Thursday, December 29, 2011

Information Content of Dividends Hypothesis

Do corporate dividend changes predict future profitability and cash flows of firms? According to John Lintner's information content of dividends (ICD) hypothesis, this question should be answered affirmatively.

Statistical Analysis

Different statistical analysis have been carried out since Lintner's first presentation of the ICD hypothesis in 1956. The main findings of these analysis can be summarized as follows:

- There is no statistically significant relationship between both above cited variables. (Watts – Journal of Business 1973, 191 et seq.)
- The ICD hypothesis is not reliable because management tends to increase dividends on the basis of overoptimistic forecasts about future earnings. (De Angelo, Skinner – Journal of Financial Economics 1996, 341 et seq.)
- The ICD hypothesis is only reliable as far as the year before and after a dividend increase is concerned. (Benartzi, Michaely, Thaler – Journal of Finance 1997, 1007 et seq.)
- The validity of the ICD hypothesis depends on firm characteristics such as corporate governance structure (How is the ownership structure shaped? Who are the shareholders and which kind of dividend policy do they expect?) and growth stage (The ICD hypothesis namely applies to low-growth firms because such firms have simply less other investment opportunities.). (Choi, Joo, Park – Accounting and Finance 2011, 869 et seq.)
- Negative dividend changes are somewhat predictive of future earnings decreases whereas positive dividend changes provide less information about future earnings. (Choi, Joo, Park – Accounting and Finance 2011, 869 et seq.)


Reading about the above described ICD hypothesis discussion, I am wondering about 3 main issues:

- First and foremost, can we lead this discussion without taking into account the legal form of the firm, the practical implementation of such legal form, and the way dividends are decided upon by respective organs? For example, many jurisdictions provide for the shareholders’ meeting to decide upon a distribution of dividends. However, the processes of such shareholders' decision making as well as the required quorum might deviate substantially among various jurisdictions. In addition, I would expect a decision and (its motivation) to distribute dividends differentiate considerably in a small company where shareholders and top management are identical as opposed to a multinational corporation where stocks are listed and widespread among individuals.

- What about the applicable tax regime for dividends? For example, a higher dividend policy might be linked to a favorable tax regime rather than the company's past and/or future profitability.

- Finally, is this discussion not an example of a confusion between correlation and causality? Is a firm's future profitability higher because of higher dividends in the past? Isn't it more likely that past dividends got higher because of higher profits? Didn't those higher profits simply mean that the company was doing well in the past and, therefore, continued to do well in the future?

Friday, December 23, 2011

Quantitative Easing Operations by the European Central Bank

On December 22, 2011, the Financial Times has discussed the possibility and appropriateness for the European Central Bank to carry out quantitative easing operations. In his FT interview, Lorenzo Bini Smaghi has argued in favor of such operations and called for “policymakers not to hide behind lawyers to avoid taking action”.

When reading this interview, I was wondering if and how policymakers can hide. My conclusion is that the legal texts support Smaghi’s point of view and, as a matter of fact, contain no stipulation that could reasonably justify a prohibition of QE operations.

Let’s have a look at the texts:

The Statute of the European System of Central Banks (Protocol No. 4 of the Treaty on the Functioning of the European Union) reads as follows:

Article 18 - Open market and credit operations

18.1. In order to achieve the objectives of the ESCB and to carry out its tasks, the ECB and the national central banks may:

- operate in the financial markets by buying and selling outright (spot and forward) or under repurchase agreement and by lending or borrowing claims and marketable instruments, whether in euro or other currencies, as well as precious metals;

- conduct credit operations with credit institutions and other market participants, with lending being based on adequate collateral.

18.2. The ECB shall establish general principles for open market and credit operations carried out by itself or the national central banks, including for the announcement of conditions under which they stand ready to enter into such transactions.”

Art. 21 – Operations with public entities

21.1. In accordance with Article 123 of the Treaty on the Functioning of the European Union, overdrafts or any other type of credit facility with the ECB or with the national central banks in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.


On the basis of the above, my conclusions are as follows:

The ECB has 3 alternative possibilities to act on the financial markets:

- buying and selling [claims and marketable instruments] outright (spot and forward);
- [buying and selling claims and marketable instruments] under repurchase agreement;
- lending or borrowing claims and marketable instruments.

In my view, the first alternative covers quantitative easing operations. As a matter of fact, only direct underwriting is prohibited by Art. 21.1 of the Statute.

Based on Art. 18.2 of the Statute, the ECB has established its guidelines on monetary policy instruments and procedures of the Eurosystem (lastly modified on September 20, 2011). It is right that, today, these guidelines do not provide for QE operations (See Art. 1.3.1). However, the ECB can modify its guidelines on its own, and the European treaties should not contradict such modification.