Author Topic: Dividend Growth Funds  (Read 12476 times)

Bardo

  • Stubble
  • **
  • Posts: 213
Dividend Growth Funds
« on: May 12, 2015, 11:29:23 AM »
Hi there.  My target retirement is in about a year, so at my last rebalancing I targeted a conservative 40% cash and bonds and 60% equities.  Now I have some extra cash I need to invest, and instead of maintaining that ratio I'm thinking of increasing to ~65% equities using Vanguard dividend appreciation funds.  My thinking is that while we might be due for a correction, there is more short-run downside to bonds than equities as the Fed tightens, and dividend stocks are a reasonably conservative halfway house. 

Anyone else thinking along these lines?

forummm

  • Walrus Stache
  • *******
  • Posts: 7388
  • Senior Mustachian
Re: Dividend Growth Funds
« Reply #1 on: May 12, 2015, 12:12:20 PM »
No, I basically disagree with all of this. I think the risk to equities is pretty strong too. And dividend stocks are not a safe haven.

skyrefuge

  • Handlebar Stache
  • *****
  • Posts: 1015
  • Location: Suburban Chicago, IL
Re: Dividend Growth Funds
« Reply #2 on: May 12, 2015, 01:32:05 PM »
and dividend stocks are a reasonably conservative halfway house. 

Why do you have this impression?

Here are three dividend-growth funds compared to the S&P 500. During the 2008 crash, one crashed less than the S&P 500, one crashed about the same, and one crashed harder.

So it's not at all clear that dividend funds are more "conservative" than any other stock funds. Even for the one that crashed less, it's behavior is not at all "bond-like".

Maybe increasing your equity exposure would be a good idea, or maybe it wouldn't (it depends on your risk-tolerance), but don't fool yourself into thinking that investing in dividend funds is less risky than any other equity funds.

Furthermore, making investment decisions based on prognostications about the near future (aka "market timing") is a bad idea, and especially suspect if you aren't even clear about what has happened in the past.

Aphalite

  • Bristles
  • ***
  • Posts: 425
Re: Dividend Growth Funds
« Reply #3 on: May 12, 2015, 02:08:31 PM »
The only advantage equities that pay dividends (let's say Exxon or Coke) over an equity that reinvests all of its earnings (let's say Berkshire or Google) is that in downturns, if you have dividend reinvestment turned on, it will buy you more shares at lower prices - there's no reason why stocks that pay dividends are automatically a more conservative investment than stocks that do not, although generally stocks that pay dividends are more mature. There are, for example, plenty of energy stocks that are paying dividends right now but are plenty risky as they have callable short term debt that will need to be refinanced soon, but are holding longer term assets with dimished cash flows/earnings that cannot be expedited

Besides, VTI has a div yield of close to 2%, and most Dividend funds don't have a yield thats much higher - you're not getting much difference nowadays
« Last Edit: May 12, 2015, 02:10:11 PM by Aphalite »

Bardo

  • Stubble
  • **
  • Posts: 213
Re: Dividend Growth Funds
« Reply #4 on: May 12, 2015, 03:01:52 PM »
Good points all.  Thanks!

forummm

  • Walrus Stache
  • *******
  • Posts: 7388
  • Senior Mustachian
Re: Dividend Growth Funds
« Reply #5 on: May 12, 2015, 03:29:59 PM »
The only advantage equities that pay dividends (let's say Exxon or Coke) over an equity that reinvests all of its earnings (let's say Berkshire or Google) is that in downturns, if you have dividend reinvestment turned on, it will buy you more shares at lower prices

This isn't an advantage. Coke is making the company less valuable by paying out dividends. If you buy more shares with the dividends, you still own the same amount of value. Same as Berkshire not paying out any dividends.

You might be saying that if a stock is "undervalued" you can buy more shares of that stock while it's "undervalued". But the opposite would be true in times like now where stocks are "overvalued"--you're buying back new shares at much less than they are "worth".

And when stocks are "undervalued", whatever Berkshire is buying with their profits is also "undervalued". And vice versa.

So it's no difference at all really.

Aphalite

  • Bristles
  • ***
  • Posts: 425
Re: Dividend Growth Funds
« Reply #6 on: May 12, 2015, 03:37:20 PM »
You might be saying that if a stock is "undervalued" you can buy more shares of that stock while it's "undervalued". But the opposite would be true in times like now where stocks are "overvalued"--you're buying back new shares at much less than they are "worth".

And when stocks are "undervalued", whatever Berkshire is buying with their profits is also "undervalued". And vice versa.

That's what I'm saying, that in the specific scenario asked about by the OP, where there's a crash, you have an advantage of having a source of cash flow via dividends to buy more shares of the "undervalued" stock

Your second point is only true for a company like Berkshire, which retains earnings to buy other companies or stocks of other companies, for most companies, their investment in their business operations doesn't magically get cheaper just because the stock market is on sale. Chipotle doesn't get a discount on its flour, avocados, and beef just because it's share price dropped 50%. Now, if your point is that non-dividend paying Companies during a downturn could return a lot of shareholder value through buybacks, you would be correct, except then we're ignoring what actually happens when there is a crash - Companies get tight with their cash flow
« Last Edit: May 12, 2015, 03:40:15 PM by Aphalite »

TreeTired

  • Bristles
  • ***
  • Posts: 451
  • Age: 136
  • Location: North Carolina
  • I think we can make it
Re: Dividend Growth Funds
« Reply #7 on: May 12, 2015, 03:39:43 PM »
I am getting a littel uncomfortable with some of my dividend stocks.   I bought some when they yielded 4%, which looked pretty good when the 10 yr US Treasury yield was less than 2%.   Now the stocks yield 3%,  or even 2.90% and the 30 yr bond yield is also 3%,  so the stock needs to offer more than just a 3% dividend.  Is it suddenly a growth stock?  I don't think so.

Interest Compound

  • Pencil Stache
  • ****
  • Posts: 655
Re: Dividend Growth Funds
« Reply #8 on: May 12, 2015, 03:51:48 PM »
That's what I'm saying, that in the specific scenario asked about by the OP, where there's a crash, you have an advantage of having a source of cash flow via dividends to buy more shares of the "undervalued" stock

Dividends are mathematically equivalent to selling stock.  As Skyrefuge once said:

Dividend payment: reduces your stake in the company and gives you cash in exchange.
Selling shares: reduces your stake in the company and gives you cash in exchange.

Wanting the first but not wanting the second is a clear contradiction.  It has been shown that dividend stocks crash more than the market, and this is when dividends are included.  While it may seem like an intuitive idea, that's not how it works.

skyrefuge

  • Handlebar Stache
  • *****
  • Posts: 1015
  • Location: Suburban Chicago, IL
Re: Dividend Growth Funds
« Reply #9 on: May 12, 2015, 05:03:56 PM »
That's what I'm saying, that in the specific scenario asked about by the OP, where there's a crash, you have an advantage of having a source of cash flow via dividends to buy more shares of the "undervalued" stock

You own 100 shares of Divcorp at $10/share. It crashes 50%, to $5/share. It pays a $1/share dividend, which reduces the share price further, to $4/share. You reinvest that $100 dividend payment at $4/share. You now own 125 shares @ $4 = $500. It gains 100%, and you end with 125 shares @ $8 = $1000.

You own 100 shares of Capgains at $10/share. It crashes 50%, to $5/share. It retains its earnings and pays no dividend. You now own 100 shares @ $5 = $500. It gains 100%, and you end with 100 shares @ $10 = $1000.

