Dividend Policy and Market Movements

Transcription

1 Dividend Policy and Market Movements Kathleen Fuller Terry College of Business, University of Georgia, Athens, GA Michael Goldstein* Finance Department, Babson College, Babson Park, MA August 21, 2003 Abstract Using S&P 500 monthly returns as a proxy for market conditions, we investigate whether investors prefer dividend-paying stocks to non-dividend-paying stocks in declining markets. We find that dividendpaying firms have higher returns than non-dividend-paying firms. These results are robust for adjustments for risk using CAPM adjusted deciles, CAPM excess returns, the Fama-French three-factor model, and dividing the sample into size and book-to-market quartiles. Furthermore, we find that the simple payment of dividends, and not the level of the dividend yield, drives returns asymmetric behavior relative to market movements, consistent with the signaling hypothesis of dividends. JEL Classification Code: G35 Keywords: Dividend policy, asymmetry, market movements *Corresponding author: Michael Goldstein, Finance Department, 223 Tomasso Hall, Babson College, Babson Park, MA tel: (781) fax: (781) Goldstein@babson.edu. We thank Deepak Agarwal, Jeff Bacidore, Jennifer Bethel, Wayne Ferson, Paul Irvine, Jon Karpoff, Gautam Kaul, Laurie Krigman, Marc Lipson, James Mahoney, Donna Paul, Tyler Shumway, John Scruggs, Chris Stivers, and seminar participants at the 2001 All Georgia Conference, the 2001 Financial Management Association Meetings, the 2002 Eastern Finance Association Meetings, and the University of Michigan Lunch Seminar series. Kathleen Fuller acknowledges financial support from the Terry-Sanford Research Grant. Michael Goldstein acknowledges support from the Babson College Board of Research.

2 Dividend Policy and Market Movements Abstract Using S&P 500 monthly returns as a proxy for market conditions, we investigate whether investors prefer dividend-paying stocks to non-dividend-paying stocks in declining markets. We find that dividend-paying firms have higher returns than non-dividend-paying firms. These results are robust for adjustments for risk using CAPM adjusted deciles, CAPM excess returns, the Fama-French three-factor model, and dividing the sample into size and book-to-market quartiles. Furthermore, we find that the simple payment of dividends, and not the level of the dividend yield, drives returns asymmetric behavior relative to market movements, consistent with the signaling hypothesis of dividends. JEL Classification Code: G35 Keywords: Dividend policy, asymmetry, market movements

3 Dividend Policy and Market Movements Companies provide investors with returns in two different ways: a regularly scheduled dividend, or a probabilistic capital gain or loss. Previous theoretical and empirical research indicates that investors preferences for dividends vary across shareholder types. For example, depending on their tax bracket, some shareholders may prefer high dividend-paying stocks while others may prefer non-dividend-paying stocks. In this paper, we extend this line of research by exploring under what conditions investors care how they get compensated. Specifically, we investigate if investors preferences for dividends depend on market conditions; that is, do investors prefer dividend-paying stocks to non-dividend-paying stocks depending on whether the overall market is doing well or not? 1 Using S&P 500 returns as a proxy for market conditions, we examine the return behavior of dividend-paying and non-dividend-paying firms in both up and down markets from January 1970 to December We find that dividend-paying firms have higher returns than non-dividend-paying firms for the 31-year period. These results are strongest in down markets, implying that dividends do provide a differential benefit depending on market conditions. These results are also robust to various controls for size, time period, and risk, including the CAPM and the Fama-French three-factor model, as well as alternative definitions of up and down markets. Further, we find that the market reacts primarily to the dividend-paying or non-dividend-paying nature of the stock, but that this reaction does not vary with dividend yield, implying the ability to pay a dividend and not its size is of primary importance. In addition, we find these results hold even during the months between dividend payments when the dividend-paying firms did not pay a dividend, indicating that it is not the receipt of the cash that is driving these results. 1 In fact, Fidelity advertises a mutual fund consisting of only dividend-paying stocks that began airing after the market downturn in The investor in the ad is seen agreeing with the Fidelity advisor that dividend-paying stocks would be a nice addition to his portfolio to help diversify and moderate losses in down markets. Further, as of October 2000 Standard & Poor s predicted a revived interest in dividends, stating market weakness may boost interest in dividends as investors begin to see the value of a bird in the hand. 1

