Dividend signaling is the concept that a company that pays dividends is signaling to the market that management is optimistic about its prospects. The theory being, quite simply, that a company would not continue to maintain or increase a dividend unless it knew the immediate future was bright; the act of returning cash to investors is the truer sign of the company’s prospects than any press release could reveal.
But, if you believe in the dividend signaling theory, could the act of declaring dividends itself act as a signal for decreased volatility in a stock? There appears to be evidence indicating as such.
A 1989 research paper found that after a company began declaring dividends, its stock price experienced lower price movements after earnings release and price variability falls after the initiation of a dividend policy. The conclusion being that investors tend to look at the dividend policy as a signal or bellweather to the future much more than earnings itself. Certainly, this would be reflected in the greater price effects of a dividend paying stock increasing or decreasing its dividend than merely meeting earnings expectations.
There is, admittedly, self-selection in the process; dividend stocks tends to attract certain types of investors who place a relatively larger premium on the cash flow component of the stock than pure momentum traders/investors. This raises the larger question of whether it is wise to purchase a dividend paying stock purely on the dividend increase itself rather than the underlying fundamentals. However, very few of us are purely rational beings in the market.
Not surprisingly, where dividends cease to be paid, two inter-related results arise. Without a dividend policy, earnings variance increases and earnings predictability decreases. This is explainable in that earnings and cash flow have to be predictable to declare dividends in the first place; dividends tend to be revoked once you lose that predictable cash flow (see banks in 2008 and 2009) which effects earnings expectations as well. Without any consistency in earnings, companies are more likely to meet earnings expectations and be punished by the markets.
The conclusion seems to be that investors with low tolerance for volatility and a desire for some type of predictability, but require an exposure to equities, should gravitate towards dividend paying stocks.
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