- The video discusses the concept of dividend irrelevance in finance.
- Dividend investing is a popular style where investors focus on companies that pay dividends.
- Dividend irrelevance argues that dividends are not a source of investment returns, but rather a way of delivering returns to investors.
- Dividend irrelevance suggests that investors can achieve the same result by selling some of their capital gains.
- The theory assumes that dividend policy does not impact the value of a stock, but there are real-world implications such as tax differences and market inefficiencies.
- Dividend policy can serve as a signal to investors about a company's future success.
- The theory also assumes that management always acts in the best interest of investors, but there have been instances of abuse.
- Dividends can help reduce agency costs and prevent misallocation of funds by management.

- The video discusses the argument of empire building versus prudent capital management in dividend investment strategies.
- Dividend investors believe that companies that pay dividends are better run and have more prudent capital management.
- However, picking stocks based on whether they pay dividends or not is not a proven method for achieving outperformance.
- Focusing on dividend paying stocks narrows the scope of focus and may result in holding more domestic stocks than foreign companies.
- Dividends can be inefficient for a company and may not reflect the underlying cash flows.
- Dividend investing is also influenced by the free dividend fallacy, where investors view dividends as free money and are more likely to spend them rather than reinvest.
- Dividend growth funds have historically outperformed, but this can be explained by other factors in the Fama-French 5 factor model.
- Dividends are not the only way to be prudent with capital and return capital to investors, as stock buybacks can also be beneficial.
- Dividend investing has its pros and cons, and it is important to be aware of the limitations and consider other factors before buying a stock.

*Correction: The five factor model includes market beta, not "quality."

00:00 - Intro
02:09 - Dividend Irrelevance Theory
05:31 - Assumptions
10:38 - Dividend Downsides
14:35 - Why People Still Like Dividends
15:30 - Closing Thoughts

Today we explain dividend irrelevance theory, some common misconceptions about dividends, and why some investors still prefer to focus on stocks that pay dividends.

This channel is for education purposes only and does not constitute financial advice - Richard is not responsible for investment actions taken by viewers. Please seek out a registered advisor if you require assistance (while Richard is a registered portfolio manager at WDS Investment Management, he does not provide advice through The Plain Bagel, which is not affiliated with his employer).

Ladies and gentlemen, welcome to the plain bagel.

I'm your host Richard Coffin in perusing online I recently stumbled upon some discourse in the finance space on the topic of dividends and more specifically dividend irrelevance I Know this is what conflict in the finance space looks like.

At the center of all this seemed to be a short video posted by Ben Felix, a fellow Ottawa portfolio manager who posted a video on Twitter where he highlighted that dividends are irrelevant.

They are not a source of investment returns, but rather are more on par with taking money out of 1 pocket and putting it into another.

And as you would imagine, this garnered a bit of an uproar.

Dividend investing is a very popular style of investing where you focus on companies that pay a dividend to their investors, and a lot of people popped into the fray.

So in this video, I wanted to address the topic.

And to be clear, Ben Felix is a friend of the channels, even though in reality, we actually employ opposing investment views.

And in that same fashion, I don't inherently dislike any of the creators who were coming out to defend dividends here.

So my goal really isn't to take sides but rather to annoyingly chime in with a few points on my own and to help explain the nuance of the situation and help answer the bigger question of are dividends irrelevant?

To which I would say the answer is sort of, but it really depends on what you're talking about.

The truth is that there is truth to both arguments here and some empirical evidence to support some arguments and some opposing arguments.

But I think a big part of the discourse here is really that people are arguing about different things.

Because yes, dividends aren't really a source of return per se.

They're just an avenue for delivering the return that a company earns to its investors.

On the other side, dividend irrelevance really comes across as a blanket judgment, when I think there's a lot of room for nuance in that discussion.

So in today's video, I'll explain dividend irrelevance, why it does highlight the flaws of focusing on dividend yield when investing, but also why it doesn't mean that dividends don't matter.

And I also want to address this because I have an older video that talks about why investors love dividends that doesn't really touch on any of this nuance.

So I want to take the opportunity to explain dividend irrelevance.

But let's start by covering the basics of the dividend irrelevance theory.

This is actually a concept that came from an old research paper from 1961 titled Dividend Policy, Growth, and the Valuation of Shares.