4 This paper is the first to examine returns conditional on two dimensions: dividend policy and overall market movements. Although there are several reasons why investors might prefer dividendpaying stocks in down markets, traditional asset pricing models that examine returns symmetrically, such as the Sharpe (1964) Lintner (1965) CAPM or the Fama-French (1992, 1993) models, do not account for state-specific investor preferences. It is possible, however, that investors may not have symmetric preferences. For example, Harvey and Siddique (2000) find that risk-averse investors dislike negative skewness. An increasing body of work examines asymmetric responses of returns to market movements, and finds different return characteristics in up or down markets. 2 Ang and Chen (2001) find that correlations between stocks returns and the market increase when the market declines. DeBondt and Thaler (1987) find different upside and downside betas for previous winners, although Ang, Chen, and Xing (2001) find that it is downside correlations, and not downside betas, that investors price. Additionally, they find that firms whose correlations with the market increase when the market is declining have higher expected returns. Karceski (2002), citing institutional reasons, finds that mutual funds prefer high-beta stocks in up markets. Other studies, such as Goldstein and Nelling (1999), find that the returns on REITs have different risk characteristics in advancing and declining markets, with different correlation structures and betas with the S&P 500 depending on whether the market has a positive or negative return. Papers such as Faugère and Shawky (2002), examine markets during downturns exclusively. Internationally, Longin and Solnik (2001) find that large negative correlations are 2 The idea that investors may prefer stocks that pay dividends at times when they sense future uncertainty or bad states of the world, but prefer non-dividend-paying stocks when the market is going up is consistent with prospect theory. Prospect theory, developed by Kahneman and Tversky (1979), indicates that people respond differently to certain verses probabilistic gains and losses, and care more about losses than they do to gains. First-order risk aversion utility functions such as in Gaul (1991) provide a similar result. Markowitz (1959) notes that investors may care about downside risk differentially. In addition to the signaling benefits, investors may prefer stocks whose dividend payment provides a return where at least part of the return is a certain gain over those non-dividend-paying firms for which the entire gain or loss is uncertain. In markets that are moving upward, this preference for loss avoidance is mitigated, and investors, while still valuing the relatively more certain gain, may value it less so. During periods of market decline, however, investors prefer dividends as a cushion to their returns, particularly if they are downside risk-averse. 2

5 much higher than upside correlations, thereby reducing the benefit of international diversification. 3 There are a variety of reasons why investors might condition their preference for dividend-paying stocks on the state of the market. According to the theoretical literature, dividend-paying firms have greater ability to signal managers expectations of future cash flows and growth rates credibly than do non-dividend-paying firms. Previous theoretical research argues that dividends either signal managers private information regarding future earnings [e.g., Bhattacharya (1979), John and Williams (1985), and Miller and Rock (1985)] or that dividends signal that managers will not waste excess cash [e.g., Easterbrook (1984), Jensen (1986), and Lang and Litzenberger (1989)]. As noted in Allen and Michaely (2003), empirical tests of these two hypotheses fail to pick an overwhelming winner. In this paper, we argue that such signals are likely to be more valuable in some markets than others. Broadly rising or falling markets tend to indicate albeit imperfectly investors perceptions of the state of the economy in the future. In particular, broadly falling markets indicate either an increase in interest rates or a reduced expectation of future cash flows across most firms. When future projections of the economy are poor or uncertain, investors are likely to look to managers for information regarding their firm s financial health and future prospects. Given the probability and costs of financial distress generally rise in down economies, this information is particularly valuable. During these times of reduced expectations, investors may be searching for signals to help reduce future uncertainty. In down markets by maintaining or increasing dividend payments, dividend-paying firms can credibly signal positive information, especially during times when other companies are decreasing their dividend payment or going out of business altogether. Non-dividend-paying firms, however, cannot. On the other hand, in up markets the value of dividend signals is likely to be lower; firms generally perform well, and the 3 There is also a large body of research that examines dividend and non-dividend-paying stocks separately, but that does not consider the state of the market. Papers such as Blume (1980), Litzenberger and Ramaswamy (1980, 1982), and Elton, Gruber, and Rentzler (1983) examine dividend yields in a modified version of Brennan (1970) s after-tax CAPM that explicitly accounts for non-dividend-paying firms. These papers find that although there is a relation between expected returns and dividend yields for those firms that pay dividends, this relation does not hold for non-dividend-paying firms. Christie (1990) examines non-dividend-paying firms explicitly and finds that nondividend-paying firms underperform firms of similar size. 3

