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Dividends matter, growing dividends matters more
Dividend payments are a classic example of mental accounting. In theory, it shouldn’t matter if a company pays a dividend to investors and these investors use that dividend for their consumption or other purposes, or if a company pays no dividend and investors sell parts of their holdings to finance the same consumption. In theory, it shouldn’t matter, but in practice it does. This is why investors treat companies that pay a dividend differently than those that do not.
Paul Schulz from the University of Notre Dame surveyed a representative sample of 1.291 Dutch investors who own stocks or funds. 95% of them said they do not regularly sell stocks to fund expenses and 68.5% agreed or somewhat agreed with the statement that they try to avoid selling down stocks for fear it would deplete their savings.
Hence, when a company starts to pay dividends, it implicitly says to its shareholders “we are going to help you fund your consumption or cash flow needs and you can rely on our dividend payments in the future”. And when a company cuts or even suspends its dividends, share prices often plunge because investors consider this a breach of trust in the implicit contract they had with the company.
The reason why companies should care about this result is simple. If you enter this implicit bond with your investors, they are less likely to sell your stock in a tough environment as long as you continue to pay your dividend.
Paul Schulz found that share turnover of US stocks dropped 23% after a company initiated a regular dividend payment. This simply reflects the fact that the shareholder register stabilises, and investors hold shares that pay a dividend longer than those that don’t. This is something that pays off for the company in a recession or a bear market when investors are thinking about reducing their equity investments. Shares that pay dividends are lower down the list of “stocks to sell”.
But there is more to this story. If dividend income is used to fund consumption and other cash flow needs, dividends should keep up with inflation, something that they haven’t quite managed to do in the US. During the last 20 years, dividend growth was significantly higher than inflation, but especially during the high inflation era of the 1970s, dividend growth could not keep up with inflation.
Dividend growth and inflation in the US
Source: Schulz (2023)
This provides an additional opportunity for companies that pay a progressive dividend that increases over time. Shares of companies that regularly increase their dividends per share are even lower on the list of stocks to sell by investors. For every 1% increase in dividends per share, turnover in the stock drops by another 0.9%. Alas, paying a progressive dividend is a good way for companies to reduce the exposure of their share price to the swings in investor sentiment and the activities of fickle traders.