It is by Merton Miller and Frankel Modigliani, 2 Nobel Prize winning economists who actually made a lot of contributions to the space of corporate finance.

If you ever had the pleasure of taking a corporate finance course, they're the ones behind the M&M propositions.

And the central premise of the theory is that dividends are relevant, that stakeholders don't, or at the very least shouldn't care about whether a company pays a dividend or not.

To explain this line of thinking, I'll use an oversimplified example that takes away the veil of the stock market.

Imagine that you own a convenience store that in year 1 of operation generates $1 million.

With this $1 million of profit, you now have 1 of 2 things you can do.

You can either pay the money out as a dividend and cash out that million dollars to have on hand, or you can keep that million dollars in the business, perhaps even reinvested into operations to continue your growth.

Regardless of the option you pick, you still benefit from that $1 million.

If you take it as cash, then you have that million dollars on hand, but if you keep it in the business, the value of that company is now $1 million more.

You still have that net benefit on your net worth.

After all, if you look to sell the company, you'd be able to sell it for what it's worth plus that million dollars it holds.

In other words, if you do pay out that million dollars, the value of your company will drop by the amount of that money.

We actually see this in the world of stocks.

If a company pays a dividend, the stock will have what's called an ex-dividend date, which is the date on which and thereafter new investors of that stock will not be paid the dividend that's coming up.

And on the ex-dividend date, the stock price for the dividend paying company tends to drop by the value of the dividend.

In other words, when investors are paid a dividend, they see an in-step decline in the value of their position.

And because of this, dividend irrelevance actually argues that even investors who require income from their investments don't necessarily need dividends because rather than taking that hit on the capital gains and getting paid the dividend, they could simply manufacture a dividend by selling some of their capital gain, which effectively would lead to the same end result.

And this is what Ben Felix is referring to when he says that dividends don't really matter and that they aren't returned.

Companies generate a total return of sorts through the profits they grow, and then that return is delivered to investors via either capital gains or dividends or some combination of the 2.

Theoretically though, the 2 are fungible and investors shouldn't really care about whether they receive 1 or the other, which is where that analogy of taking a dollar out of 1 pocket and putting it into the other comes from.

You know, It would be like saying, okay, I've got $10 in my right pocket.

I'm gonna put a dollar bill in my left pocket.

And it's like, no, you've still got the $10.

So right away, that's clear up a lot of confusion and really address the more culty kind of arguments that are being made.

Not all dividend investors are like that, but there are some people who believe that a stock that doesn't pay a dividend is worthless.

Cause they don't pay a dividend every month.

Which is a really flawed way of thinking.

It's again, like saying that a convenience store is worthless because it didn't pay that million dollars and still has it on hand.

And while some people like dividends for generating passive income, it's important to understand that those payments are effectively coming out of your capital gains.

You could achieve a similar lifestyle by just systematically selling off a portion of the gains on your portfolio.

That being said, it is important to highlight that dividend irrelevance is a model with a lot of assumptions.

And many of those assumptions don't hold in the real world.

From the company's perspective, it's assumed that dividend policy doesn't have any implication on the cost of capital, debt covenants, anything like that.

But the thought being that even if the company pays too much in dividends and then needs more money to pursue an attractive project, it can then raise capital with relative ease to take advantage of that, which isn't necessarily the case, there are flotation costs to issuing new shares and raising capital could prove to be quite costly.

But even from the investor perspective, there are a lot of reasons why dividend irrelevance doesn't hold perfectly.

With the first point being that a dividend irrelevance assumes no tax implications or transaction costs.

And while these days transaction costs do seem to be approaching 0, there are very real tax implications and differences between dividends and capital gains.

In Canada, for example, capital gains are taxed at half of the marginal tax bracket, whereas dividends from Canadian corporations that are eligible are given a preferential tax rate.

With this rate being more attractive at the lower tiers and less so at the higher tax brackets.

Now in the US, the taxes are more similar for long-term capital gains and qualified dividends, But there still is that implication that when a dividend is paid, there's that immediate tax recognition, that expense, if you will, whereas a capital gain has a bit more of a timing aspect to it, which could give it an advantage.

So all this, at least in some circumstances, actually gives a bit of a benefit to capital gains over dividends, Especially given that investors are unlikely going to be able to match their income needs perfectly with dividends and will need to receive more dividends than what they need to cover expenses.