6 probability of, and costs associated with, financial distress are lower. It is possible, therefore, that a policy of paying dividends during up markets conveys less information than a policy of paying dividends during down markets, since during up markets investors know that things are generally going well. 4 In any case, just the knowledge that a signal will be received reduces some uncertainty for investors. Indeed, it need not be that each individual dividend payment has great signaling value. Instead, the commitment to pay regular dividends allows the firm to send a signal that the future prospects for the firm remain positive. More importantly, investors know when to expect this signal. A dividendpaying firm currently has a regularly scheduled signal to send to its shareholders (through maintaining, increasing, or reducing its dividend); a non-dividend-paying firm does not (though at any moment it could choose to initiate a dividend and then commit to provide this signal in the future). Investors in nondividend-paying firms do not know when they will next receive credible information about their investment. 5 In particular, the value of dividend-paying stocks should be highest in those states of the world where the signal is of the most value, i.e., when there is either increased uncertainty or when expectations of the future have become less rosy. Whether the signal is the maintenance or increase in future earnings or the reduction of waste of free cash flows, the ability to signal should be most valuable in periods of poor overall stock market performance. As a result, investors may prefer dividend-paying stocks to non-dividend-paying stocks even in the months when the dividend-paying stock does not pay a 4 A similar signaling argument can be made for the free cash flow hypothesis as developed by Jensen and Meckling (1976) and Jensen (1986), which suggests that managers can credibly signal they will not invest in negative NPV projects through the bonding of maintaining dividend payments. This signal of avoidance of future negative NPV projects should be most valuable when the market is down, since the probability that the bonding will be a binding constraint increases as the state of the economy decreases. Thus, we are not concerned with what managers are signaling (a reduction in agency costs or maintenance or increase of future earnings), but rather whether investors value the signal offered by dividend payments. 5 While investors in non-dividend-paying firms could mimic this cash flow by selling stock, they would be doing so at depressed prices (given the market downturn) and incur potentially non-trivial transaction costs (a guaranteed loss). It is possible, therefore, that in these states of the world investors would prefer dividends, while in more positive states of the world the receipt of dividends would be less valuable. Allen, Bernardo, and Welch (1998) also note that firms prefer to pay out dividends rather than repurchase shares. Brennan and Thakor (1990) note that uninformed investors would prefer dividends to share repurchases due to adverse selection effects. Further, as a great deal of stock is now held in tax-deferred accounts, it is no longer clear that dividends are tax-disadvantaged to selling stock. See Clements (2002) for a larger discussion on this point. 4

7 dividend, as investors reasonably expect to get a signal within a few months for dividend-paying stocks. 6 Recent studies on dividends have focused more on the tendency of firms to pay or not pay dividends. Fama and French (2001) show that firms tend to view dividends as less necessary now than in the past, although DeAngelo, DeAngelo, and Skinner (2002) find that this trend has occurred due to very small dividend payers omitting dividends; increases by large dividend payers have more than offset these omissions in value. On the other hand, Allen, Bernardo, and Welch (1998) note that firms have continued to pay out more of their earnings in dividends than in repurchases. Baker and Wurgler (2003) find some evidence that when investors value dividends, managers will initiate dividend payments and when investors value non-dividend-paying stocks, managers omit dividend payments. These papers have not, however, examined investors responses across advancing or declining markets. The remainder of the paper is organized as follows. Section I presents the data and methodology. Section II describes the empirical results from CAPM and Fama-French three-factor model tests. Section III provides some robustness checks for our results by examining liquidity issues and dividend changes. Section IV concludes. I. Data and Methodology We identify a sample of dividend- and non-dividend-paying firms from the Center for Research in Security Prices (CRSP) monthly master file by examining all NYSE, AMEX, and Nasdaq listed stocks with data in CRSP over the 31-year period from January 1970 to December For each firm, we collect its monthly return, market capitalization and share volume data from CRSP. Since studies of returns and dividend yields such as Blume (1980), Litzenberger and Ramaswamy (1980, 1982), Elton, Gruber, and Rentzler (1983), and Christie (1990) note a U-shaped pattern in returns due to the unusual 6 For example, if a stock pays dividends in March, June, September, and December, the non-dividend-paying months are January, February, April, May, July, August, October, and November. While Easterbrook (1984) noted that designing an empirical test [of constant-payout policies] is formidable, Section II.E provides an empirical test of dividend-paying firms in non-dividend-paying months to examine the benefit of such constant dividend-payout policies. 5

8 nature of non-dividend-paying stocks, we identify dividends by comparing the CRSP total return to the CRSP return that does not include dividends. If the returns are different, the firm is considered to have paid a dividend in that month, and the difference is considered to be the dividend. Although this method might result in the calculation of negative dividends, these likely errors were retained so as to not impart any bias by correcting errors on only one side. Next, we used the distribution code in CRSP to determine if the dividend was a special, annual, semi-annual, quarterly, or monthly. As we are concerned with the signaling aspect of dividends, we only examine quarterly-dividend-paying stocks. Choosing quarterly-dividend-paying stocks increases the frequency of the possibility of signal observations while decreasing the length of time between potential signals. Thus, only quarterly-dividends were considered when determining whether a firm was a dividend-paying firm. All other dividend payments were considered as non-dividend-paying. In this way, to the extent that non-quarterly-dividends are at all considered positive, we will bias our results against finding any results for quarterly-dividend-paying firms. 7 For each month we classify firms as either dividend-paying or non-dividend-paying. If a firm paid a quarterly-dividend in that month, it is classified as a dividend-paying firm. Further, the months between quarterly-dividend payments are also classified as dividend-paying months. If a firm does not pay a dividend and then begins paying a dividend, it is classified as a non-dividend-paying firm until the month after the dividend is paid. That is, if a firm lists on January 1989 but does not pay a quarterlydividend until June 1992, then the firm is considered a non-dividend-firm from January 1989 through June 1992 and is classified as a dividend-paying firm as of July 1992 until the firm stops paying a dividend, the firm is delisted, or the sample period ends. In this way, any positive return in the stock 7 As one area of concern is the response of dividend-paying stocks, we chose a classification method that, if anything, will bias downwards the returns of dividend-paying stocks. In particular, this classification method does not bias upward the results for the dividend-paying stocks due to initiations and omissions. To insure that these rules did not affect our results, we re-ran our tests using alternate definitions of dividend-paying stocks. For example, we also included all regularly scheduled dividend payments (monthly, quarterly, and yearly) when classifying firms as dividend-paying. As another alternative classification method, we dropped all non-quarterlydividend payments from the sample so non-dividend-paying firms never paid any type of cash dividend. Results are qualitatively similar and available upon request. 6

