Returns of high dividend yield stocks in the Dutch market

Master Thesis (20 ects) Returns of high dividend yield stocks in the Dutch market Author: R.C.M. Mosch Student number: 5621151 Master s in Business Economics, Faculty of Economics and Business, University of Amsterdam Completion date: 16 July 2010 Abstract: The relationship between stock returns and dividend yield is investigated for the Dutch market. We perform conventional tests and regression analyses. We find evidence that high dividend yield stocks achieve statistically excessive returns. However, we would like to control these returns for risk, taxes, and transaction costs. Risk is measured by three different risk measures: Sharpe measure, Treynor measure, and Jensen s alpha. These controlled returns do not achieve excessive returns. Supervisor: Second examiner: dr. J.W.T. Bogers dr. J.E. Ligterink

Table of contents 1. Introduction 2 2. Literature review 3-2.1 Payout policy 3-2.2 The stocks with the highest dividend yield strategy 4-2.3 The Efficient Market Hypothesis (EMH) 6-2.4 Validity of the high dividend yield strategy 7 3. Methodology 7-3.1 Sample period 8-3.2 The conventional tests 9-3.3 Regression analysis 13-3.3.1 The level of the dividend yield 14-3.3.2 The existence of dividend yield 15 4. Data 16 5. Empirical results 16-5.1 Statistical results on a single year basis 17-5.2 Statistical results on a multiple year basis 20-5.3 Economical results 23-5.3.1 The Sharpe ratio 24-5.3.2 The Treynor ratio 26-5.3.3 Jensen s alpha 30-5.3.4 The final economical results corrected for risk, taxes, and transaction costs 31-5.3.4.1 Economical results for the top-one portfolio and the AEX-index 31-5.3.4.2 Economical results for the top-five portfolio 32-5.3.4.3 Economical results for the top-ten portfolio 33-5.4 Regression analysis 33-5.4.1 Influence of the level of dividend yield 34-5.4.2 Influence of the existence of dividend yield 35 6. Summary and conclusions 36 References 39 Appendix 41 1

1. Introduction In this thesis we investigate the relationship between dividend yield and stock returns. We are interested in strategies that can beat the market. A general assumption made by other researchers is that the higher the dividend yield, the higher the stock return. In the United States, a strategy called The Dogs of the Dow was developed. This popular strategy is probably one of the most successful strategies ever. The basic variant of this strategy picks, each year, the 10 stocks with the highest dividend yield. The performance of these 10 stocks is compared to a portfolio of all 30 stocks in the Dow Jones Industrial Average (Dow-30). There are several variants of this strategy. For example, you can pick only 5 stocks with the highest dividend yield. Another interesting point is splitting the results into several time periods, for example in bull-market periods and bear-market periods. McQueen et al. (1997) investigated the performance of the 10 stocks with the highest dividend yield over a time period of 50 years. Only stocks from the Dow-30 were chosen. Consequently, their survey is focused on the United States. McQueen et al. (1997) showed that these 10 stocks had a statistically higher mean return than the index. However, this strategy results in higher risk, higher transaction costs, and higher tax payments. After adjusting for risk and transaction costs and allowing for tax disadvantages, the 10 stocks with the highest dividend yield do not outperform the index anymore. The strategy of picking the 10 stocks with the highest dividend yield is applied on several countries throughout the world with different results. Filbeck and Visscher (1997) investigated this strategy for the British market from 1984 till 1994. They cannot show significant results of this strategy. However, McQueen et al. (1997) showed that the 10 stocks with the highest dividend yield statistically out perform the index. An explanation of these different conclusions can be found in the way researchers set up their models and the methodologies being used. However, it could also be true that one country is different from the other country. Knowing all these results, we think it is interesting to do research on the Dutch market. The purpose of this thesis is to analyze the stock returns of the stocks with the highest dividend yield in the Dutch stock market. These returns will be compared with the returns of the index. Firstly, we have chosen the Dutch market because there are no articles written on this topic, as far as we know. Furthermore, the AEX-index (which we will use as the benchmark for the Dutch market) contains not only industrial companies. There are many 2