Now, second assumption of dividend irrelevance is that shares are fairly priced and that dividend policy won't impact the value of a stock.

That really hinges on whether you believe in market efficiency or not.

If you believe in market efficiency, then none of this really applies.

But if you believe that markets are inefficient and that investors can exploit that inefficiency, then investors might prefer a dividend because compared to capital gains, which can be more volatile and be more influenced by say negative market sentiment, dividends can offer investors direct access to those underlying profits without the obscuring impact of market volatility.

And some papers have shown that A, the dividend policy of a company does impact the value of the firm and B, the stocks can trade at a premium in low interest rate environments, meaning investors are willing to pay up for dividend paying stocks versus non-dividend paying stocks even if there isn't a rational explanation there.

Dividend policy is also frequently used by investors as a signal, which just means that because management likely knows more about the company, its future opportunities and prospects than its public investors, investors will take any announcement around dividend policy and interpret it to try and infer things about the company's future success.

Companies that cut their dividend, for example, are frequently punished by investors seeing their share price drop because it's interpreted as meaning that the company expects to have hard times ahead whereby they will no longer be able to pay this dividend with some research even showing how dividend cuts being done for the purpose of pursuing attractive growth opportunities are still frequently met with a sell off of the stock.

This is often referred to as the clientele effect whereby investors have purchased a stock for its dividend policy and will likely sell if that policy changes, even though, again, there's no rational justification if you view capital gains and dividends as being fungible.

But you can see how it means that changes in the dividend policy obviously do impact how the stock is going to be valued for better or for worse.

Now a third assumption of the theory is that there is no agency cost, meaning that management will always act in the investor's best interest.

Whereas in reality, there have been circumstances where capital allocation policy has absolutely been abused by executives.

For example, part of dividend irrelevance holds that cash dividends and stock buybacks where the company takes that same money and simply uses it to buy shares on the open market, that those will have a similar benefit to investors.

Whereas in reality, stock buybacks increase a company's earnings per share, which can be directly tied to management's compensation.

And there have been instances of management using those announcements around share buybacks to offload their own positions and take advantage of that increased share price.

With this in mind, some do view dividends as a way of reducing this agency costs as it forces the company to hand away some of those cash flows that it could otherwise abuse for its own intention.

Or on the other side of it, there's the argument of empire building where some management will just spend as much as possible to try and build larger and larger, even if that growth isn't as efficient as the investor just taking that money themselves.

And this is really the crux of a lot of dividend investment strategies.

There's this belief that companies who have to pay a dividend to their investors will be a lot more prudent with their capital than if they had free access to all the money they created.

So you can see why dividend investors who don't necessarily subscribe to those more extreme views, that a company that doesn't pay a dividend is worthless, while they still might be against dividend irrelevance as there's this belief that companies who pay a dividend will just be better run because they view good dividend policy as evidence of prudent capital management.

But even with all those points, and even as an active investor myself, I do agree with a lot of what Ben has to say.

My understanding of Ben's video is that he's not arguing that dividends are irrelevant for individual companies.

There may in fact be a policy that is better or worse for a given company based on whether they have those opportunities for growth and attractive ROI projects or whether they don't, which is importantly different from what the original dividend irrelevance theory purported that it doesn't matter at all whether a company pays a dividend or not.

What Ben seems to be arguing here is that picking a stock based on whether they pay a dividend or not, isn't a proven method for achieving outperformance.

And this does again, come from a firmer belief in market efficiency.

But the idea is that if a company is diligent with its capital, whether or not it pays a dividend, that will be reflected in its price valuation.

So you won't be able to benefit from that more prudent capital management just by identifying that company, because it will already be priced into the stock.

And outside of arguing about dividend irrelevance, Ben also does highlight some of the flaws that come with focusing on dividend paying stocks.

For 1, it greatly narrows your scope of focus.

Only roughly half of companies listed in the United States, for example, do pay a dividend.

So you do kind of cut out half of the universe of stocks.

Not to mention that companies that pay a dividend do tend to on average, be larger, more mature firms.

Certain industries are more likely to pay a dividend than others, and you may end up holding more domestic stocks than foreign companies, given that dividends from foreign companies don't often receive that preferential tax rate, so they are meaningfully tax disadvantaged.