9 price due to the initiation of a dividend will be attributed to the non-dividend-paying stock group, thereby biasing our results against finding outperformance by dividend-paying stocks. If a firm pays a dividend and then stops paying a dividend, it is classified as a dividend-paying firm until the month after the scheduled quarterly-dividend payment. That is, a firm lists on January 1989 and begins paying a quarterly-dividend as of March 1989 but does not pay the June 1992 dividend, then the firm is considered a non-dividend-paying firm for January, February, and March 1989, a dividend-paying firm from April 1989 to June 1992 (the month of the expected quarterly-dividend), and a non-dividend-paying firm from July 1992 until it is either delisted, pays a dividend, or the sample period ends. 8 Thus, any negative surprise due to the cessation of a dividend will be attributed to the dividend-paying group, further biasing our results against finding outperformance by dividend-paying stocks. Because we want to examine if investors value firms that pay dividends, we must look at those periods where dividend payments should be most valuable. We use down markets as a proxy for those times when investors should more highly value dividend payment. Similar to Goldstein and Nelling (1999), we collect the S&P 500 returns for each month from CRSP and classify an up market as a month during which the monthly return on the S&P 500 was positive, while a down market is one where the S&P 500 posted a negative monthly return. Other papers examining asymmetric market responses have defined up/down markets differently. For example, Ang and Chen (2001) define up and down markets by looking at returns in excess of the one-month Treasury bill. Ang, Chen, and Xing (2001) define up and down markets by whether the excess market return is below its mean in the previous year. Given that the market historically has a positive excess return, these alternate definitions would result in more months being classified as down markets than will our more restrictive definition. As we are primarily interested in different responses in down markets, we use the more conservative definition. 9 8 As a robustness check, we also ran the results requiring that for a firm to be called a dividend-paying firm, the firm must pay dividends for the entire time period. All of the results were substantively unchanged. 9 As a robustness check, we also ran tests defining down markets as negative excess returns. The results on excess returns (not reported here) are substantively similar. In the robustness section, we classified up and down markets based on bull and bear market definitions provided by Ned Davis Research Inc. 7

10 Overall, our sample includes 20,315 NYSE, Amex and NASDAQ listed firms from January 1970 to December Each firm was classified as either dividend-paying or non-dividend-paying for every month of the sample period in which data was available, resulting in a total of 2,161,688 firm months in our time period, of which 1,392,422 are non-dividend-paying firm months and 769,266 are dividendpaying firm months. Table 1 describes the dividend- and non-dividend-paying firm months in our sample. As Panel A indicates, the average market capitalization of firms during the months when they were classified as dividend paying is almost five times that of firms classified as non-dividend-paying. This larger size is due to having twice as many shares outstanding and an average price about 2.5 that of the non-dividend-paying firms. Trading volume was relatively similar for dividend-paying firms and non-dividend-paying firms. Betas for non-dividend-paying firms were slightly larger than those classified as dividend-paying firms. Finally, non-dividend-paying firms on average returned 1.01% per month, while dividend-paying firms had a larger average return of 1.375%. For exposition, we provide data on four sample months at the end of each decade. As shown in Panel B, the overall results in Panel A were generally the same for the months of December 1970, December 1980, December 1990, and December Insert Table 1 here II. Results To examine investors preferences for dividends in up and down markets, we examine returns of dividend-paying and non-dividend-paying stocks overall and in up and down markets separately. In addition to showing results for all markets, Table 2 presents evidence for the 217 months in our sample where the S&P 500 had a positive return ( up markets ) and the 155 months where it did not ( down markets ). Panel A shows that overall, dividend-paying firms significantly outperformed non-dividendpaying firms by 0.37% per month. Further, dividend-paying firms outperformed non-dividend-paying firms in both up and down markets, with the differences statistically significant at the 1% level for non- 8