The dividend cash flow when the stock was "undervalued" didn't affect your situation at all. (unless we assume the dividends are taxable, in which case they left you worse off!)

forummm

  • Walrus Stache
  • *******
  • Posts: 7388
  • Senior Mustachian
Re: Dividend Growth Funds
« Reply #10 on: May 12, 2015, 05:13:28 PM »
I am getting a littel uncomfortable with some of my dividend stocks.   I bought some when they yielded 4%, which looked pretty good when the 10 yr US Treasury yield was less than 2%.   Now the stocks yield 3%,  or even 2.90% and the 30 yr bond yield is also 3%,  so the stock needs to offer more than just a 3% dividend.  Is it suddenly a growth stock?  I don't think so.

You can't really compare a stock to a bond like this. What percent does your asset allocation tell you that you want to be in equities and bonds? That's the way to think about it. And then, for equities, buy an index fund, so you don't have individual stock risk.

forummm

  • Walrus Stache
  • *******
  • Posts: 7388
  • Senior Mustachian
Re: Dividend Growth Funds
« Reply #11 on: May 12, 2015, 05:16:26 PM »
You might be saying that if a stock is "undervalued" you can buy more shares of that stock while it's "undervalued". But the opposite would be true in times like now where stocks are "overvalued"--you're buying back new shares at much less than they are "worth".

And when stocks are "undervalued", whatever Berkshire is buying with their profits is also "undervalued". And vice versa.

That's what I'm saying, that in the specific scenario asked about by the OP, where there's a crash, you have an advantage of having a source of cash flow via dividends to buy more shares of the "undervalued" stock

Your second point is only true for a company like Berkshire, which retains earnings to buy other companies or stocks of other companies, for most companies, their investment in their business operations doesn't magically get cheaper just because the stock market is on sale. Chipotle doesn't get a discount on its flour, avocados, and beef just because it's share price dropped 50%. Now, if your point is that non-dividend paying Companies during a downturn could return a lot of shareholder value through buybacks, you would be correct, except then we're ignoring what actually happens when there is a crash - Companies get tight with their cash flow

But that's not how it works. Dividend stocks often crash more in a crash. And many of them actually drop their dividend in a crash (because companies get tight with their cash flow as you point out). So you're actually buying less back in those cases. And then when the market goes back up they pay out your dividend again.

Aphalite

  • Bristles
  • ***
  • Posts: 425
Re: Dividend Growth Funds
« Reply #12 on: May 12, 2015, 05:35:09 PM »
The dividend cash flow when the stock was "undervalued" didn't affect your situation at all. (unless we assume the dividends are taxable, in which case they left you worse off!)

Sky, I made a huge error when discussing treasury yield vs stock earnings yield with you previously, I'll try to incorporate all relevant factors this time, but forgive me if I miss something again

You scenario had very elegant math, but here's how I see the case unfolding:

Divcorp is valued at $100 (we'll assume for this exercise that it's perfectly valued by the market with respect to its cash generation capability), with $5 in earnings, for a very reasonable 20 P/E, it can get a return on assets of 5%, you own 10 shares

Scenario 1: Divcorp pays out $3 of its $5 earnings in dividends, for a div yield of 3%
Divcorp crashes from $100 to $50, pays out $3, and invests the $2 remaining back into the business, the $2 and $100 (just because price crashed doesn't mean it generates any less returns) generates 5% return and now Divcorp is worth 50+5+2+0.1 or 57.1, your $30 in dividends buys .577 shares (bought at 52, after dividend payout - $50 price + $2 retained earnings), and now you have 10.577 shares.

Divcorp decides to award management stock/stock options, and dilutes your position by 2%, now you have 10.365 shares (10.577*.98).

Divcorp then increases 100%, now your position is 10.365*57.1*2=$1,183.73

Scenario 2: Divcorp returns all of its earnings
Divcorp crashes from $100 to $50, and invests the $5 earnings into its business, this generates 5% return and now Divcorp is worth 50+5+5+.25 or 60.25, you have 10 shares

Divcorp decides to award management stock/stock options, and dilutes your position by 2%, now you have 9.8 shares

Divcorp then increases 100%, now your position is 9.8*60.25*2=$1,180.9

All in all, a small difference as you were only playing with $1000 to start, but I hope this illustrates my line of thinking - of course, there are sensitivities, if you can generate a higher return on your assets, for example, but in that case, the total earnings would also change (please excuse me if I have made any mistakes)

Aphalite

  • Bristles
  • ***
  • Posts: 425
Re: Dividend Growth Funds
« Reply #13 on: May 12, 2015, 05:42:48 PM »
But that's not how it works. Dividend stocks often crash more in a crash. And many of them actually drop their dividend in a crash (because companies get tight with their cash flow as you point out). So you're actually buying less back in those cases. And then when the market goes back up they pay out your dividend again.

I agree with you that there were a lot of financials (banks, GE capital, etc.) that stopped paying dividends during the crash, but there are even MORE companies that didn't, and in fact, raised their dividends during the crash. Here's a good real world story away from the elegant math of EMT that might be an interesting read for you - the two companies are valued differently, of course, but that's the point, IBM actually had better growth prospects than standard:

http://theinvestmentsblog.blogspot.com/2014/06/the-growth-trap-ibm-vs-standard-oil.html

Again, I'm with you all on the opinion that a dividend fund isn't worth buying, as you pointed out, some companies do cut dividends and get tight on their capital allocation when the market goes haywire. But I also think it's unwise to complete bet/trust in the companies' ability to continuously compound their earnings (the driver of firm value) once they reach the very top, which is what holding a large company that doesn't pay dividends is (and when you use index funds as your major source of investment income, the top 10 holdings can be up to 30% of your portfolio due to market cap weighting methodology)

Interest Compound

  • Pencil Stache
  • ****
  • Posts: 655
Re: Dividend Growth Funds
« Reply #14 on: May 12, 2015, 05:45:54 PM »
The dividend cash flow when the stock was "undervalued" didn't affect your situation at all. (unless we assume the dividends are taxable, in which case they left you worse off!)

Sky, I made a huge error when discussing treasury yield vs stock earnings yield with you previously, I'll try to incorporate all relevant factors this time, but forgive me if I miss something again

You scenario had very elegant math, but here's how I see the case unfolding:

Divcorp is valued at $100 (we'll assume for this exercise that it's perfectly valued by the market with respect to its cash generation capability), with $5 in earnings, for a very reasonable 20 P/E, it can get a return on assets of 5%, you own 10 shares

Scenario 1: Divcorp pays out $3 of its $5 earnings in dividends, for a div yield of 3%
Divcorp crashes from $100 to $50, pays out $3, and invests the $2 remaining back into the business, the $2 and $100 (just because price crashed doesn't mean it generates any less returns) generates 5% return and now Divcorp is worth 50+5+2+0.1 or 57.1, your $30 in dividends buys .577 shares (bought at 52, after dividend payout - $50 price + $2 retained earnings), and now you have 10.577 shares.

Divcorp decides to award management stock/stock options, and dilutes your position by 2%, now you have 10.365 shares (10.577*.98).