financial companies incorporated in this index. This makes it more interesting to investigate. The central question in our thesis is as follows: Do high dividend yield stocks achieve excessive returns in the Dutch market? In Section 2 we present a literature overview. The main articles regarding this topic will be discussed. The methodology will be discussed in Section 3. In this section we explain the setup of the several models that we will use to compare the returns of the stocks with the highest dividend yield and the market. Furthermore, we present an econometric view of these models. Section 4 specifies the data that we want to use and explains how to collect it. Section 5 deals with the empirical results. Finally, a summary including the main conclusions is given in Section 6. 2. Literature review This section contains the relevant literature for our research. Section 2.1 describes the payout policy, focusing on paying dividends. In Section 2.2 several high dividend yield strategies are treated. The main findings from the authors are presented. The critiques on the Efficient Market Hypothesis are explained in Section 2.3. Finally, in Section 2.4, the validity of the high dividend yield strategy is described. 2.1 Payout policy The first question to consider is, why do firms pay dividends? The payout policy is different for every firm. Berk and DeMarzo (2008) describe in their book Corporate Finance the concept of payout policy. When a firm s investments generate free-cash flow, the firm must decide how to use that cash. If the firm has new Net Present Value investment opportunities, it can reinvest the cash and increase the value of the firm. Many young and rapidly growing firms reinvest all of their cash flows in this way. However, mature and profitable firms often find that they generate more cash than they need to fund all of their attractive investment opportunities. If the firm decides to follow the latter approach, it has two choices. According to Berk and DeMarzo (2008), a firm can pay dividend or it can repurchase shares from current owners. By paying dividends, the board authorizes the dividend on the declaration date. The firm will pay the dividend to all shareholders on a specific date, called the record date. The date two days before the record date is called the ex-dividend date; anyone who purchases the stock on 3

or after the ex-dividend date will not receive the dividend. Finally, on the payable date the firm mails dividend checks to the registered shareholders. With a share repurchase, the firm uses cash to buy shares of its own outstanding stock. These shares are generally held in the corporate treasury, and they can be resold if the company needs to raise money in the future. The three possible transaction types for a share repurchase are summarized as follows. The first one is an open market repurchase. A firm announces its intention to buy its own shares in the open market, and then proceeds to do so over time like any other investor. The firm may take a year or more to buy the shares, and it is not obligated to repurchase the full amount it originally stated. About 95% of all share repurchases is represented by an open market repurchase. The second one is a tender offer. The firm offers to buy shares at a pre-specified price during a short time period, generally within 20 days. The price is usually set at a premium (typically 10%-20%) to the current market price. The offer often depends on shareholders tendering a sufficient number of shares. If shareholders do not tender enough shares, the firm may cancel the offer and no buyback occurs. The last example of share repurchase is called a targeted repurchase. The purchase price is negotiated directly with the seller. A targeted repurchase may occur if a major shareholder desires to sell a large number of shares but the market for the shares is not sufficiently liquid to sustain such a large sale without severely affecting the prices. Under these circumstances, the shareholder may be willing to sell shares back to the firm at a discount to the current market price. In a perfect capital market the method of payment does not matter. However, paying dividend is more common than share repurchases. Therefore, in this thesis we will focus on the dividend payments by firms. According to Chay and Suh (2009), the cash-flow uncertainty is an important cross-sectional determinant of corporate payout policy. Cash-flow uncertainty, measured by stock return volatility, has a negative impact on the amount of dividends as well as the probability of paying dividends. This could be interesting because stock investors usually do not like high cash-flow uncertainty. Furthermore, Chay and Suh (2009) stated that the impact of cash-flow uncertainty on dividends is generally stronger than the impact of other potential determinants of payout policy, such as the earned/contributed capital mix, agency conflicts, and investment opportunities. 2.2 The stocks with the highest dividend yield strategy McQueen et al. (1997) investigate in their article a strategy that is called the Dow-10 investment strategy, which we explained in the introduction. In their article, the performance 4

