Apple and the Dividend Puzzle

April 20, 2012

As loyal readers will know, I’ve been critical of the zeal with which some investors approach dividends. Based on countless blog posts, emails and conversations, I feel that many investors’ preference for dividends is often irrational. And that’s not simply my opinion—the dividend puzzle has been a popular topic in financial theory for decades.

There are some situations where dividends are clearly preferable to price appreciation. The most clear-cut is the tax advantage enjoyed by investors (especially those in a low tax bracket) who hold Canadian dividend stocks in a non-registered account. But there are other situations where investors should actively avoid dividends—and yet they flock to them anyway. The latest example of misplaced enthusiasm comes from Apple.

As everyone knows, Apple announced in March that it will pay a quarterly dividend starting later this year. Predictably, the news was met with widespread approval—the dividend was called “payback,” and a “reward.” As The Globe and Mail reported, “It will raise demand for the stock, since dividend-focused investors, mutual funds and exchange-traded funds will now put Apple on their radar screens.”

Therein lies the puzzle. Because whether you hold Apple stock directly or in an index fund (as the largest company in the world, it’s a significant 4.5% of the S&P 500), it’s hard to see this dividend announcement as anything other than bad news.

Taking a bite out of Apple

Several American commentators have argued against Apple paying a dividend, because US investors will face a 15% tax on the distribution. For Canadians, it’s much worse. If you hold the stock in a taxable account, your annual dividend of US$10.60 is subject to a 15% withholding tax (which may be recoverable), and the remainder will be fully taxable as income. You could easily lose half of it. By contrast, when the stock was paying no yield, you would only have incurred a taxable event if you sold shares at a profit—and these capital gains would have been taxed at only half your marginal rate.

It’s also interesting that the dividend hoopla overshadowed the announcement that Apple is also planning to repurchase USD$10 billion of its shares in 2013. Unlike the dividend, this move is likely to be a boon to investors, since it will raise the value of remaining shares by a corresponding amount. The pre-tax impact of a dividend and a share repurchase is the same (either a $1 cash distribution or a $1 increase in share price), but the buyback is likely to deliver a higher after-tax return. So where are the cheers from investors?

Finally, even if you hold Apple in a tax-sheltered account where you’ll keep all of the dividend, it’s difficult to understand why you would want the company to fork over its cash. The Financial Post quoted an analyst who said “it’s probably better to have the cash in the shareholders’ pockets then in Apple’s pockets.” Really? Apple’s return on equity is over 36%, which blows most other companies out of the sky. The company’s share price has increased 574% over the last five years. Do you think you’ll be able to do better with the $10.60 that will go into your pocket next year? And if you do, why not sell a few shares today and deploy the proceeds somewhere else?

“Why is Apple initiating quarterly payouts?” asked Forbes columnist William Baldwin, one of the more vocal critics of the decision. “Because the mob wants it.”

{ 23 comments… read them below or add one }

Lake Superior John April 20, 2012 at 8:17 am

Your quote, ‘company’s share price has increased 574% over the last five years’, looking forward do you really think this will happen in the future? I’ve read many times past performance is not necessarily indicative of future performance. Hence is a dividend a bad thing, either in or out a sheltered account?

FrankP April 20, 2012 at 8:40 am

Great post. One thing to consider re: your last point is the amt of $ they’re sitting on. If they were putting it to use I see the rationale for keeping it (generating value) but instead its only been growing (a great problem to have).

Canadian Couch Potato April 20, 2012 at 9:35 am

@Superior John: I have no idea where the stock will go in the future, though it seems unlikely that any company could duplicate Apple’s performance of the last five years. I just find it interesting that investors who own any stock think they can put cash to better use than the company, especially one that has rewarded investors so handsomely. To make that argument, you have to assume that you have identified another stock (or some other investment) that will put your money to better use than the stock you currently own. And if you really believe that, why don’t you sell your entire holding and deploy all of the cash somewhere else?

I have the same question about DRIPs, which many people embrace as though they were a magical form of compounding. With a DRIP, a company pays you cash (with a corresponding drop in the company’s value), and then you give it back to them. So it’s a neutral transaction, and if you’re paying tax on the dividend, it can result in a loss. They’re convenient, for sure, and I use them myself for my ETF holdings. But they’re no different from any other type of compound growth.

Mike Holman April 20, 2012 at 10:03 am

Great example Dan. I too have never understood the desire for dividends for investors in the accumulation phase.

Capital gains are almost certainly better taxwise for someone in a moderate to high tax bracket and the timing of capital gains can be controlled, unlike dividends.

As you say – if I want to invest some money with a company, I want them to keep all of it and make it grow!

On a slightly different tack – it would be neat if “dividend” companies could offer two types of shares which differ only in that one type would pay the regular dividend and the other type wouldn’t pay any dividend and the share price would reflect the fact that the ‘dividend’ is basically getting reinvested.