Divcorp then increases 100%, now your position is 10.365*57.1*2=$1,183.73

Scenario 2: Divcorp returns all of its earnings
Divcorp crashes from $100 to $50, and invests the $5 earnings into its business, this generates 5% return and now Divcorp is worth 50+5+5+.25 or 60.25, you have 10 shares

Divcorp decides to award management stock/stock options, and dilutes your position by 2%, now you have 9.8 shares

Divcorp then increases 100%, now your position is 9.8*60.25*2=$1,180.9

All in all, a small difference as you were only playing with $1000 to start, but I hope this illustrates my line of thinking - of course, there are sensitivities, if you can generate a higher return on your assets, for example, but in that case, the total earnings would also change (please excuse me if I have made any mistakes)

Your mistake is bolded in red above.  When Divcorp pays out $3, the price drops from 50 to 47.  You did not account for this, as in your next calculation you still have Divcorp priced at $50.

Aphalite

  • Bristles
  • ***
  • Posts: 425
Re: Dividend Growth Funds
« Reply #15 on: May 12, 2015, 05:51:37 PM »
Your mistake is bolded in red above.  When Divcorp pays out $3, the price drops from 50 to 47.  You did not account for this, as in your next calculation you still have Divcorp priced at $50.

Companies don't pay dividends out of their book value (at least, they shouldn't, since that would mean they're liquidating the business), they pay dividends out of earnings

When Divcorp crashes to 50, it still retains $2 out of the $5 it earned during the year, as such, it's valued at 52 immediately after payment of the dividend. At the end of the year, it will have generated another $5.10 in earnings (from it's $102 in assets), which, before dividend payment, would mean it's valued at $52+$5.1 = $57.1

Interest Compound

  • Pencil Stache
  • ****
  • Posts: 655
Re: Dividend Growth Funds
« Reply #16 on: May 12, 2015, 06:04:44 PM »
Your mistake is bolded in red above.  When Divcorp pays out $3, the price drops from 50 to 47.  You did not account for this, as in your next calculation you still have Divcorp priced at $50.

Companies don't pay dividends out of their book value (at least, they shouldn't, since that would mean they're liquidating the business), they pay dividends out of earnings

When Divcorp crashes to 50, it still retains $2 out of the $5 it earned during the year, as such, it's valued at 52 immediately after payment of the dividend. At the end of the year, it will have generated another $5.10 in earnings (from it's $102 in assets), which, before dividend payment, would mean it's valued at $52+$5.1 = $57.1

Ok, if you do it that way, then:

Scenario 1: 50 + 2 (earnings reinvested) = 52.  The $3 dividend gives you $30, which lets you buy 0.577 shares.  10 shares + 0.577 = 10.5769 shares, at $52 each = $550

Scenario 2: 50 + 5 (earnings reinvested) = 55.  10 shares at $55 each = $550

Aphalite

  • Bristles
  • ***
  • Posts: 425
Re: Dividend Growth Funds
« Reply #17 on: May 12, 2015, 06:11:52 PM »
Ok, if you do it that way, then:

Scenario 1: 50 + 2 (earnings reinvested) = 52.  The $3 dividend gives you $30, which lets you buy 0.577 shares.  10 shares + 0.577 = 10.5769 shares, at $52 each = $550

Scenario 2: 50 + 5 (earnings reinvested) = 55.  10 shares at $55 each = $550

Don't forget to dilute your positions and add in next year's expected earnings to the value of the company - I think this represents the real world economics of companies much better than a spot check right after a dividend payment

Interest Compound

  • Pencil Stache
  • ****
  • Posts: 655
Re: Dividend Growth Funds
« Reply #18 on: May 12, 2015, 06:19:52 PM »
Ok, if you do it that way, then:

Scenario 1: 50 + 2 (earnings reinvested) = 52.  The $3 dividend gives you $30, which lets you buy 0.577 shares.  10 shares + 0.577 = 10.5769 shares, at $52 each = $550

Scenario 2: 50 + 5 (earnings reinvested) = 55.  10 shares at $55 each = $550

Don't forget to dilute your positions and add in next year's expected earnings to the value of the company - I think this represents the real world economics of companies much better than a spot check right after a dividend payment

That's not relevant.  If you have an equivalent position immediately post dividend, further calculations won't affect that.  But sure:

Scenario 1: 10.5769 shares, at $52 each = $550

Diluted by 2%, I now have (10.5769 * .98) = 10.3653 shares * 52 share price = $539.  Price doubles, I now have $1,078.

Scenario 2: 10 shares at $55 each = $550

Diluted by 2%, I now have (10 * 0.98) = 9.8 shares * 55 share price = $539.  Price doubles, I now have $1,078.

Aphalite

  • Bristles
  • ***
  • Posts: 425
Re: Dividend Growth Funds
« Reply #19 on: May 12, 2015, 06:27:47 PM »
That's not relevant.  If you have an equivalent position immediately post dividend, further calculations won't affect that.  But sure:

Scenario 1: 10.5769 shares, at $52 each = $550

Diluted by 2%, I now have (10.5769 * .98) = 10.3653 shares * 52 share price = $539.  Price doubles, I now have $1,078.

Scenario 2: 10 shares at $55 each = $550

Diluted by 2%, I now have (10 * 0.98) = 9.8 shares * 55 share price = $539.  Price doubles, I now have $1,078.

Earnings - the company at its value of 52 generates $5.1 in earnings (100*5%+2*5%) - remember we're assuming the value is really $100 and investors are just panicked, since we're about to make the stock double

At 55 generates $5.25 in earnings (100*5%+5*5%)

Now it's 10.3653 * 57.1 (52+5.1) = 591.86, price doubles, you have 1183.72

9.8 * 60.25 (55+5.25) = 590.45, price doubles, you have 1180.9

You can change the earnings % (as long as you're applying the % to it's true value of 100) and still get the same answers - that's compounding at its finest - you're using cash flow to get a bigger share of the company's earnings and earning power, which didn't disappear just because its market value decreased, and it will continue to compound to higher and higher levels in the future (assuming I didn't make any additional mistakes in my math/assumptions - completely possible!)
« Last Edit: May 12, 2015, 06:34:40 PM by Aphalite »

Cathy

  • Handlebar Stache
  • *****
  • Posts: 1044
Re: Dividend Growth Funds
« Reply #20 on: May 12, 2015, 09:50:35 PM »
It's actually true that, from the perspective of an investor, dividends are superior to capital appreciation if the company is underpriced. I casually mentioned the same point in a much earlier post on this forum on February 5, 2015, without explaining the claim. Here's the explanation.

This argument assumes that the intrinsic value of the company is different from its market price, likely significantly different. Consider a company Q with an intrinsic value of $1000 per share. The value at which this stock trades on the open market -- i.e. its extrinsic value -- is currently $100 per share, i.e., the company is mispriced by the secondary market.

Consider an investor Jane who owns one share of Q.

Company Q normally does not pay dividends, but in the deep depths of this mispricing, the board of directors decides to keep shareholder morale high by paying a special dividend of $50 per share. Our hypothetical investor Jane receives $50 in cash and the market value of Q changes to $50 per share, so Jane is able to buy another share, and she now has two shares of Q. The intrinsic value of each share is $950 per share. In 2025, when the market value corrects to match the intrinsic value, Jane's holdings will be worth $1900.

Compare this to what would have happened if Q did not pay the special dividend. In that case, in 2025, Jane would have had a single share of Q valued at $1000. The payment of, and reinvestment of, the special dividend actually increased Jane's future wealth by $900.

Of course, as usual, a buyback would likely be an even better way to achieve this goal.