of this strategy is measured in two ways: statistically and economically. If the performance of the 10 stocks with the highest dividend yield is significantly better than the performance of all the 30 stocks in the Dow Jones Industrial Average (DJIA) you can conclude that the 10 stocks with the highest dividend yield are statistically outperforming. McQueen et al. (1997) have also measured the economic performance in their article by adjusting for higher risk, additional transaction costs, and tax payments. By adjusting for these variables, no significant differences remains. Hence, the 10 stocks with the highest dividend yield do not outperform the market economically. Visscher and Filbeck (2003) apply the strategy described above on the Canadian stock market. Their conclusions are almost similar to the conclusions made by McQueen et al. (1997). The Dow-10 portfolios higher compounded returns were sufficient to compensate for taxes and transaction costs. Furthermore, they showed that the strategy produced higher riskadjusted returns. The Sharpe ratio, which measures total risk, indicates that the 10 stocks with the highest dividend yield results in excessive returns. However, if an investor has other market investments and this strategy is only part of an overall portfolio, the Treynor index, which measures systematic risk, is the appropriate indicator of risk. The 10 stocks with the highest dividend yield show superior performance when adjusted for systematic risk in the Treynor test. Hence, for the Canadian stock market this is a profitable strategy. These two articles thus prove that the dividend yield strategy can achieve excessive returns compared to an index. However, some researchers cannot prove this effect for other stock markets. For example, Filbeck and Visscher (1997) applied this strategy on the British stock market. The Dow-10 portfolio returns exceeded the market returns, on both unadjusted and risk adjusted bases, in only four out of ten years. A possible explanation for the difference in performance between the FTSE-100 (benchmark for the British market) and the DJIA could be the differences between these two indices. Where the DJIA contains only 30 stocks, the FTSE-100 contains 100 stocks. Theoretically, the DJIA contains no financial stocks, but J.P. Morgan and American Express were included in 1994. However, the FTSE-100 contains 18 financial stocks, including banks, insurances companies, and life assurance companies. The difference in strategy performance may be partly explained by the extent to which British financial stocks behave differently from the DJIA industrial stocks. Filbeck and Visscher (1997) come up with another difference between the two indices, which may explain the difference in performance. The FTSE-100 is a value-weighted index, whereas the DJIA is a price-weighted index. According to the Dow-10 strategy, the high dividend yield stocks would tend to be 5

underpriced. Hence, these stocks are also relatively low priced. As a result, their price movements would have a small effect on the index value. If the high dividend yield stocks in the FTSE-100 include high market value companies, the Dow-10 portfolio stock price movements would also drive the index price movements and no differential return would be evident. 2.3 The Efficient Market Hypothesis (EMH) The Efficient Market Hypothesis states that the expected return of any security should equal its cost of capital, and thus the Net Present Value of trading a security is zero (Berk and DeMarzo, 2008). The EMH is linked with the idea of a random walk, which is defined as a price series where all subsequent price changes represent random departures from previous prices. The logic of the random walk idea is that if the flow of information is unimpeded and information is immediately reflected in stock prices, then tomorrow s price change will reflect only tomorrow s news and will be independent of the price changes today. However, news is unpredictable and thus stock prices must be unpredictable and random. Uninformed investors buying a diversified portfolio should, in theory, obtain the same rate of return as achieved by the experts. A couple of decades ago, the EMH was widely accepted by academic financial economists, for example see the article written by Fama (1970). It was generally assumed that the markets were extremely efficient in reflecting information about individual stocks and about the market as a whole (Malkiel, 2003). It was taken as an assumption that when information arises, the news spreads very quickly and is incorporated into the prices of securities without delay. Thus, neither technical analysis nor fundamental analysis would enable an investor to achieve excess rates of return adjusted for risk. If the EMH is completely true, a high dividend yield strategy, as described in Section 2.2, cannot achieve excessive risk adjusted returns. However, the intellectual dominance of the EMH has become far less accepted nowadays. Many statisticians and financial economists began to believe that stock prices are at least partially predictable. They believe that future stock prices are somewhat predictable on the basis of past stock price patterns as well as certain fundamental valuation methods. Moreover, some economists state that these predictable patterns enable investors to earn excessive risk adjusted returns. Malkiel (2003) concludes that as long as stock markets exist, the collective judgement of investors will sometimes make mistakes. He found that some market participants are demonstrably less than rational. As a result, pricing irregularities and even predictable 6

