Many of us like firms that pay dividends because it’s a bird in the hand. In addition, stocks of dividend-paying firms are typically thought of as safe investments. However, based on some of the latest academic research, we need to be careful about “appearances.” 

It turns out that firms will try to figure out what investors like, and then they will become exactly that.  Let me give you some examples.  When investors are bullish about firms that increase their capital expenditures (that is, increase their corporate investments), then firms will start to increase their capital expenditures.  When investors place a high value on firms with sales growth, then firms will focus on trying to increase their sales.  

However, when investors place a high value on firms that that cut costs to increase profit margins, then firms will try to cut costs.  And, getting back to the point of this post, when investors are in love with firms that pay dividends, then firms will pay dividends.

In other words, firms cater to investors’ tastes. So what?  Well, if you buy a stock that pays dividends, thinking that the dividends signal something good about the firm, you could be getting fooled. This is just another game of “they are saying what you want to hear.” Another kind of payout are stock repurchases. We love it when firms repurchase their own stocks because it usually indicates that firms believe their shares are undervalued. So, for firms that repurchase stocks, they subsequently enjoy higher stock valuations. 

However, I wondered if firms were repurchasing their stocks simply because they knew this is what we, as investors, sometimes liked. So, I did a study. I looked at U.S. listed-firms during 1964-2010. I was able to get over 125,000 data points (number of firms times number of years). Here’s what I found:  When investors placed a value premium on firms that repurchased their own stock, then other firms started repurchasing their stock, too. When investors were not that into firms that repurchased, then firms did not repurchase. So, the repurchases might not really indicate anything about the firm’s quality! 

And, are you ready for this? I also found that when investors placed a value premium on dividends, then firms paid dividends instead of repurchasing stock. When investors placed a value premium on repurchases, then firms repurchased stock instead of paying dividends. Firms don’t seem to care how they made their payouts. They just did whatever investors liked. So, the bottom-line is this: Don’t be fooled by appearances.        

Kenneth A. Kim is chief financial strategist for Eqis, which provides asset management, practice management and operations automation on an integrated platform for advisors.