This theoretical argument falls into the group of "next level" issues we discuss on this forum from time to time, and I'm not suggesting that any action be taken based on it. The insight is just that the usual arguments about the irrelevance of dividends assume that the market has correctly priced the security relative to its intrinsic value. If it makes it easier to accept the argument, think of company Q as being a variant of BGC, mispriced by the market in the other direction, and authorised by its corporate documents to pay a lone special dividend.
« Last Edit: May 12, 2015, 11:22:04 PM by Cathy »

Roland of Gilead

  • Handlebar Stache
  • *****
  • Posts: 2296
Re: Dividend Growth Funds
« Reply #21 on: May 12, 2015, 10:48:39 PM »
I think a company should pay dividends.   What if you were self employed?   Would you not take money out of your company to pay for food, rent, other personal expenses?   Yes, you may funnel some of the profits back into the company to grow it, but paying yourself seems quite natural.

If you accept the idea that a shareholder is just a partial owner of a business, then why should they not receive some of the profits of the business each year to use for their personal reasons without having to sell out their share of the business?

Without dividends, you totally operate on a greater fool principle if you want to get money without having to sell out.

skyrefuge

  • Handlebar Stache
  • *****
  • Posts: 1015
  • Location: Suburban Chicago, IL
Re: Dividend Growth Funds
« Reply #22 on: May 12, 2015, 11:25:19 PM »
    Sky, I made a huge error when discussing treasury yield vs stock earnings yield with you previously, I'll try to incorporate all relevant factors this time, but forgive me if I miss something again

    The flaw in your analysis is hiding in the implicit assumption that you can acquire capital (by buying the company's stock) for a lower cost than the companies themselves can acquire capital for their own expansion.

    (also, your example had more details than necessary, so I'm paring it down. The dilution/regrowth don't add anything so I'm dropping those. A 100% dividend payout by Divcorp also would have been easier than a 60/40 split, but I'll hang onto that 60/40 for consistency. And you essentially mashed two earnings cycles into one, so I'm splitting those out individually.)

    So, let's get a little more concrete in our example. Divcorp and Capgains are both companies that own magic geese. These geese each shit out a $5 bill every December. The market values each goose at $100, for a very reasonable 20 P/E. Each company owns 100 of these geese, and has 100 shares outstanding, for a $10k market cap. You own 10 shares (10%) of each goose holding company.

    • A chaotic neutral 16th-level Mage has appeared in the kingdom, and investors believe he will cast a Constipation spell on the magic geese, causing them each to only shit out $2.50 instead of $5 this December. So the share price of both companies crashes 50%, from $100 to $50, maintaining the expected 5% return on assets.
    • The geese made their saving throw vs. poop spells, so they in fact still shit out $5 in December, for total earnings of $500. The market is unware that the mage's spell didn't work, so they still undervalue the companies by 50%.
      • Divcorp:
        • Divcorp keeps 40% of earnings ($200) and pays out 60% ($300) in dividends. It buys $200 worth of geese. Even though it knows its own $50 geese are healthy, Divcorp pays $100/goose for a new strain of goose immune to Constipation spells, and thus, only acquires 2.
        • 100 geese valued at $50/goose + 2 @ $100/goose = $5200mkt cap = $52/share
        • $300*10% = $30 dividend = .577 shares @ $52/share, so you now own 10.577 shares out of 100, or 10.577%
        • Next year: 102 geese * $5 shit (the mage's spell failed again) = $510 earnings
        • $5200 + $510 = $5710mkt cap (this year we'll say they just retained the earnings in cash for simplicity).
        • 10.577% * $5710 = $603.9467

        Capgains:
        • Capgains keeps 100% of earnings ($500). It buys $500 worth of geese, again at $100/goose, and thus, only acquires 5.
        • 100 geese valued at $50/goose + 5 @ $100/goose = $5500mkt cap = $55/share
        • Next year: 105 geese * $5 shit = $525 earnings
        • $5500 + $525 = $6025mkt cap
        • 10% * $6025 = $602.5

    This is the same 0.24% difference in your $1,183.73 vs. $1,180.9 numbers.

    Capgains loses in this case because it acquired all of its new geese at $100/goose, while your holding in Divcorp added 40% of its geese at a rate of $100/goose, and 60% at a rate of $50/goose (the latter by acquiring a portion of an undervalued goose holding company rather than buying geese directly).  If the companies would have instead been able to acquire all their new magic geese at the undervalued-rate of $50, then both end equal, at $605.

    As we see, your assumption about differing costs of geese is not an impossible situation in the real world, and if in fact the public can acquire geese for less than Capgains can for some reason, then Capgains should not be reinvesting its own money in new geese, because it would be violating its mandate to maximize shareholder value. Instead, it should spend its earnings on a share buyback. After all, it knows its own geese are healthy. By buying when its shares (aka, geese) are undervalued by 50%, it is achieving the same 50% discount that you get by reinvesting dividends in Divcorp, and it's that reinvesting-at-a-discount that boosts returns.

    As forummm points out, any advantage gained by automatic dividend reinvestment in Divcorp when its shares are "undervalued" is canceled out by dividend reinvestment at times when its shares are "overvalued". Likewise, when Capgains is "overvalued" and trading at $200/goose, you definitely want it to plow its earnings back into new geese at $100/goose. Since there's no reason to believe shares are undervalued more often than they're overvalued, this shows that, while there are times when dividend reinvestment gives an investor an advantage, there is no general advantage to be gained there.

    If you think you have a better idea than the market does about when companies are overvalued or undervalued (hint: you probably don't), then you should actively be managing your portfolio anyway, rather than letting things like automatic dividend reinvestment manipulate your allocations.

    In a shocking twist, the next year it's discovered that the Constipation spell was in fact a Dastardly Delayed Spell of Constipation. It takes effect two years after it's cast, and all 200 original geese now only shit out two $1 bills and a couple quarters every December. The newly-acquired immune geese still keep up their $5 output, however. Since your Capgains holding has 4.8% (5/105) immune geese vs. your Divcorp holding of 2% (2/102) immune geese, Capgains' growth strategy suddenly isn't looking so inferior any more. And nor is the market's decision to cut the value of the companies in half two years earlier.[/list]
    « Last Edit: May 12, 2015, 11:33:47 PM by skyrefuge »

    MDM

    • Senior Mustachian
    • ********
    • Posts: 10630
    Re: Dividend Growth Funds
    « Reply #23 on: May 13, 2015, 12:16:54 AM »
    Of course, as usual, a buyback would likely be an even better way to achieve this goal.
    That (which is better: dividend or buyback?) is an interesting question.  Using some quick spreadsheet calcs (attached here FWIW), "it depends" on the stock price increases due to dividend reinvestment vs. buybacks.

    If the stock price doesn't change in either case, it seems the results are identical for Jane: her current market value would be $100 and her long term value would be $1,900.

    Let's say there are 100,000 shares available.

    If we assume
     - the publicity regarding the dividend or buyback causes the stock price to increase (from $50 in the dividend case and $100 in the buyback), and
     - Jane's dividend reinvestment buys at 50% of the market price increase
     - the buyback average cost is 50% of the market price increase
    then things change.

    E.g., let's further assume that in both cases the market price increase by 10% - to $60 with the dividend and $120 in the buyback.
     - Jane's $50 buys 0.91 shares ($50/$55/share)
     - the buyback purchases 45,454.5 shares ($5,000,000/$110/share)

    At this point,
     - for the dividend case, Jane has 1.91 shares now worth $  60/share and with $   950/share intrinsic value.  Jane's current value is $115 and her long term value is $1,814.
     - for the buyback case, Jane has 1.00 shares now worth $120/share and with $1,742/share intrinsic value.  Jane's current value is $120 and her long term value is $1,742.

    The buyback appears better for Jane in the near term, but in the long run the reinvested dividend is better.

