The Market for ‘Lemons’: A Lesson for Dividend Investors by Research Affiliates
In the latest piece from Research Affiliates, Chris Brightman, chief Investment officer, Vitali Kalesnik, head of equity research, and Engin Kose, vice president, equity research, look at dividend investing, noting that “measuring the quality (reducing our information asymmetry) of the companies whose equities we are considering adding to our portfolio can improve our investment returns.”
“When purchasing high dividend-yielding equities, the challenge is to find high-quality companies at reasonable prices. Simply paying the lowest price for a given dividend is not an optimal strategy. Some high-yield equities are cherries, cheaply priced equity of high-quality dividend-paying companies. Other high-yield equities are lemons, cheaply priced equity of low-quality companies with unsustainable dividends. Identical dividend yields may hide important differences in the quality of companies arising from financial distress, unsustainability of profits, and poor accounting practices, sometimes even extending to fraud.”
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The Market For ‘Lemons’: A Lesson For Dividend Investors
Central banks the world over are buying high-quality bonds, thereby removing them from the market and forcing savers to find alternative strategies to meet their income needs. In this environment of financial repression and near-zero interest rates, dividend-yield (or equity income) investing has become increasingly popular. Investors are understandably reallocating their portfolios from lower yielding bonds to higher yielding equities. But in selecting equities with a high dividend yield, investors should be aware of the risk of concentrating their portfolios in low-quality companies.
In 1970, George Akerlof published “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” an article for which he won the Nobel Prize. In the article, he explains the problem of asymmetric information by examining the market for used cars: some used cars are “cherries” and others are “lemons.” The rub, however, is that the buyer cannot distinguish between them. Only the seller knows if the used car is a cherry or a lemon. Afraid of buying a lemon, the buyer demands a discount from a would-be cherry’s price, and the seller—if knowingly selling a cherry—will refuse to deal at the discounted price. Without a meeting of the minds, the seller will not receive a fair price and is discouraged, as are other owners of cherries, from even offering them for sale. As a result, the market for used cars contains a disproportionate amount of lemons.
Akerlof’s observation about used cars can help us understand why more information improves purchasing decisions, and not just for used cars. As when buying a used car, buying bargain equities can produce nasty surprises. Measuring the quality (reducing our information asymmetry) of the companies whose equities we are considering adding to our portfolio can improve our investment returns.
Investing to earn a high dividend yield is a venerable and sound strategy. Because most companies choose to pay a steady dividend to their shareholders, dividends—their frequency and amount—are persistent and much less volatile than equity prices. Investors can thus use the much higher volatility of equity prices as an opportunity to buy future dividends quite cheaply. Further, dividend-yield investing allows investors to distinguish income from principal: investors can spend dividends and leave principal intact. The income sustainability strategy works better, however, if the companies whose equities investors buy are not lemons.
Table 1 compares a portfolio composed of the 200 highest yielding U.S. equities selected from the 1,000 largest companies by market capitalization, rebalanced annually, with a portfolio of the 1,000 largest U.S. equities. Both portfolios are capitalization weighted.
The high-yield portfolio provides a much higher realized dividend yield (5.6% vs. 2.9%) and total return (12.3% vs. 10.2%) with lower volatility (14.2% vs. 14.8%). The higher return is no surprise because yield is measured as the ratio of dividend to price and is thus a direct measure of value. Cheap equities (i.e., equities with a relatively higher yield, or higher dividend to price) have historically, on average, outperformed expensive equities. Lower volatility, however, is a pleasant surprise.
See full article online at: “The Market for “Lemons”: A Lesson for Dividend Investors”
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