Should Companies Pay High Dividends? Part 1

This is part one (out of three) of Kernel’s investigation into Dividends and their purpose, attractiveness and use for New Zealand-based investors.

• Part two: Is investing for Dividends Bad for Long Term Wealth?

• Part three: Dividends vs Portfolio Drawdown

• Or download the full research paper

Getting paid simply by owning shares in a company feels good. But is it ultimately the best outcome for you or the company to do so?

New Zealand is recognized globally for its high dividend payouts, but in this three-part series, we have done the research to investigate the reasons, implications, and alternatives for you as an investor and our economy.

Dividends are an amount per share paid out to shareholders which is taken from the company’s earnings. It is an important strategic decision made by a company's board of directors.

In simple terms, it is a decision of what proportion of the company’s earnings will be retained for growth and stability or distributed to shareholders as cash.

This balance is crucial, as it affects a company's trajectory and appeal to investors.

New Zealand is recognized for its high dividend payouts. In 2023, the New Zealand (S&P/NZX 50) companies distributed an impressive 82.5% of their post-tax income as dividends, far surpassing the global average of 47.6%. In contrast;

• U.S. companies allocated only 34.2% of their profits as dividends, implying a focus on corporate growth rather than immediate cash returns.

• UK and Europe have dividend payout ratios around 45-50%, striking a balance between dividends and retained earnings.

• Australia, despite having a similar tax system to avoid double taxation of corporate profits, still has a significantly lower payout ratio of 55% in 2023.

In our opinion, there are four main factors that may be contributing to why New Zealand companies exhibit higher dividend payout ratios compared to companies in other countries.

The first is tax, as the high dividend payout culture in New Zealand is influenced by the dividend imputation credit regime, introduced in 1987.

This system mitigates double taxation on company profits by attaching imputation credits to cash and non-cash dividends distributed to shareholders, incentivizing companies to distribute profits to shareholders in the form of dividends.

The second factor is the composition of the NZ stock market with mostly mature stage companies having limited expansion opportunities.

New Zealand's relatively stable economy, coupled with its smaller market size, has fewer corporate investment opportunities compared to larger economies and markets. This encourages companies to distribute a higher proportion of their profits as dividends rather than retaining them for reinvestment.

The third factor is investor preferences, as New Zealand investor demographics have a history of favouring companies that provide regular dividends.

High dividend-yield stocks are attractive to income-seeking investors, especially through the low interest rate environment of 2008-2022.

Companies may also align their dividend policies with market expectations to retain and attract investors. These align to some behavioural economics biases: Prospect theory, mental accounting bias and anchoring.

• Prospect theory: individuals often prioritise immediate value over uncertain future gains. Cash dividends, received promptly, can outweigh potential capital appreciation down the line.

• Mental accounting bias: selling shares can be more emotionally painful because it depletes capital while receiving dividends as cash leave the number of shares intact and requires no action or cost of selling.

• Anchoring: Large mature companies have a dividend history of paying out consistently creating an expectation. Investors can mistakenly think that the company is contractually bound or obligated to continue, when lower profits or other opportunities for investment would be a better choice.

The fourth factor is internal corporate governance, and the relationship between internal practices, conflicts of interest and dividend payout policies.

This topic has been extensively studied but findings from various sources remain diverse, with some suggesting that dividends can act as a substitute for weak governance acting in the interests of some shareholders rather than what is best for the company. While other studies show that higher dividends are often associated with stronger board governance.

All of these factors, whether important or not, ultimately have a dampening effect on the expansion of capital markets.

Looking at the graph below, we can see that the majority of the growth comes from the inclusion of income (gross return), rather than from capital gains represented by changes in share prices (price return).

For instance, in the 20 years leading up to December 31, 2023, the price index increased by 96%, whereas the gross return index grew by 501%.

Although this ignores the inherent value of cash dividends received as a source of income, it vividly illustrates the power of compounding.

To sum up, New Zealand's stock market stands out globally for its tendency to distribute such a large portion of company profits.

This practice, largely influenced by fiscal policies and market expectations is, in some ways, hindering the growth of our capital markets

In part 2, we will explore the pros and cons of investing for dividends and the impact and distortion of transaction costs.

Then in part 3, especially considering there are zero transaction fees in Kernel funds, we explore whether investors should regularly drawdown rather than relying on the irregular and unknown amount of dividend payments.

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