    But for Mary the CEO, her options to buy 1,000 shares at $40/share are worth much more in any buyback case - which, I believe, is why one sees more and more buybacks driven by CEOs....

    Or did I fat-finger a number or formula somewhere, or use inappropriate assumptions?

    kgoodguitar

    • 5 O'Clock Shadow
    • *
    • Posts: 5
    Re: Dividend Growth Funds
    « Reply #24 on: May 13, 2015, 07:21:44 AM »
    I'm still getting my sea-legs with stock valuation, however:

    1) Those who are bullish on the market say a rise in interest rates is already priced into stocks (while I wouldn't disagree with this, I'm hardly bullish)
    2) While the 30 year bond rate may rise, but a 30 year bond is pretty high risk (for bonds). You're basically making a bet on what interest rates will be from now until 2045. If rates go up, the value of your bond goes down. Buffet's letters to stockholders from somewhere in the early to mid 80s talks about this (or maybe very late 70s), as does the article recommended below.
    3) With that it mind, you may consider short and intermediate term bonds to reduce volatility in the bond segment. Yes, it reduces yield, but increases stability (which is what the bonds are for, no?)

    I personally utilize Paul Merriman's Ultimate Buy and Hold strategy ( a google search will pull it up). Also, I'm nowhere near retirement (except in lifestyle; I live very frugally and work about 1/4 to 1/2 time for myself making a respectable living), so my outlook may be a bit different.

    brooklynguy

    • Handlebar Stache
    • *****
    • Posts: 2204
    • Age: 40
    Re: Dividend Growth Funds
    « Reply #25 on: May 13, 2015, 07:29:10 AM »
    Divcorp and Capgains are both companies that own magic geese. These geese each shit out a $5 bill every December.

    Whoever is keeping tracking of the Hall of Fame posts, please add this one by skyrefuge.  The dividend-focused investor's classic false comparison of a dividend-paying stock to an egg-laying chicken has now been forever replaced in my mind with a dollar-shitting goose.

    - the publicity regarding the dividend or buyback causes the stock price to increase (from $50 in the dividend case and $100 in the buyback)

    Are you saying that there was a disproportional increase in market price as between the dividend case and the buyback case?  If so, I think that is an inappropriate assumption.

    beltim

    • Magnum Stache
    • ******
    • Posts: 2961
    Re: Dividend Growth Funds
    « Reply #26 on: May 13, 2015, 07:45:37 AM »
    Divcorp and Capgains are both companies that own magic geese. These geese each shit out a $5 bill every December.

    Whoever is keeping tracking of the Hall of Fame posts, please add this one by skyrefuge.  The dividend-focused investor's classic false comparison of a dividend-paying stock to an egg-laying chicken has now been forever replaced in my mind with a dollar-shitting goose.

    Hear, hear!

    And, while, it's been fascinating to watch this theoretical exchange, I'm going to fling some reality poo into this thread.  My reason for preferring dividends to stock buybacks is behavioral in nature.  Simply put, managers are terrible at determining appropriate times to buy back stock - they're most likely to when their stock is doing well and the price is high, and least likely to when the stock price is low.  In many cases they actually destroy value during this process.  To some extent this can be true of dividends, except that in the US most companies pay a relatively stable dividend, increasing it when appropriate, but rarely decreasing it (especially compared to buybacks).

    https://doc.research-and-analytics.csfb.com/docView?language=ENG&source=emfromsendlink&format=PDF&document_id=979523241&serialid=cbWwRRD8BPCNJ%2B%2BehG6tXJo50lwZZncJDGPsGRFN%2B54%3D
    « Last Edit: May 13, 2015, 08:34:08 AM by beltim »

    Aphalite

    • Bristles
    • ***
    • Posts: 425
    Re: Dividend Growth Funds
    « Reply #27 on: May 13, 2015, 08:32:59 AM »
    The flaw in your analysis is hiding in the implicit assumption that you can acquire capital (by buying the company's stock) for a lower cost than the companies themselves can acquire capital for their own expansion.

    ...

    As we see, your assumption about differing costs of geese is not an impossible situation in the real world, and if in fact the public can acquire geese for less than Capgains can for some reason, then Capgains should not be reinvesting its own money in new geese, because it would be violating its mandate to maximize shareholder value. Instead, it should spend its earnings on a share buyback. After all, it knows its own geese are healthy. By buying when its shares (aka, geese) are undervalued by 50%, it is achieving the same 50% discount that you get by reinvesting dividends in Divcorp, and it's that reinvesting-at-a-discount that boosts returns.

    As forummm points out, any advantage gained by automatic dividend reinvestment in Divcorp when its shares are "undervalued" is canceled out by dividend reinvestment at times when its shares are "overvalued". Likewise, when Capgains is "overvalued" and trading at $200/goose, you definitely want it to plow its earnings back into new geese at $100/goose. Since there's no reason to believe shares are undervalued more often than they're overvalued, this shows that, while there are times when dividend reinvestment gives an investor an advantage, there is no general advantage to be gained there.

    I agree with everything you wrote - but again, the OP's question was what happens in a downturn, and my point (please re-read my opening post again, it contains very specific qualifications) is that dividends have an advantage in a downturn because you're buying at a market value that's lower than intrinsic value. As you and forummm have said, the reverse is true during "overvaluation" - and no one can say for sure when under or over occurs, because price isn't only related to fundamentals, but also psychology and optimism as well. Again, we're talking real world economics and corporate behavior, not EMT's world view of things

    Cathy's post also contains the same points that I am trying to make - buybacks would be better because you avoid dividend tax, but as I've already discussed with forummm - companies get tight with cash flow during market downturns, tho they're more loathe to cut dividends than to stop a repurchase program - it's a US cultural thing

    Jeff Immelt of GE said that if he were in 2009 again, he would absolutely cut dividend again because it saved the Company, but it really weighed on him - European companies have no problems cutting dividends, but in the US it's some sort of sacred cow - see beltim's post above mine for what happens in reality

    Aphalite

    • Bristles
    • ***
    • Posts: 425
    Re: Dividend Growth Funds
    « Reply #28 on: May 13, 2015, 08:45:06 AM »
    Whoever is keeping tracking of the Hall of Fame posts, please add this one by skyrefuge.  The dividend-focused investor's classic false comparison of a dividend-paying stock to an egg-laying chicken has now been forever replaced in my mind with a dollar-shitting goose.

    I'm not comparing a dividend-paying stock to an (golden?) egg-laying chicken (goose?), I'm saying that in certain real world situations, dividends have an advantage. In other situations, dividends would not be advantageous, since you have to deal with the tax hurdle as well. But I think it's dishonest and disingenious to write off dividends as being no different to growth, which is the insinuation when you and other posters in the forum equate dividends with "false" illusions - the market changes all the time, and you end up in these situations where short term results (buying in at a low price) influences long term compounding pretty heavily - at other times, dividend reinvestment can lag growth because you're hit with a Dastardly Delayed Spell of Constipation

    MDM

    • Senior Mustachian
    • ********
    • Posts: 10630
    Re: Dividend Growth Funds
    « Reply #29 on: May 13, 2015, 09:21:33 AM »
    - the publicity regarding the dividend or buyback causes the stock price to increase (from $50 in the dividend case and $100 in the buyback)
    Are you saying that there was a disproportional increase in market price as between the dividend case and the buyback case?
    Nope - assumed a 20% increase for each: $10/share for the dividend case and $20/share for the buyback.

    skyrefuge

    • Handlebar Stache
    • *****
    • Posts: 1015
    • Location: Suburban Chicago, IL
    Re: Dividend Growth Funds
    « Reply #30 on: May 13, 2015, 10:20:38 AM »
    I agree with everything you wrote - but again, the OP's question was what happens in a downturn, and my point (please re-read my opening post again, it contains very specific qualifications) is that dividends have an advantage in a downturn because you're buying at a market value that's lower than intrinsic value.

