Positive dividend surprises such as unexpectedly high annual rises or one-off special payouts can be a welcome boost for income hunters – and, unsurprisingly, some investors spend a lot of time trying to find them. Indeed, evidence suggests that companies that catch the market (and their shareholders) by surprise are frequently rewarded with a rising share price as a result.
We’ve talked in the past about Earnings Surprise as a source of market-beating returns. This phenomena is known as ‘Post Earnings Announcement Drift’ – and research has found that stocks that beat analyst forecasts tend to outperform the market for the next 6-12 months. This is generally attributed to the fact that analysts are slow to revise these forecasts and the market does not fully react to the information about future growth conveyed by the earnings surprises.
As it turns out, this thinking can also be applied to dividends too – and it works even better. Research by Michaely, suggests that post-dividend price drift “is distinct from and more pronounced than that following earnings surprises”. Meanwhile, Shore Capital investment strategist Gerard Lane, who’s tracked this strategy for the UK market, says “there is much more proliferation of story around earnings upgrades and downgrades”, which means there is a greater tendency by analysts to move sales and earnings numbers and less tendency to focus on the resulting dividend change.
So, how can dividend investors find these potential surprises?
Defining the Dividend Surprise Factor
The search for surprises is not difficult in theory. ShoreCap defines the ‘dividend surprise factor’ as the difference between what was forecasted 12 months ago for the forthcoming 12 months and what was actually delivered during the period on a dividend per share basis. Of course, implementing this systematically as part of a screening system is another matter - we're not aware of this being possible using another UK stock screener but we’ll be setting it up shortly as part of Stockopedia PRO.
Lane’s research suggests that the pursuit of companies that have produced dividend surprises is a strong trading strategy even in troubled times. During the 12 months to the beginning of April 2012 companies with the top 10 percent of dividend surprises returned 0.0 percent on an equal-weighted basis in capital returns versus -3.6 percent from the FTSE 350 benchmark. According to Lane, dealing with ‘known knowns’ not only reduces forecast risk but enables an intuitive approach to stock selection of favouring those companies that have over-delivered on dividends compared with previously held expectations.
The allure of dividend surprises is not confined to individual investment strategies, either. Last year Andy Jones and Kyle McClements, who manage Black Rock’s European Enhanced Equity Yield Fund (which is 30% weighted to the UK), put specific emphasis on the search for dividend surprises. They noted that while dividends were generally the only option for investors seeking high income (given the relatively modest yields available from government bonds), dividend stocks were trading at a premium: “As expected-dividends are likely priced into the market, we feel adding a dividend surprise component to our portfolio construction will benefit our investors.” Like ShoreCap, the fund managers compare actual dividends with earlier forecasts in order to find stocks that paid a higher dividend than the market expected. Or, to explain that in their words: “This results in our current high dividend yield, plus a dividend surprise component that will help total return.”
Why dividend surprises matter
The subject of dividends, and dividend policy in particular, is one that’s hotly contested by academics. Often, much of this noise can be ignored but in the case of dividend surprises, it’s worth exploring the history of the research in order to understand the thinking on why they occur and what they mean…
…back in 1959, US economists Miller and Modigliani came up with something called the ‘capital structure irrelevance principle’ and an associated ‘dividend irrelevance’ theory. They argued that neither a firm’s capital structure or its dividend policy had any influence on its market value (you can read a 30 year update from Miller here). On the dividends front, their assertions sparked fierce debate about how dividend policy actually influences share price – leading M&M to revisit the subject a in 1961 paper. And this debate gets to the heart of why dividend surprises – both positive and negative – really matter to investors. As the academic research has unfolded, the focus has turned to WHY and HOW dividend policy influences share price rather than IF. Among the most interesting arguments is something called ‘dividend signalling’ which, among other things, claims that by implementing a dividend increase or cut, management are signalling to investors their confidence or concerns about future earnings – and the share price moves as a consequence. The implication is that a dividend surprise is not only a welcome financial boost but it’s also a confident message from management that’s likely to have a positive influence on the share price as well.
There is a second strand of academic research that is worth exploring, and that is a view that brokers and analysts are generally better at forecasting dividends that they are at predicting earnings. An international study by Brown, How and Verhoeven, concluded that this is because managers have greater control over the dividends they pay to shareholders than the earnings they report. To a point, this finding ties-up with the idea of dividend ‘smoothing’ first presented by Lintner in the 1950s, which argues that managers typically ‘smooth’ dividend increases over time and only make upward changes when they are sure that earnings can support the increase. As a consequence, analysts generally have a pretty good fix on a company’s dividend policy and the management’s ability to fulfil it. Why is that important? Well, if analysts are typically on the money when it comes to predicting dividends (and their payout forecasts are priced in to the shares), then a positive dividend surprise represents new information. Research suggests it will push up the price as the market assimilates this new information and broker forecasts are revised.
Tracking down those surprises
All this research spells great news for investors – and it explains why, in day-to-day investment commentary and analyst research, a positive dividend surprise often makes the headlines. A higher than expected payout combined with management signalling optimism about the future mean that dividend surprises offer an intriguing and even exciting pursuit for dividend investors that are looking for outperformance from their stocks. By comparing 12-month dividend forecasts with how stocks then go on to perform, it is possible to lift the lid on those companies that are confident enough about their future to payout extra rewards to shareholders.