11 parametric tests, as indicated by the Wilcoxon sign-rank test and the Kruskal-Wallis test, and dividendpaying firms outperformed non-dividend-paying firms in down markets at the 1% level using the Student s t-test. The magnitude of the difference, however, depended on the state of the market. Although dividend-paying firms returned only 0.16% more than non-dividend-paying firms during up markets, they provided 0.90% more than non-dividend-paying firms during down markets. We find similar results for all markets and down markets for the three-decade sub-periods examined January 1970 to December 1979, January 1980 to December 1989, and January 1990 to December (In the 1970s and 1990s, non-dividend-paying firms significantly outperform dividend-paying firms in up markets.) Finally, the difference between dividend-paying firms and non-dividend-paying firms was more than twenty times larger in down markets than in up markets (and is statistically significant). These results are consistent overall and in each of the three sub-periods; an indication that investors value dividend-paying firms much more than non-dividend-paying firms during down markets. Insert Table 2 here A. CAPM Results Although the state of the market affects the magnitude of the difference, so too does the level of risk of the stock. 10 To adjust for any differences in risk across stocks, firms were assigned into ten groups based on their CRSP beta decile classification: Group 1 had the most risky firms according to the CRSP beta decile, while Group 10 had the least risk. The results in Panel B of Table 2 indicate that in up markets the risk of the stock is positively associated the outperformance of dividend-paying stocks over non-dividend-paying stocks. The least risky stocks (decile 10) show no difference in returns for all markets. In addition, dividend-paying firms on average outperform non-dividend-paying firms in down markets, even after controlling for risk. A comparison of the differences indicates that for all beta deciles except decile 9, the dividend-paying stocks outperformed the non-dividend-paying stocks by more in the 10 Based on the issues raised in Christie (1990), these tests were also performed on deciles sorted by market capitalization; the results were substantively similar and are available from the authors upon request. 9

12 down markets than in the up markets. These differences in differences were mostly significant. Collectively, these results indicate that in general investors dividend preference is a function of the state of the market, and specifically that investors find a differential benefit to dividends in down markets. To further control for risk, we also examine the abnormal return for each firm i using the capital asset pricing model to determine expected returns; we estimate: Abnormal Return ( r β ( r r )) = ActualReturn F (1) i i F i M where Actual Return i is the return for firm i for that month, r F is the three-month Treasury bill for that month, r M is the return on the CRSP equally-weighted portfolio, and β i is the beta for stock i. We then compare the abnormal returns for divided-paying and non-dividend-paying firms for all markets, up markets and down markets. As shown in Table 3, we find that for all markets, dividend-paying firms significantly outperform non-dividend-paying firms. For up markets, non-dividend-paying firms outperform dividend-paying firms. Yet, once again, for down markets dividend-paying firms perform significantly better (i.e., significantly less negative returns) than non-dividend-paying firms. Insert Table 3 here Thus, the answer to our central question, do investors prefer dividend-paying firms to nondividend-paying firms in down markets, is yes. Further, these results are robust to controlling for beta, regardless of the time period. Dividend and non-dividend-paying stocks have dissimilar asymmetric return characteristics in up and down markets. These differences appear to increase as risk increases. In this way, our results differ from those in Ang and Chen (2001), which finds that stocks with lower betas have a greater asymmetry of up/down correlation once correlations exceed a pre-specified level. 11 Our tests therefore measure something besides the asymmetric correlation result in Ang and Chen (2001). 11 Ang and Chen (2001) define downside (upside) correlations to be correlations where both the equity portfolio and the market return are below (above) a pre-specified level. They further develop a summary statistic to compare the difference in their up/down correlation measures to a particular distribution. Their tests and measures are therefore conditional on more extreme movements than those in this paper. In addition, they focus on the return itself; they do not partition into dividend and non-dividend-paying firms. 10

13 B. Size and Market-to-Book Results Fama and French (1992) and others have suggested that book-to-market and size are also important determinants of returns. To test if the results are robust to segmentation by book-to-market and size, we replicate the original Fama and French (1992) methodology by dividing our samples of dividendpaying and non-dividend-paying stocks into four market capitalization quartiles and then further subdividing those quartiles into four book-to-market quartiles, for a total of 16 sub-groups for each of the dividend-paying and non-dividend-paying stocks. 12 The end result is thirty-two portfolios: sixteen portfolios of dividend-paying stocks based on book-to-market and size quartiles, and sixteen portfolios for non-dividend-paying stocks. We then calculate the average excess return (return of a firm in month t over the three-month Treasury bill rate in month t) for each portfolio. Insert Table 4 here Table 4 examines the excess return characteristics for the portfolios formed on size and book-tomarket. Overall, size seems not to matter as much as book-to-market in determining the difference between the dividend-paying and non-dividend-paying groups for all markets. As shown in Panel A, nondividend-paying stocks seem to outperform dividend-paying stocks for the lower book-to-market groups across all markets, with the reverse true for the higher book-to-market quartiles. However, as Panel B shows, in up markets the non-dividend-paying stocks outperform the dividend-paying stocks for low book-to-market quartiles, but for the higher book-to-market groups, size becomes a factor and only the smaller stocks in the higher book-to-market quartiles have a significant difference. Panel C, however, presents results that during down markets, dividend-paying stocks do better than non-dividend-paying 12 We thank Ken French for providing the cutoff points for the market capitalization and book-to-market quartiles. 11

