Do investors see dividend increases as good or bad news? It depends on whether they’re looking at an individual stock or an entire market. Larry Swedroe reviews a new study into how a country’s aggregate dividend payout rate affects its equity returns.
It’s been well-documented that stock prices tend to react positively when companies announce an increase in dividends. That’s in contrast to economic theory, which holds that companies should distribute earnings to investors when they cannot earn a rate of return in excess of their cost of capital; otherwise, they should reinvest in their business.
The explanation for the positive reaction to such corporate announcements is that managers are signaling good news about the future prospects for the company—the firm is becoming more mature and less risky, enabling it to take on more leverage or hold less cash reserves.
Haim Mozes contributes to the literature on the relationship between dividend policy and stock returns with his study, “Reinvestment and Global Stock Returns,” which was published in the Summer 2018 issue of The Journal of Investing. Mozes examined the relationship between a country’s aggregate dividends and its equity market returns. His data sample covered the period 1999 through 2016 as well as 11 developed and nine emerging markets.
Following is a summary of his findings.
Mozes noted that his findings “are particularly relevant for the current low-interest-rate environment, in which investors are aggressively searching for opportunities to generate yield.” He added: “Countries with high dividend yields are not necessarily good investment candidates if those high dividend yields are generated by high dividend payout rates or by strongly increasing dividend payout rates.”
The implication of Mozes’ work is that, at least at the country level, investors interpret changes in dividend policy in the way economic theory would predict: Increases in dividend payout rates signify a reduction in a country’s investment opportunity set and so are interpreted by investors as bad news. The reverse holds as well.
This is in striking contrast to prior research showing that, for individual stocks, investors view dividend increases as good news, and such an increase leads to higher stock prices (and vice versa). The fact that increases in dividend payout ratios at the country level represent bad news is evidenced by the data showing the change in dividend payout rates is negatively related to the change in analysts’ expectations of long-term earnings growth.
Today’s yield-chasers should beware: Countries with high dividend yields are not necessarily good investment candidates if those high dividend yields are generated by high dividend payout rates and/or are accompanied by significant rises in dividend payout rates.
This commentary originally appeared June 29 on ETF.com
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