This way, the DRIPers could probably save some tax by going with the non-dividend class and people who need income or are in very low tax brackets can get the dividends.

Of course, the prices for the two classes will vary quite a bit over time.

SterlingF April 20, 2012 at 11:29 am

Interesting article. This is definitely an area I want more knowledge in. I’m not a dividend investor but one day I’m sure I will be.

Eric April 20, 2012 at 2:08 pm

Countless studies have shown that excess corporate cash from retained earnings (not paid out to shareholders but reinvested) tends to be wasted…. And the genius behind this success story is gone.

As for the planning to repurchase USD$10 billion of its shares in 2013, a ‘bad habit’ for corporations to do so when the stock hits an all-time high.

DaveL April 20, 2012 at 2:10 pm

Dan,

Having being burned by a few accounting scandals (three to be exact) while owning individual stocks, I can appreciate why dividend paying stock can have added appeal.

As has been said many times “Companies can fake earnings, but you can’t fake a dividend”.

Great site!

Mike Holman April 20, 2012 at 2:21 pm

As has been said many times “Companies can fake earnings, but you can’t fake a dividend”.

I disagree – YLO did it for a couple of years. ;)

Canadian Couch Potato April 20, 2012 at 2:27 pm

@Eric: That argument has been made many times, and there is probably some truth to it, though I would be interested in seeing links to some of the studies. It’s going too far to suggest that this is always true. Apple, as I argued, has one of the highest returns on equity of any large company.

If you believe that Apple’s best days are behind it, then you should sell the stock, period. And you should ask yourself why you have this insight, but the market does not.

@Dave: The best way to ensure that you never have to worry about accounting scandals (or other company-specific risks) is to avoid individual stocks altogether and invest in broad-based index funds. If you own the whole Canadian market, you can completely ignore the daily saga of Sino-Forest, RIM, SNC Lavalin and everything else, because none of these firms represents a significant portion of your portfolio.

LighteningKid April 20, 2012 at 3:14 pm

“Because the mob wants it.” Exactly! You should have been reading rumour websites like AppleInsider a couple of months ago, or every time there’s a quarterly report or shareholder’s meeting, really. There’s always a ton of clamouring for a dividend and complaining about their giant “war chest” that’s sitting and doing nothing. A buyback is probably better than money most people will put back, anyway.

Most of the members of that site are fanatics, so Apple will probably get their money again. I think they just like to feel like they’re getting something and don’t believe the stock price will be affected by the dividend.

DaveL April 20, 2012 at 3:39 pm

Dan,

I agree with you regarding individual stocks and scandals. I would add that when selecting “broad based index funds” you consider indexes that are capped, since some big players can affect major indexes significantly.

For example, According to investopedia.com, Nortel at its peak accounted for almost 1/3 of the total market capitalization of all stocks on the former TSX-300 index. Yikes!

Canadian Couch Potato April 20, 2012 at 3:47 pm

@DaveL: Agreed. The Nortel example is true, of course, but it’s a bit of a red herring. That was a unique situation that can only happen in a small country, and since that time pretty much all Canadian index funds have been capped at 10% to prevent it from happening again.

That said, some sector funds still have huge weights to single companies: iShares’ sector funds are capped, but the cap is 25%. That’s the reason I recommend the BMO Equal Weight REITs instead of iShares XRE.

Eric April 20, 2012 at 3:55 pm

@ccp: ”If you believe that Apple’s best days are behind it, then you should sell the stock, period”.
I don’t know…. I have no crystal ball. But what I know is that they were sitting on too much cash & didn’t know what to do with it. Yes, I prefer cash in my own pockets than cash in Apple’s bank account. Microsoft or IBM are not bad stocks because they have a dividend policy.

Chris April 21, 2012 at 11:45 am

Apple’s total return on equity isn’t particularly relevant. What’s relevant with respect to determining what to do with the cash pile is Apple’s potential return on equity *on the cash pile*. Excluding portions of the cash pile (perhaps $20 billion, max) that could be potentially be used to fund major acquisitions, the rest is just going to investments, about a third of it, to short term investments.

As someone who believes in indexing, and by extension the EMH, you can’t simultaneously argue that Apple will be able to better invest the money than you can.

The only rational argument against paying out the money is issues with tax efficiency, but this is offset by reduced risk to the individual investor, reduced potential volatility in the stock price, and reduced risk of boneheaded uses of the money (particularly an issue in the tech sector).

Canadian Couch Potato April 21, 2012 at 12:53 pm

@Chris: RE: “As someone who believes in indexing, and by extension the EMH, you can’t simultaneously argue that Apple will be able to better invest the money than you can.” This is a fair point, and I should have been clearer in my argument.

Remember, the people who prefer the dividend are the ones who are making this argument—actually, the opposite one—if they agree with the analyst who said “it’s probably better to have the cash in the shareholders’ pockets then in Apple’s pockets.” I should have simply said that, before considering the tax issue, investors should be indifferent to the dividend. I also find it a bit arrogant that Joe Investor believes he knows the best way for Apple to use its resources.