14 stocks for all book-to-market categories, but only for the smaller stocks. Thus, the results are strongest for low book-to-market small stocks. 13 C. Fama-French Three-Factor Model Results Similar to Ang, Chen, and Xing (2001), we also use the Fama and French (1993) (FF) threefactor model to estimate abnormal returns for monthly portfolios. This model controls for nonindependence of returns over time, size, and book-to-market effects. We estimate a modified FF threefactor model as follows: r r = α + b RMRF + s SMB + h HML + d DOWN + ε (2) it Ft it it t it t it t it t it where r it is the monthly return on a portfolio i of dividend-paying or non-dividend-paying firms, r Ft is the monthly return on three-month Treasury bills, RMRF is the excess return on a value-weighted aggregate market proxy, SMB is the difference in the returns of a value weighted portfolio of small stocks and large stocks, HML is the difference in the returns of a value-weighted portfolio of high book-to-market stocks and low book-to-market stocks as in Fama and French (1993), and DOWN is a dummy variable which takes on the value one if the market is down and zero if the market is up. For each month we calculate the excess return on an equally-weighted portfolio composed of either all dividend-paying firms or all nondividend-paying firms. We then regress this portfolio return on the factors in equation (2) and examine the differences in coefficients. We would expect that if investors prefer dividend-paying firms in down markets, that for the dividend-paying portfolio the coefficient on DOWN should be significantly higher than that of the non-dividend-paying portfolio. 13 To determine if the results in Table 4 were driven by differences in size and book-to-market values for dividendpaying versus non-dividend-paying stocks within each individual size and book-to-market subgrouping, we examined the median size and book-to-market values for each group in the sixteen groupings. We found that only for the smallest firms were there significant differences between the median size of dividend-paying and nondividend paying firms (dividend paying firms were significantly larger than non-dividend paying firms). There were no significant differences in median book-to-market ratios for dividend-paying and non-dividend paying firms across the sixteen groups. 12

15 1. Econometric issues and weighting methodology There are a number of factors in favor of equally weighting of portfolios. First, we are examining the responses of dividend and non-dividend portfolios to up and down markets, where up is defined as a positive S&P 500 return. The S&P 500 index is itself a value-weighted portfolio. Thus, the valueweighted dividend and non-dividend portfolios will be very highly correlated with the variable that conditions on the up and down market, namely S&P 500 index. 14 Many of the same stocks will determine the return characteristics of both the portfolios and the index that divides our sample. This effect will be particularly exacerbated for the value-weighted dividend portfolio, given the structure of the S&P 500 index, which will further complicate comparisons across the dividend and non-dividend portfolios. 15 A second issue related to the use of equally-weighted portfolios instead of value-weighted portfolios is the increased transaction costs that may arise from increased trading due to more frequent portfolio rebalancing. While holding an equally-weighted portfolio may incur more transaction costs and therefore may be more difficult to trade, the issue in this paper is the differential asymmetric response of dividend and non-dividend-paying stocks in up and down markets. Given that the state of the market is fixed during any one month, investors cannot trade on this information; it is a state of the world for all stocks. Furthermore, even if it were possible to trade on the state of the market, it would be prohibitively expensive for investors to move from an all dividend-paying portfolio to an all non-dividend-paying portfolio based on the state of the market. Therefore, given the focus of the question and the nature of the test, trading considerations are not a primary concern. Third, the results in Table 4 for the sixteen size and book-to-market portfolios indicate that the results vary with size, so making size-weighted portfolios would somewhat obfuscate the results. Ang and Chen (2001) also note that these asymmetric results decrease with size; therefore, value-weighted 14 We also changed the definition of up/down markets to be based on whether the CRSP equally-weighted index had positive returns or not. The results provided even more support that dividend-paying stock outperform nondividend-paying stocks even when portfolio returns were value-weighted. 15 For example, since the value-weighted dividend-paying portfolio returns are highly correlated with the S&P 500 return, we would expect that dividend-paying portfolios to always do worse than non-dividend-paying firms in down markets. 13

