Apple and the Dividend Puzzle

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.”