I accept that there is some evidence that paying dividends imposes discipline on management, and that a dividend policy signals management’s confidence in the future, etc. But it is hard to make sweeping generalizations about this. There are other companies who seem bound by their dividend policy, paying out distributions against their better judgement because investors punish them mercilessly if they cut their dividend, even if that might be the right thing for the business.

Nathan April 22, 2012 at 2:03 am

One very theoretical reason why dividends are seen as a positive thing is that stocks only fundamentally have value on the basis of discounted future dividends. If Apple were to somehow enact a permanent policy guaranteeing that they would _never_ pay a dividend, then there would be no rational reason to buy their stock, because the only possible future payoff would be from someone else paying even more for it, regardless of its continuing lack of intrinsic value. The performance of the underlying company would essentially be meaningless.

Of course in reality a company never has to _actually_ pay a dividend, there just has to be the potential. So I agree that most taxable investors would be better off without it.

Tax-free investors on the other hand should prefer the dividend since it allows them to maintain control over their asset allocation. As mentioned above, the dividend would presumably only be out of excess cash, so there’s no reason to believe Apple could invest those funds better than you or I.

James Meyer April 22, 2012 at 8:24 am

Definitely won’t be getting into AAPL until they show a few years of dividend growth.

Russ April 22, 2012 at 9:05 am

I just read this article in the Globe and Mail online by Norm Rothery, “Dividend stocks aren’t fail-safe (but buy them anyway),” quoting a study by Professor French. The article argues that, in the long run, a portfolio of stocks that pays high (but not the highest) dividends tends to outperform for the market. Your thoughts?

Canadian Couch Potato April 22, 2012 at 9:38 am

@Russ: I’ll start by saying that Norm is much smarter than I am, and I am wary of debating with him, because I would lose. That said, I’ve always been a bit confused by his interpretation of these data, because I don’t think it’s the same as Prof. French’s own.

Remember that high dividend yield, by definition, also indicates low price. So dividend yield is a common value characteristic, along with low P/E, high book-to-market and low price to cash flow. As I understand it, the higher returns you see when screening for high dividends come from the low price: in other words, it’s just the value premium at work. In fact, as Larry Swedroe has argued, dividend yield is actually the least useful of the four value metrics I listed:
http://www.cbsnews.com/8301-505123_162-37841850/why-a-high-dividend-stock-strategy-isnt-a-good-approach/

Prof. French’s research is the foundation for the investment strategies developed by Dimensional Fund Advisors: he is the Director of Investment Strategy for DFA. And DFA has never advocated a dividend-oriented strategy: DFA uses book-to-market when creating their value-oriented strategies.

I also like to remind people that French’s data assume 100% turnover: the entire portfolio must be sold and replaced every year. (And, of course, the cost and taxes are assumed to be zero.) This bears absolutely no resemblance to a dividend growth strategy, so we should be clear on that.

Andrew F April 23, 2012 at 1:35 pm

I agree that Apple would have been better to direct the cash for the dividend to share repurchases. Had they been doing this since the cash horde started to grow out of hand, their share price would have been even higher.

I wonder why it is a faux-pas for companies to strategically buy back their own shares on pull-backs (not on non-public material information). If anything, it is good for existing shareholders and those being bought out, as it provides liquidity.

Lisa April 27, 2012 at 1:55 pm

Apple doesn’t make money on the $100 billion it has invested in US treasury bills paying close to 0% interest. I’d rather have that money in my hand to invest as I see fit.
The tax argument only applies to Canadians who don’t have tax advantaged space. The more important tax argument is that Apple would have to pay US corporate tax of 35% if they bring offshore cash back to US to pay dividends.

Enough studies have shown that share buybacks do not benefit shareholders as much as dividends that companies like Apple have listened.

DSO April 27, 2012 at 3:32 pm

Buybacks are better than dividends because you do not pay taxes when the company buys back stock but you do when you receive dividends. When you reinvest a dividend after you paid tax on it you are not getting the same value as you would if the company just bought back its stock. Therefore your total return compounds at a better rate with a buyback.

But… a $10B buyback on a stock with a market cap of $563B is a 1.8% change in value and is really not a big deal. Apple said they were buying back stock to use for distribution to employees. Apple has an EPS growth rate of about 80% and is trading at 12x 2012 earnings. How is it a bad move for Apple to buy back stock? Find me another company with those kinds of growth to P/E numbers.

In my opinion, no one should be buying Apple for the dividend. I have always owned it for the growth.

Patrick May 6, 2012 at 11:58 am

To be fair, it’s possible that management knows a 36% ROE is not sustainable (or else one day the entire economy would be AAPL). And, tax implications aside, share buybacks make sense only when management thinks the shares are actually undervalued (just like any other stock purchase).

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