16 portfolios would tend to understate the magnitude of the results. In addition, Fama and French (1993, 1996a) find that three-factor models have systematic problems explaining returns for small stocks, making this methodology not as useful. As Fama (1998) notes, the weighting structure of the portfolio should determined by the underlying question. Because the question under investigation is more a question about the particular nature of an individual stock does it or does it not pay a dividend and not particularly about a portfolio, Fama (1998) implies that equally weighting is appropriate. Further, equally-weighted portfolios allow for an examination of individual characteristics of a stock by treating each stock similarly, while value weighted portfolios can be primarily driven by a limited number of stocks. Results from equally-weighted portfolios therefore better represent the average stock. A number of recent papers, such as Lowry (2003), have therefore presented equally-weighted results. More importantly, dividend policy is a management choice variable. As managers do not control a portfolio of firms, but instead a single firm, managers are more concerned with the results for an average stock. Finally, another issue related to the use of equally-weighted portfolios instead of value-weighted portfolios is the issue of small stock bias due to poor performance of the Fama-French model with respect to small stocks. One can mitigate the small stock issue by removing some of the smaller stocks from the analysis and verifying the results. To this end, we re-ran all of our tests removing the bottom quartile of stocks based on market capitalization. As we found substantively similar (or stronger) results on this subset, we have retained the full sample for presentation in the paper Fama-French overall results We first verify that the FF three-factor model using our sample provides consistent results with prior research. Below are the results for equally-weighted dividend-paying and non-dividend-paying 16 For evenness, we also re-ran the results removing the top quartile as well, so as not to impart any bias. In this case, we truncated the distribution of firms at both the upper and lower 25% points, so that the tests were run on the middle 50% of the firms. All of the results were substantively similar and are available from the authors upon request. 14

17 portfolios for the pure Fama-French three-factor model: Intercept RMRF SMB HML Adjusted R 2 Non-Dividend-paying ** ** ** 89.4% Dividend-paying ** ** ** 92.3% Differences ** ** The coefficients on the FF three-factors indicate that the data load properly on the factors, do not have significant alphas, and have very high adjusted R 2, of around 90% for all portfolios, indicating that the FF model works well with this data. In addition, although the factor loadings are significantly different from each other, unlike the hypotheses in Brennan (1970) or the empirical results in Black and Scholes (1974), Litzenberger and Ramaswamy (1979, 1980, 1982), and Blume (1980), we do not find differences between dividend-paying and non-dividend-paying stocks overall. 3. Modified Fama-French results Table 5 presents the results for the modified FF model with the additional dummy variable DOWN. Panel A examines the differences between dividend-paying and non-dividend-paying stocks. In general, we find that the return-generating process is different for dividend-paying stocks than for stocks that do not pay a dividend. In particular, we find that the state of the market affects the return of the portfolios when the market is going down, and that this difference between the two portfolios is significant. More specifically, we find that the down market dummy variable is significant for nondividend-paying firms, indicating that non-dividend-paying firms have a different return-generating function in down markets. Furthermore, the coefficient on the down dummy variable is more negative for non-dividend-paying firms than it is for dividend-paying firms and the difference between the two coefficients is significant, indicating that dividend-paying firms, on average, outperform non-dividendpaying firms. Insert Table 5 here 15

18 D. Dividend Yield, Tax Clienteles, and Signaling The previous tests focus only on whether or not firms pay dividends, and not the magnitude of dividend payments. In this way, we control for the U-shaped pattern in dividend yields that resulted from non-dividend-paying stocks. A question arises, however, whether these results are sensitive to the size of the dividend yield. After all, the results found above may be an asset pricing result due to some form of tax clientele or dividend-capture strategy. Alternatively, investors might reevaluate positively the benefit of the ability of dividend-paying firms to signal issues related to future performance during periods when the future performance of all stocks is being devalued (hence the downturn in prices across the market resulting in the decline). In either case, because non-dividend-paying firms do not credibly provide this signal, investors may discover that their state preferences for dividend payments cause them to value dividend-paying firms higher than non-dividend-paying firms during market downturns. 17 If the results found in this paper were due to an asset pricing result, it should be true that dividend yields are positively associated with differences in returns in up and down markets. Alternatively, if the additional value of the dividend were due to the signaling nature of dividends, it may matter more that the firm pays a dividend at all and not the magnitude of the dividend. To investigate further whether the results in the paper are due to more of an asset pricing or signaling nature, we divide stocks that paid dividends into quintiles based on yearly dividend yield. If the previous results are due to an asset pricing strategy, the results should be stronger for high-dividend-yield stocks than for low-dividend-yield stocks. In addition, there should not be much of a difference between the low-dividend-yield and the non-dividend-paying stocks. Alternatively, if the signaling nature of 17 While non-dividend-paying firms can initiate stock repurchase plans, these repurchases are discretionary and are not observable by investors, as noted by Howe, He and Kao (1992). Thus, these plans have a different signaling ability than regular dividend payments. 16

