for ITW has been growing over the last 20+ years (over 15% / year for the last 4 years), while for the debt instrument you only get your payment back (no improvement).

Thus for ITW at least, their dividend payment is higher than you can receive as an interest bearing instrument (bond or note), adjusted for taxes.  THIS IS UN-PRECEDENTED in modern times.

Viability of Dividends as an Alternative to Bonds

Due to this historic inversion (companies with solid credit can borrow almost at their dividend rate, adjusted for taxes), companies have new options.  They can choose to borrow money to support items that might have been paid for our of current cash flow and support a higher dividend policy.

While this post is already covering a lot of ground, at this point today high dividend stocks can be treated as a viable alternative to debt in some circumstances.  This is due to the fact that 1) bonds are yielding almost nothing to investors 2) bonds are taxed unfavorably 3) dividends generally increase over time while interest rates are flat.  A major offset is that stocks are inherently more risky than bonds, meaning that they fluctuate in value and a large price “loss” can far and away offset any favorable impact from an increase in dividends (i.e. if the stock drops 25% in value then the dividend policy is mostly irrelevant at that point).

Survivorship Bias and Dividends

When you look at stocks, dividend policy is an ATTRIBUTE.  Thus there is a history of dividend payouts, and you can see the growth in dividends over years for those stocks that are selected.  Based on this historical data, you might infer something about that stock such as

“Company X has paid out a great dividend for 20 years and has raised their dividend 5% / year thorughout that time frame, making it a good candidate for a dividend investor.”

This all sounds rational.  However, let’s think through what (likely) really happened to company X over the years.

1) company X started out as unprofitable, like virtually all companies

2) company X started to earn more money, and re-invested it back in the business as it grew

3) company X then wasn’t a growth company anymore, and started holding cash and giving it back to shareholders

4) once you start paying a dividend and having shareholders EXPECT a dividend, it helps to GROW the dividend which makes your stock more valuable (all else being equal)

5) then the stock really becomes sort of a debt-like instrument to shareholders, and they view it under the lens of a growing return of dividends on their investment

You are looking now at a company in the fifth stage of its life.  What happens next?  Does a company forever stay in the dividend phase of its life, with the dividend growing forever?

This is where the survivorship bias comes in.   Companies that  have grown dividends for many years and managed the transition from a growth company to a value company (and a successful one, on the measure of growing their dividend) now have to continue to grow and support their dividend indefinitely, while the economy goes up and down and new, more nimble competitors enter the market (or giant competitors buy into the market by snapping up other companies).  This is not necessarily an easy thing to do long term or pull off since it is not always an “equilibrium” situation.

For example let’s look at Alcoa (AA).  Alcoa was a “dividend aristocrat” for many years, using its strong position in the US and world wide aluminum industry to pay a steady and growing dividend.  When it started out it needed cash to grow and pay for expensive infrastructure, but then over the years it was able to harvest these investments and throw off cash to investors rather than continuing to make expensive investments for growth. In 2001 they paid a dividend of 15 cents a share (and had been paying a growing dividend on a per share basis since 1988 prior to that, at a minimum) and it peaked at 17 cents in 2009 (they probably held on as long as they could to the dividend after the 2007-8 crash) until they capitulated and reduced their dividend down to 3 cents / share where it is today.  Cutting their dividend corresponded with a significant fall in their share price, as well, dropping from a high of over $40 / share to about $9 / share, a drop of 75%+ in value.

Whether the drop in dividend CAUSED the drop in the stock price or whether the events that made Alcoa less competitive in the global marketplace (overall shrinking demand and tough competition from global players, especially out of China) caused the drop in cash flow which in turn led to the massive drop in dividends paid to shareholders, is tough to tell, but they both contributed to the stock downfall.

You can see the same process happening right now with Telefonica (TEF), the ADR for the Spanish telecom company, as it drops its dividend.  TEF grew its dividends from  41 cents / share in 2007 to $1.05 in 2011, the mark of a “dividend aristocrat” (it had been paying a dividend for a long time previously, this was just the recent growth in dividends per share).  By many metrics this type of behavior would reward them and put them on recommended lists for “widows and orphan” stocks as a steadily growing payer of dividends to shareholders.

Today, however, TEF is facing hard times and cut the dividend back to 35 cents  / share, a more than 2/3 reduction from the 2011 payout.  This also corresponded (but did not necessarily cause, but likely contributed to) a stock price reduction from 22 to 14, an over 40% drop.  One item that partially shields TEF from even greater hardship is the amazingly low interest rates that corporations can now use to borrow funds – per this article (aptly) titled “Telefonica Leads Corporate Bond Rush Amid Record Low Yields”

Borrowing costs are tumbling with average yields on investment-grade securities dropping to 2.58 percent, Bank of America Merrill Lynch’s EMU Corporate Index shows, compared with 4.4 percent at the start of the year.

At this type of rate TEF is roughly able to borrow funds at approximately the same rate as they paid out to shareholders in their last dividend payment in 2011 (35 cents was about 2.84% of the stock price at the time).  Adjusted for the tax deductibility of interest rates to the corporation (dividends are not deductible), the company is able to borrow for LESS than it takes to pay out their dividend, meaning that in some sense on the margin they can borrow money from the bond market and pay it back to the stock market to prop up their dividends.  This isn’t saying that the company is actually doing this, but on the margin for their dividend payout ratio and their most recent debt issuance this could be considered the financial impact overall.

Conclusion

Like most items about stocks, the conclusions are hazy and subject to interpretation.  In general, whether a company pays a growing and steady dividend is more an attribute of its (accidental) place in  its life cycle and overall competition and profitability than a strategy that investors should lock into looking for yield as an alternative to low debt rates.  However, once a company is identified as a growing dividend payer, it becomes loathe to change that strategy because their shareholders view growing dividends as a source of worth for the stock and once the dividend policy capitulates (usually with a strong drop, not a little haircut) the stock is punished (although it potentially could be punished for other reasons, as well).

Buying a stock is a forward looking act and not a backward looking act.   A history of dividend paying growth is one of many signals to look at, although a powerful one because once a company is locked into the “dividend growth” crowd, leaving that crowd will likely take a significant part of the stock price with them (i.e. lead to a big drop in the stock price).

Take the “dividend aristocrats” with a grain of salt.

Cross posted at Chicago Boyz

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