    Yep. Here's what I would have continued to write last night if it hadn't been way past my bedtime:

    It's an interesting factoid that reinvested dividends are advantageous during periods of undervaluation, but how is that knowledge actionable? How can you take advantage of it? Do you turn on "automatic dividend reinvestment" when you know shares are undervalued, and turn it off when you know they're overvalued? At that point you're just becoming an active trader, and should make an active decision to reinvest or not at every dividend payout.

    (And if you're at that point, you should always prefer buybacks to dividends as a method to return cash to shareholders, because buybacks allow you the same flexibility to decide on your own whether the company is undervalued (in which case you should reinvest dividends, or hold your shares in a buyback), or overvalued (in which case you should invest your dividends elsewhere, or sell shares back to the company), while additionally giving you some control over taxation.)

    I operate with an underlying assumption that the company is making the best use of its capital that they know how. In some cases that may mean returning cash to shareholders (via dividends or buybacks), and in others it may mean investing to grow their business. It's under this assumption that dividends are "the same" as growth, and thus, no favoritism should be given to dividends (nor to growth). In other words, they know better than me how to make me rich, so go do your thing, boys.

    Dividends are only better than growth when you can do a better job of compounding capital than the company can. For this to make you generally favor dividends over growth, you have to operate under the opposite of my assumption, and believe that capital decisions are made by a bunch of idiots who always make the wrong choices. I generally don't think it's worth addressing that assumption, because if that's your belief, why the hell are you invested in those terrible companies in the first place? That's why I don't think it's dishonest or disingenuous to ignore the alternate universe that operates under this assumption. If anything, the disingenuousness comes from investors who are so distrustful of a company's management that they demand all earnings be returned to them, yet somehow can't find a better place to put their money. Really bro? I think you just enjoy bitching, and telling yourself how much smarter you are than corporate finance managers.

    brooklynguy

    • Handlebar Stache
    • *****
    • Posts: 2204
    • Age: 40
    Re: Dividend Growth Funds
    « Reply #31 on: May 13, 2015, 10:27:33 AM »
    But I think it's dishonest and disingenious to write off dividends as being no different to growth, which is the insinuation when you and other posters in the forum equate dividends with "false" illusions

    I agree (to an extent), which is why I made a similar point just last week, and I agree with Cathy's nicely illustrated example above.  But my comment about the "false" comparison, and the skyrefuge-led campaign in this forum against the fallacies inherent in most dividend-focused investment strategies, are targeted at the first-order misunderstanding many investors clearly have (as evidenced by the misinformed posts that routinely show up in the forum on this topic) about the operation of dividends and corporate finance in general.

    - the publicity regarding the dividend or buyback causes the stock price to increase (from $50 in the dividend case and $100 in the buyback)
    Are you saying that there was a disproportional increase in market price as between the dividend case and the buyback case?
    Nope - assumed a 20% increase for each: $10/share for the dividend case and $20/share for the buyback.

    Ok, now I looked at your spreadsheet and see what you did.  Under either scenario (dividend or buyback), in the aggregate, this is what's happening (assuming, in the dividend scenario, that every shareholder/dividend-recipient reinvests the dividend received by him/her/it):  the company is taking $5M of its cash on hand, distributing that cash outside of itself, and then those five million dollars are being used (by the shareholder/dividend-recipients, in the dividend scenario, and by the company itself, in the buyback scenario) to purchase shares of the company.  In the dividend scenario, the company's divestiture of $5M has already been priced into the market price when the share purchase occurs (i.e., the dividends are reinvested at a market price of $60 in your example), but in the buyback scenario, the company's divestiture of $5M has not been priced into the market price when the share purchase occurs (i.e., the company is conducting the buyback at a market price of $110 in your example), because in the latter case the share purchase occurs before (or, more accurately, simultaneously with) the parting of the company and its cash.  I think that is the questionable assumption in your hypothetical -- the market knows that the company will be parting with $5M in cash, so why doesn't it price in that knowledge?  (Of course, in the hypothetical, the market was so grossly inefficient/irrational in the first place as to underprice the company by 90%, but if we're going to stick to an apples-to-apples comparison of the two scenarios, I think you need to assume that the $5M cash divestiture gets priced into the market price under either scenario.)

    MDM

    • Senior Mustachian
    • ********
    • Posts: 10630
    Re: Dividend Growth Funds
    « Reply #32 on: May 13, 2015, 10:40:54 AM »
    Ok, now I looked at your spreadsheet and see what you did.  Under either scenario (dividend or buyback), in the aggregate, this is what's happening (assuming, in the dividend scenario, that every shareholder/dividend-recipient reinvests the dividend received by him/her/it):  the company is taking $5M of its cash on hand, distributing that cash outside of itself, and then those five million dollars are being used (by the shareholder/dividend-recipients, in the dividend scenario, and by the company itself, in the buyback scenario) to purchase shares of the company.  In the dividend scenario, the company's divestiture of $5M has already been priced into the market price when the share purchase occurs (i.e., the dividends are reinvested at a market price of $60 in your example), but in the buyback scenario, the company's divestiture of $5M has not been priced into the market price when the share purchase occurs (i.e., the company is conducting the buyback at a market price of $110 in your example), because in the latter case the share purchase occurs before (or, more accurately, simultaneously with) the parting of the company and its cash.  I think that is the questionable assumption in your hypothetical -- the market knows that the company will be parting with $5M in cash, so why doesn't it price in that knowledge?  (Of course, in the hypothetical, the market was so grossly inefficient/irrational in the first place as to underprice the company by 90%, but if we're going to stick to an apples-to-apples comparison of the two scenarios, I think you need to assume that the $5M cash divestiture gets priced into the market price under either scenario.)
    That could be true.  The spreadsheet does assume the $5M decreased the intrinsic value in both cases.

    In support of the stated assumptions on market price, the stock exchange will drop the opening price of the stock when a dividend occurs but will not do so when a company is doing a buyback.  Depends, perhaps, on how efficient the market is...and as noted we're already assuming gross inefficiency. ;)

    This also starts to get into the issue of "do companies overpay when doing buybacks?"....


    Cathy

    • Handlebar Stache
    • *****
    • Posts: 1044
    Re: Dividend Growth Funds
    « Reply #33 on: May 13, 2015, 10:49:06 AM »
    Of course, as usual, a buyback would likely be an even better way to achieve this goal.
    That (which is better: dividend or buyback?) is an interesting question.  Using some quick spreadsheet calcs (attached here FWIW), "it depends" on the stock price increases due to dividend reinvestment vs. buybacks.

    If the stock price doesn't change in either case, it seems the results are identical for Jane: her current market value would be $100 and her long term value would be $1,900.

    The difference I was intending to allude to with my quote was that buybacks allow the owners to defer the payment of taxes, whereas dividends (if made out of earnings and profit) require income to be realised immediately. (In the case of a true BGC company with no income, the so-called dividends would not be taxable to the shareholder, but in the case of a real life company, they typically would be.)

