Academic journal article American Economist

The Changing Nature of Corporate Distributions and Its Implications for Investors

Academic journal article American Economist

The Changing Nature of Corporate Distributions and Its Implications for Investors

Article excerpt

1. Introduction

In academic research, there has been increasing interest in analyzing the implications of the shift from cash dividends towards share repurchase. One of the most important issues is what the shift may mean for investors. According to Modigliani and Miller's argument that dividend policy is irrelevant, the shift should not matter to them. However, their irrelevance proposition holds only under very restrictive assumptions, including the absence of taxes and transactions costs, and perfect information.

Because cash dividends no longer appear to be a full measure of distributions, it is not clear whether tests of dividend irrelevance versus dividend preference based on cash dividends are well specified. This consideration motivates our inquiry into the general issue of dividend irrelevance, and into several more specific questions of corporate practice, and effects of policy on firm valuation and stock performance. To test for this, we compare stock performance of high, low-, and zero-payout firms.

We begin our empirical analysis with a comprehensive overview of changes in corporate distribution policies from 1973-2007. We further analyze these trends across ten major sectors in order to determine whether the general trend from cash dividends to share repurchase applies uniformly across different industries. We supplement this with a similar analysis across different firm sizes. Overall, we verify the increasing reliance of U.S. firms on share repurchase (and share issuances) to distribute cash to shareholders since 1973. However, there are some exceptions, including firms in the telecommunications and utilities sectors, and the smallest firms.

We next evaluate the effectiveness of investment strategies utilizing three measures of shareholder payout within different economic sectors and size categories. These measures are (1) the traditional dividend yield; (2) a payout yield that adds repurchases to dividends; and (3) a still more comprehensive measure, called "net payout yield," which also takes cash flows into the firm from new stock issues into account.

We find that high payout portfolios significantly outperform low payout portfolios for all three measures. In particular, we show that an investment strategy that is long in high-payout stocks and short in low-payout stocks results in significant risk-adjusted profits. The specific strategy with the highest risk-adjusted returns is the one based on the most comprehensive measure of payout, which includes dividend yield, share repurchases, and share issuances. These results apply not only to the largest sample of firms on average, but that it also applies fairly consistently across the

by Susana Yu, Associate Professor of Finance, Montclair State University

different sectors. Overall, the evidence is inconsistent with the dividend policy irrelevance theory and supports the traditional view that shareholders have a preference for stocks that pay something out, whether in the form of dividends or share repurchases.

By contrast, when we compare the high payout portfolios to a portfolio of stocks with zero payouts, there is no difference in performance. To help explain this finding, we determine the extent to which corporate profitability and investment opportunities drive corporate distribution policies across all sectors and sizes. We find that both factors are significantly associated with firms' payout policies, and conclude that this helps explain the fact that the stock performance of firms with zero payout policies perform as well on average as stocks with high-payout policies.

The rest of the paper is organized as follows. We review related literature and develop our testable hypotheses in Sections 2 and 3. We describe our data and sample in Section 4, and then document trends in the use of repurchase and cash dividends by industry sector and firm size. We test whether a profitable trading strategy can be formed based on high and low payout firms in Section 5A. …

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