19 dividends is important, there should be little difference between the high- and low-yield-dividend portfolios and a much larger difference between the low-yield and non-dividend-paying firms. 18 The results in Panel B of Table 5 for the quintile portfolios based on dividend yield of dividendpaying stocks indicate that each quintile loads differently on the Fama-French factors. In particular, the smallest two dividend yield quintiles have statistically significant positive alphas, while the highest dividend yield has a statistically significant negative alpha. Not surprisingly, the F-test rejects the null of equality of the alphas across the quintiles at the 1% level. However, we cannot reject the hypothesis that the coefficients on the DOWN variable are statistically different across the quintiles. This result indicates that the results presented in Panel A of Table 5 and in previous tables on the asymmetric response of nondividend and dividend-paying stocks to down markets are not related to dividend yield, but rather to the existence of dividend payments themselves. In fact, all of the coefficients on the DOWN variable are insignificantly different from zero for all quintiles (except for the lowest dividend yield quintile), as was the case in Panel A. As a further test, Panel C of Table 5 examines the difference between the non-dividend-paying group and the quintile with the lowest dividend yield. In this case, the coefficients on the alphas and the HML book-to-market variables were not significantly different from each other. However, the coefficients on the DOWN variable were significantly different for the non-dividend-paying and lowest dividend yield portfolios, further indicating that it is the dividend payment, and not the magnitude of the payment, that drives previous results. The results in Panels B and C indicate a much larger difference between the non-dividend-paying and low dividend yield portfolios than among the dividend-paying portfolios themselves. These results support the signaling hypothesis over the tax clientele/dividend capture hypotheses for explaining the 18 Again, we are not suggesting that each individual dividend payment has great signaling value, but that the regular payment of a dividend sends a signal as does increasing or decreasing a dividend. In addition, investors know when to expect this signal. Alternatively, from a prospect theory perspective, the two tests examine different parts of the loss avoidance that makes investors prefer a certain gain: is it the level of certainty (similar to the signaling theory) or the size of the gain (similar to the asset pricing theory)? 17

20 reason for the asymmetric responses in up and down markets shown by the data. These results do not support Brennan (1970) or Litzenberger and Ramaswamy (1979, 1980, 1982), in that the lower dividend yield stocks seem to outperform the high dividend yield stocks on a pre-tax nominal return basis. Instead, these results are consistent with the findings in Miller and Scholes (1982). Collectively, the results in Tables 2, 3, 4, and 5 indicate that it is the payment or non-payment of dividends not the level of the payment that drives the results that dividend-paying firms outperform non-dividend-paying firms in down markets. To this extent, they support earlier findings by Blume (1980), Litzenberger and Ramaswamy (1980, 1982), Elton, Gruber, and Rentzler (1983), and Christie (1990) that non-dividend-paying stocks are different from dividend-paying stocks. Further, it seems less likely that the tax clientele/dividend capture hypothesis is driving the results, but that dividend signaling (either the dividend-signaling hypothesis or the free-cash-flow hypothesis) is more likely the cause. E. Dividend-paying stocks during non-dividend-paying months Possibly, dividend-paying firms outperform non-dividend paying firms simply because of the return in the month the firm paid the dividend, and in the remaining months when no dividend is paid returns for dividend and non-dividend paying firms are similar. If this is true, then there may be no information or signal in the fact that a firm continues to pay a dividend but only a signal in the dividend payment itself when it is received. 19 Alternatively, it could be that the knowledge that a signal will be received (via the dividend payment) is in itself valued as well. To test this hypothesis, we eliminate the returns for dividend paying firms in the month the dividend is paid and compare the returns of non-dividend-paying firms to the returns of dividend-paying firms in months with no dividend payments. As indicated in Table 6, we find that for up markets, dividend-paying and non-dividend-paying firms have the same average monthly return, but in down markets, dividend-paying firms still significantly outperform non-dividend-paying firms, even when the 19 Similarly, any asset pricing strategy that involves dividend capture or tax clienteles should not have different results in non-dividend-paying months. 18

21 dividend return is excluded. The difference of differences is significant at the 1% level. Further, we estimate the modified FF model in equation (2) and find that again, the down market dummy variable is significantly higher (less negative) for dividend-paying firms than for non-dividend paying firms. These results indicate not only that the dividend-payment is valued as a signal, but that even during the time periods when a dividend is not being paid (and thus no signal is being given), the mere knowledge that within three months a signal will be received is valued as well. Our results not only indicate that there is value in the signal of paying a dividend and not just the dividend payment itself, but also that there is a value in the knowledge that a signal will be received. Overall, these results further support the dividend signaling hypothesis. F. Dividend Changes Finally, we test whether dividend payments matter based on market conditions by examining the market's reaction to dividend changes and no changes during up and down markets. From an asset pricing or dividend capture/tax clientele perspective, we would expect that market responses to changes in dividends would not be a function of the state of the market. In other words, the market should respond similarly to increases in dividends in either an up or down market. Not changing a dividend would likely have little effect from an asset pricing perspective regardless of the overall state of the market. From an information or signaling perspective, however, we would expect an asymmetric response. In down markets, investors perceptions of future profits tend to be lower, while investors tend to have positive outlooks on future earnings during up markets. Increasing dividends in down markets therefore provides a much stronger signal about the future than a similar increase during an up market. Similarly, not changing a dividend during up markets likely provides little additional information to investors. However, during a down market, when investors may be more pessimistic about the overall economic outlook, not changing a dividend provides investors with a reassuring signal that the company is not headed for bankruptcy. Finally, decreasing dividends in down markets may be expected by investors and 19