Carnival is one of many pandemic-hit companies that paused dividends. Companies should reassess such payouts, argues a professor.
Photo: Chris O'Meara/Associated PressOver the past year, voices across the corporate and political spectrum have argued that companies are beholden to all stakeholders, not just shareholders. And indeed, many companies are recognizing these responsibilities in the current pandemic, with several paying furloughed workers and donating products. Investors have largely supported those efforts.
But when it comes to corporate responsibility, there’s one red line that many shareholders say should never be crossed: the dividend. The dividend, they argue, shouldn’t be cut.
For instance, a British investor group, the Investment Association, recently warned company boards that as they deal with these challenging times, “dividends are an important income stream for pension funds and charities, as well as ordinary savers and pensioners,” and that “shareholders would be concerned if companies unnecessarily reduced or rebased the dividend level.” Indeed, several companies have shed workers yet maintained the dividend.
However, this is a case in which virtually everybody has a misunderstanding of elementary finance principles—to the detriment of companies, shareholders and stakeholders.
One of the most basic principles of finance is that it’s total returns, not dividends, that matter. Paying dividends doesn’t benefit investors, because a dividend of $1 simply reduces the stock price by $1—just as withdrawing from an ATM gives you cash in your pocket, but less in the account. It’s true that dividends provide liquidity, allowing shareholders to fund their obligations. But shareholders can simply create liquidity themselves by selling their shares.
Take a pension fund that needs to raise $100, and owns 100 shares trading at $10 apiece. If the company pays a $1 dividend per share, the fund’s needs are met. But the share price falls to $9, so the fund’s holdings are now worth $900. If the company scrapped the dividend, the price would remain $10. The fund could sell 10 shares to raise the $100. It’s left with 90 shares worth $10 each—so its holdings are again $900.
The fallacy about dividends can be seen clearly by comparing them with stock buybacks. Dividends and buybacks are both forms of shareholder payout. However, buybacks have a huge advantage—they’re flexible. You can undertake a buyback one year, and not do so the next year, and suffer no stock-price hit.
By contrast, dividends are largely inflexible. Once a company pays a dividend, it’s committed to continuing to do so going forward. That’s because if it cuts the dividend, the stock price plummets.
The consequences
The consequences of this situation—ignoring that dividends reduce capital gains—are substantial. First, companies are hamstrung by the level of the dividend and might take short-term actions to preserve it. In one survey, CFOs admitted that they would cut even profitable investments to maintain the dividend.
Second, shareholders might overpay for dividends. A study by Sam Hartzmark and David Solomon found that buying dividend-paying stocks when demand for dividends is high reduces investors’ returns by 2 to 4 percentage points a year. Surprisingly, professionals succumb to the fallacy as well. Equity analysts overpredict the future prices of dividend-paying stocks, forgetting that dividends come out of the share price.
Relying on dividends for liquidity also encourages investor passivity. Shareholders can sit back and finance their obligations with dividends each year, without the need to figure out which companies to sell. But when a company pays a dividend, it’s effectively making the sale decision on behalf of shareholders. A 3% dividend yield means that, each year, an investor is selling 3% of the stake—regardless of how the company is actually performing. If they weren’t so reliant on the dividend, active investors would have to truly be active—get into the weeds of every company they own and sell only those whose outlook is bleak. Such monitoring in turn will ensure that CEOs invest for the future.
It’s true that selling shares to generate cash involves small transaction costs. But equally, any shareholder who wants to remain fully invested in a dividend-paying company would have to reinvest the dividend and incur costs.
What should change
So what’s the solution? One remedy is simple. Brokerage accounts should show total returns rather than price returns to a position, and financial-information providers should display total-return graphs or indexes.
The second is to change the rules of the game for dividends. It’s true that, given the regimen we’re in, everything makes sense. The market punishes any dividend cut, so companies won’t lower the dividend unless they’re truly desperate—so it makes sense to interpret a cut as a bad sign.
But it doesn’t have to be this way, as we can see with buybacks. You can chop and change them from one year to the next. So companies are never trapped if they need to raise cash to finance an investment or pay its workers.
‘Flexible’ dividends
Is it fanciful to think that we could change the equilibrium? Not necessarily. Special dividends are already viewed as “one-off,” so investors are already willing to treat some dividends as flexible.
Moreover, the current crisis has allowed companies to cut the dividend if they have given justifiable explanations of what the cash will be used for. They should take the opportunity to reset the equilibrium to one where no or low dividends are the expectation, and investors should accommodate such cuts rather than punishing them by selling. If companies pay dividends in the future, they should stress that—like buybacks—it won’t be repeated unless it has cash left over after taking all of its profitable investments. That way, firms will never have to prioritize maintaining the dividend over paying fair wages, reducing their carbon footprint or investing for the future.
Dr. Edmans is a professor of finance at London Business School and author of “Grow the Pie: How Great Companies Deliver Both Purpose and Profit.” He can be reached at reports@wsj.com.
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