    As for your specific example, brooklynguy has already given the same response that I would have posted, but I will phrase it in a way that I find more intuitive. The questionable assumption in your example is that you have applied the 20% growth factor unfairly between the two cases:
    • In the case of the buyback, you have calculated the 20% growth based on the market capitalisation before the corporate event.
    • In the case of the dividend, you have calculated the 20% growth based on the market capitalisation after the corporate event.

    While we could debate which makes more sense, in my view there's no obvious reason to think that it would be different between the two corporate events.

    MDM

    • Senior Mustachian
    • ********
    • Posts: 10630
    Re: Dividend Growth Funds
    « Reply #34 on: May 13, 2015, 11:07:28 AM »
    The difference I was intending to allude to with my quote was that buybacks allow the owners to defer the payment of taxes, whereas dividends (if made out of earnings and profit) require income to be realised immediately. (In the case of a true BGC company with no income, the so-called dividends would not be taxable to the shareholder, but in the case of a real life company, they typically would be.)

    As for your specific example, brooklynguy has already given the same response that I would have posted, but I will phrase it in a way that I find more intuitive. The questionable assumption in your example is that you have applied the 20% growth factor unfairly between the two cases:
    • In the case of the buyback, you have calculated the 20% growth based on the market capitalisation before the corporate event.
    • In the case of the dividend, you have calculated the 20% growth based on the market capitalisation after the corporate event.

    While we could debate which makes more sense, in my view there's no obvious reason to think that it would be different between the two corporate events.
    Yes, taxation of dividends could affect things, depending on Jane's situation.  For simplicity I'll assume Jane pays no taxes on the dividend.

    For growth, if we assume
     - equal $/share increases, e.g., $10/share
       - the short term market value is greater for the dividend ($115) than the buyback ($110) but the long term values are equal ($1,814).

     - equal market caps ($6,000,000) after the events
       - both the short term ($115 vs. $113) and long term ($1,814 vs. $1,790) favor the dividend.

    In all cases Mary's stock options are far better due to the higher share price after the buyback - is that what you see also?

    Interest Compound

    • Pencil Stache
    • ****
    • Posts: 655
    Re: Dividend Growth Funds
    « Reply #35 on: May 13, 2015, 01:22:04 PM »
    It's actually true that, from the perspective of an investor, dividends are superior to capital appreciation if the company is underpriced. I casually mentioned the same point in a much earlier post on this forum on February 5, 2015, without explaining the claim. Here's the explanation.

    This argument assumes that the intrinsic value of the company is different from its market price, likely significantly different. Consider a company Q with an intrinsic value of $1000 per share. The value at which this stock trades on the open market -- i.e. its extrinsic value -- is currently $100 per share, i.e., the company is mispriced by the secondary market.

    Consider an investor Jane who owns one share of Q.

    Company Q normally does not pay dividends, but in the deep depths of this mispricing, the board of directors decides to keep shareholder morale high by paying a special dividend of $50 per share. Our hypothetical investor Jane receives $50 in cash and the market value of Q changes to $50 per share, so Jane is able to buy another share, and she now has two shares of Q. The intrinsic value of each share is $950 per share. In 2025, when the market value corrects to match the intrinsic value, Jane's holdings will be worth $1900.

    Compare this to what would have happened if Q did not pay the special dividend. In that case, in 2025, Jane would have had a single share of Q valued at $1000. The payment of, and reinvestment of, the special dividend actually increased Jane's future wealth by $900.

    Of course, as usual, a buyback would likely be an even better way to achieve this goal.

    This theoretical argument falls into the group of "next level" issues we discuss on this forum from time to time, and I'm not suggesting that any action be taken based on it. The insight is just that the usual arguments about the irrelevance of dividends assume that the market has correctly priced the security relative to its intrinsic value. If it makes it easier to accept the argument, think of company Q as being a variant of BGC, mispriced by the market in the other direction, and authorised by its corporate documents to pay a lone special dividend.

    In one case, the stock grows from $50 to $950, a 19x gain.  In the other case it grows from $100 to $1000, a 10x gain.  Under these conditions, it makes sense for the 19x gain to have more profit.  I understand the assumption relies on the intrinsic value of the company not changing, but perhaps the fact that we don't see dividend stocks performing better after a crash tells us that the market is pretty good at determining a company's intrinsic value?

    Cathy

    • Handlebar Stache
    • *****
    • Posts: 1044
    Re: Dividend Growth Funds
    « Reply #36 on: May 13, 2015, 03:12:26 PM »
    Yes, taxation of dividends could affect things, depending on Jane's situation.  For simplicity I'll assume Jane pays no taxes on the dividend.

    For growth, if we assume
     - equal $/share increases, e.g., $10/share
       - the short term market value is greater for the dividend ($115) than the buyback ($110) but the long term values are equal ($1,814).

     - equal market caps ($6,000,000) after the events
       - both the short term ($115 vs. $113) and long term ($1,814 vs. $1,790) favor the dividend.

    In all cases Mary's stock options are far better due to the higher share price after the buyback - is that what you see also?

    Regarding the options contracts, that's not a fundamental difference between dividends and buybacks. Mary prefers a buyback solely because her contracts specify a fixed strike value, but the board could have drafted those contracts differently to adjust the strike price based on the number of shares outstanding, or any number of other possible versions of the contracts. In fact, there could be a term in the contract providing that if the company ever does a buyback, then Mary's options becomes wholly worthless.

    As far the other scenarios, only the first one seems logical to me (what you describe as equal dollar share increase). This is consistent with my previous post. The way I see it, there are two logical ways that the market could apply your hypothetical 20% growth factor.

    The first way would be for the market to apply the 20% growth before considering the corporate action. In this method, the market value of the company before the announcement is $10 million and then after the announcement, the market revises its valuation to $12 million. With 100,000 shares outstanding, the market value of each share will increase by $20, regardless of whether the subsequent return to shareholders is through a dividend or buyback. Consistent with your model, we can assume that the increase is gradual and that the corporate action will take place in the middle of it, but either way, it will be the same dollar value in either case, because it was calculated by the market before considering the corporate action.

    The second way the market could react would be to apply the 20% after considering the corporate action. In this method, the market value of the company before the announcement is $10 million, but the market is going to subtract the amount of the upcoming cash expenditure before applying the 20% factor, because the market reasons that the cash that is about to be ejected is not available for compounding. With a cash expenditure of $5 million (for the $50 special dividend per share or equivalent buyback), the market would calculate the 20% growth per share as 20%*($5 million)/100,000=$10. In this case, the market value of each share will increase by $10, regardless of whether the subsequent return to shareholders is through a dividend or buyback. Consistent with your model, we can assume that the increase is gradual and that the corporate action will take place in the middle of it, but either way, it will be the same dollar value in either case, because it was calculated by the market after considering the corporate action.

    In summary, if the 20% growth factor is applied in a logically consistent fashion, then it does not appear to be relevant to the long-term analysis. It only seems to make a difference in the long-term if you apply the growth factor in a manner that seems irrational to me, whereupon you assume that the fact that a buyback is being used rather than a dividend causes the shares to increase by more.

    My analysis here (and in my previous post) is equivalent to the analysis in brooklynguy's post, but I thought this way of phrasing it was easier to agree with, but I may have been wrong about that.