Dividends can also be inefficient for a company because they don't actually often reflect the underlying cash flows that investors say they do.

Given the clientele effect that investors will react negatively to a dividend policy change, a lot of companies actually try to smooth out their dividends over time so that their dividend every quarter or every month is the same even though their earnings fluctuate from quarter to quarter.

We have also seen dividend policy be abused in the past to draw investors in with a high yield that isn't sustainable.

A key example of this is Icon Enterprises, which you might recall we covered earlier this year, a company that had 1 of the highest dividend yields among S&P 500 companies, but was in part funding that dividend using shares that it was issuing to new investors, something that was obviously unsustainable and that forced the dividend to be cut in half when a short seller came out and caused the stock price to fall.

Now, obviously, individual examples don't prove 1 way or the other, but it just goes to show that there is room for companies with good capital management and bad capital management in the world of dividends.

Another argument against dividend investing is that investors have empirically been found to treat dividends differently than capital gains.

It's something called the free dividend fallacy, where again, investors have this sort of mental model that money paid as a dividend is different from a capital gain.

And so they view it as sort of being free money.

And because of this, it's more likely that investors spend their dividends as opposed to reinvesting them.

Worse capital gains are more likely to remain invested.

Now in response to all this, a lot of dividend investors would highlight that dividend growth funds have historically outperformed.

Ben's argument there is that this outperformance isn't tied to the dividend policy of these companies, but can actually be explained by other factors that are part of the Fama-French 5 factor model, which to just oversimplify, there are other variables that can be accounted for, such as a company size, evaluation, that would explain this ill performance.

And the companies that exhibit these factors might happen to have this dividend policy, but the dividend policy itself doesn't offer that predictive power over expected returns.

So as Ben puts it himself, dividends are irrelevant to expected return, which is supported by the idea that even a company that has capital to return to investors that doesn't have attractive projects to pursue, could simply buy back its stock instead.

Might actually be preferred to some investors, given that it doesn't come with that immediate tax implication.

And if you believe in market inefficiency, a stock buyback could be done when a stock is undervalued, which would be beneficial to investors.

So you can see that dividends aren't the only way to be prudent with capital and even to return capital to investors.

And I do generally err on the side that it's as little arbitrary and you need to be really careful with those inefficiencies.

And for example, pursuing high dividend yield stocks because you need that higher income, which is a really backwards way of looking at things.

But even with that in mind, there are still reasons people like dividend investing.

Some find dividend income a lot easier to manage than selling their positions, and they put the faith in the companies that they'll be sending them the capital that they don't need.

And while there is a danger around mental accounting where you view dividends differently than capital gains, even though they come from the same pool of total returns, that has ironically helped some people with their saving strategies sort of lean into that mental bias, where they don't touch their capital, and they only use those dividends to use as income, thereby encouraging them to split their money between the money they can spend and the money that they have to save and can't touch.

And there is even some research to suggest that stocks don't perfectly drop either dividend when a dividend is paid.

So there might even be room for arbitrage or more research done in that area.

But the point is, I don't view it as being as clear cut of an issue.

Academic papers will certainly helpful, don't often quote unquote prove anything in the world of investing.

You quite often see opposing research papers on different topics.

So if you decide to pursue a dividend investing strategy, you just need to be aware of the pros and the cons to not delude yourself into thinking that dividends are the secret sauce that will ensure outperformance, to see that there's a lot more work involved and a lot of other factors you need to consider before buying a stock.

There are well-run companies that are prudent with their capital that pay a dividend.

There are poorly run companies that destroy shareholder value and still pay a dividend.

And there are excellent companies that don't pay a dividend and still are able to earn excess returns by getting that attractive return on investment on the projects they pursue.

And I think both sides would agree on that.

There's just argument about the empirical level, aggregate performance of those different strategies.

So I won't stand here and say that you shouldn't pursue dividend investing, but do be aware of the limitations.

And it's still good to understand the dividend irrelevance theory because it clears up a lot of the really common misconceptions, especially with beginner investors.

If you did, please do make sure to like, subscribe, all that good stuff.

And let me know your thoughts in the comments down below, especially if you are a dividend investor.

Would love to hear your thoughts on any of the points made and any counter arguments you have.

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Dividends Are Irrelevant (Sort Of...)