    ***

    The other point is this. My analysis does not assume that the market is inefficient. The large gap between the market and intrinsic value could be due to something that is unknowable to the market, not something that the market has irrationally failed to incorporate into the price despite knowledge of same. For instance, the management of Q might be sitting on an invention that they know will radically alter the world, but they haven't announced it yet and won't announce it until it's done in 2025. In this case, an insider of Q would know that Q is seriously underpriced, but the market has no way of knowing that, so the gross mispricing of Q is not inconsistent with most versions of the efficient market hypothesis.
    « Last Edit: May 13, 2015, 03:45:16 PM by Cathy »

    brooklynguy

    • Handlebar Stache
    • *****
    • Posts: 2204
    • Age: 40
    Re: Dividend Growth Funds
    « Reply #37 on: May 13, 2015, 03:50:03 PM »
    Yes, taxation of dividends could affect things, depending on Jane's situation.  For simplicity I'll assume Jane pays no taxes on the dividend.

    For growth, if we assume
     - equal $/share increases, e.g., $10/share
       - the short term market value is greater for the dividend ($115) than the buyback ($110) but the long term values are equal ($1,814).

     - equal market caps ($6,000,000) after the events
       - both the short term ($115 vs. $113) and long term ($1,814 vs. $1,790) favor the dividend.

    In all cases Mary's stock options are far better due to the higher share price after the buyback - is that what you see also?

    I was working on a response to this, but I'm glad Cathy beat me to it because her response is much clearer than the draft I had going.

    Regarding the options contracts, that's not a fundamental difference between dividends and buybacks. Mary prefers a buyback solely because her contracts specify a fixed strike value, but the board could have drafted those contracts differently to adjust the strike price based on the number of shares outstanding, or any number of other possible versions of the contracts. In fact, there could be a term in the contract providing that if the company ever does a buyback, then Mary's options becomes wholly worthless.

    Right - in the real world, I believe most executive compensation option contracts have anti-dilution protection provisions to protect the option-holder against the converse of what we're talking about here (i.e., dilution of share value resulting from issuance of additional shares), and I think the way those provisions are usually drafted they would also have the effect of serving as "anti-concentration protection" to protect the option-issuer in the manner you described here--but I'm not completely sure about that, and it's an interesting question.

    MDM

    • Senior Mustachian
    • ********
    • Posts: 10630
    Re: Dividend Growth Funds
    « Reply #38 on: May 13, 2015, 04:27:13 PM »
    Regarding the options contracts, that's not a fundamental difference between dividends and buybacks. Mary prefers a buyback solely because her contracts specify a fixed strike value, but the board could have drafted those contracts differently to adjust the strike price based on the number of shares outstanding, or any number of other possible versions of the contracts. In fact, there could be a term in the contract providing that if the company ever does a buyback, then Mary's options becomes wholly worthless.
    Right - in the real world, I believe most executive compensation option contracts have anti-dilution protection provisions to protect the option-holder against the converse of what we're talking about here (i.e., dilution of share value resulting from issuance of additional shares), and I think the way those provisions are usually drafted they would also have the effect of serving as "anti-concentration protection" to protect the option-issuer in the manner you described here--but I'm not completely sure about that, and it's an interesting question.
    Haven't been a CEO at multiple companies and thus can't give a first person sampling. ;)

    But I believe this version of the Golden Rule applies: "Whose who have the gold make the rules." Thus the majority of (if not all) executive stock options have one-sided protection: the option price changes if there is an announced stock split, but not if the company does a buyback.

    Google   executive stock options buyback   for a plethora of articles on the topic.

    MDM

    • Senior Mustachian
    • ********
    • Posts: 10630
    Re: Dividend Growth Funds
    « Reply #39 on: May 13, 2015, 04:35:06 PM »
    As far the other scenarios, only the first one seems logical to me (what you describe as equal dollar share increase).

    The first way would be for the market to apply the 20% growth before considering the corporate action. In this method, the market value of the company before the announcement is $10 million and then after the announcement, the market revises its valuation to $12 million. With 100,000 shares outstanding, the market value of each share will increase by $20, regardless of whether the subsequent return to shareholders is through a dividend or buyback. Consistent with your model, we can assume that the increase is gradual and that the corporate action will take place in the middle of it, but either way, it will be the same dollar value in either case, because it was calculated by the market before considering the corporate action.

    I can buy that, if for no other reason than limiting the number of if-then scenarios for discussion.  Back to:
    Of course, as usual, a buyback would likely be an even better way to achieve this goal.
    Is that based on the assumption that dividends will be taxed and thus decrease money available to Jane?

    Cathy

    • Handlebar Stache
    • *****
    • Posts: 1044
    Re: Dividend Growth Funds
    « Reply #40 on: May 13, 2015, 05:00:54 PM »
    Of course, as usual, a buyback would likely be an even better way to achieve this goal.
    Is that based on the assumption that dividends will be taxed and thus decrease money available to Jane?

    I already explained that quote above:

    The difference I was intending to allude to with my quote was that buybacks allow the owners to defer the payment of taxes, whereas dividends (if made out of earnings and profit) require income to be realised immediately. (In the case of a true BGC company with no income, the so-called dividends would not be taxable to the shareholder, but in the case of a real life company, they typically would be.)

    In other words, from the perspective of an investor, and if all else is equal, buybacks are likely to be better because of providing more control to the shareholder over when to realise the income. The use of the word "likely" is intentional in recognition of the fact that it does not always apply. The use of the prefix "of course" was because the last time I mentioned something about dividends, posters were quick to point out that it also applied to buybacks, which was true but also beside the point.

    MDM

    • Senior Mustachian
    • ********
    • Posts: 10630
    Re: Dividend Growth Funds
    « Reply #41 on: May 13, 2015, 05:02:59 PM »
    The use of the prefix "of course" was because the last time I mentioned something about dividends, posters were quick to point out that it also applied to buybacks, which was true but also beside the point.
    Ah, now I get it....

    brooklynguy

    • Handlebar Stache
    • *****
    • Posts: 2204
    • Age: 40
    Re: Dividend Growth Funds
    « Reply #42 on: May 14, 2015, 06:52:35 AM »
    Haven't been a CEO at multiple companies and thus can't give a first person sampling. ;)

    But I believe this version of the Golden Rule applies: "Whose who have the gold make the rules." Thus the majority of (if not all) executive stock options have one-sided protection: the option price changes if there is an announced stock split, but not if the company does a buyback.

    Google   executive stock options buyback   for a plethora of articles on the topic.

    The protection doesn't seem to be completely one-sided, because most of these articles discuss the incentive that exists for executives to cause buybacks in order to counteract the dilutive effect of stock option exercises in general, which would not be necessary if the executive stock options had strong anti-dilution protection against all dilutive stock issuances.

    Originally I was thinking of the types of anti-dilution provisions I have seen in convertible preferred or debt instruments of closely held companies, where the common equity conversion rate gets adjusted such that the holder will always receive the same percentage of the total outstanding common equity (and which is why, in practice, these features serve as reciprocal protection against both dilution and concentration).

    But, on reflection, it should have been obvious that stock options (especially for publicly held companies) may not work the same way.  I might ask one of my colleagues who specializes in executive compensation about this later today.

    theoverlook

    • Bristles
    • ***
    • Posts: 398
    Re: Dividend Growth Funds
    « Reply #43 on: May 14, 2015, 07:12:32 AM »

    Companies don't pay dividends out of their book value (at least, they shouldn't, since that would mean they're liquidating the business), they pay dividends out of earnings


    They don't pay dividends out of their book value, but their shares sold on the exchange reflect the dividends built into them.  The share prices will drop upon payment of the dividend, by the amount of the dividend.

    Just chose the first match on Google as a source, I'm sure there are better ones:

    http://www.investopedia.com/articles/stocks/07/dividend_implications.asp says "On the ex-dividend date, the stock price is adjusted downward by the amount of the dividend by the exchange on which the stock trades."