patterns in stock returns can appear over time and even persist for some periods. The market is not always able to correct these mistakes. Moreover, the market cannot be perfectly efficient, or there would be no incentive for professionals to uncover the information that gets so quickly reflected in market prices. Thus, a high dividend yield strategy could theoretically result in excessive risk adjusted returns. 2.4 Validity of the high dividend yield strategy Finally, the key question is why could stocks with a high dividend yield outperform the market? Basically there are two central competing hypotheses. On one hand you have the tax effect hypothesis and on the other hand you have the dividend neutrality hypothesis. Brennan (1970) had originally developed the tax effect hypothesis. He predicts that investors receive higher before-tax, risk adjusted returns on stocks with higher anticipated dividend yields to compensate for the historically higher taxation of dividend income relative to capital gain income. In contrast, Black and Scholes (1974) developed the dividend neutrality hypothesis. This hypothesis states that if investors require higher returns for holding higher yield stocks, corporations would adjust their dividend policy to restrict the quantity of dividends paid, lower their cost of capital, and increase their share price. The theory described in this literature review about high dividend yield strategies will be tested on a sample of Dutch stocks. We describe these tests in the empirical part of the thesis, which will be treated in the next sessions. 3. Methodology In this section the methodology is described. Section 3.1 describes the sample period and why we have chosen for this time frame. Two equations are included to explain exactly how the return of a stock is computed. The research can roughly be split into two parts. Firstly, the conventional tests, like the Student t-test, are used. These tests are described in Section 3.2. The second part contains the regression analysis, which is described in Section 3.3. In both parts we will analyse statistical results as well as economical results. Like we mentioned before, economical results are corrected for additional risk, taxes and transaction costs. 7

3.1 Sample period The focus of the research will be on a 10-year time period ranging from 1999 till 2008. Monthly data is used for the calculations. Hence, there are 120 observations for each stock. This is a fair number of observations to perform the tests. We have chosen this time period because this is the most recent period and probably the most relevant. Furthermore, this time period captures the dot-com bubble (roughly from 1999 till 2001) and the beginning of the credit crisis (in 2007). For every stock in the AEX-index, the dividend yield is measured using DataStream. The stocks with the highest dividend yield in a given year are picked. Then the return of these stocks in the next year is compared with the return of the whole AEX-index. Hence, at t-1 (a delay of one period) the highest dividend yield stocks are picked and at t the performance of these stocks is measured. All returns are including dividends. The monthly market return and the monthly portfolio return can be calculated as follows: R m,t = IN t + DIV t IN t 1 IN t 1 (1) R p,t = PO t + DIV t PO t 1 PO t 1 Where, in equation (1), R m,t presents the return of the market at time t, IN t presents the index at time t, DIV t presents the received dividend at t, and IN t-1 presents the index at t-1. In equation (2), R p,t presents the return of the portfolio at time t, PO t presents the portfolio of the high dividend yield stocks at t, DIV t presents the received dividend at t, and PO t-1 presents the portfolio of the high dividend yield stocks at t-1. Both equations present the return at time t, measured by the value of the market/portfolio at time t plus the received dividend between t-1 and t minus the value of the market/portfolio at time t-1, dividend by the value of the market/portfolio at time t-1. Hence, the return of the market/portfolio is thus depending on the price movement and the dividends received. The stock prices obtained via DataStream are adjusted prices, which means that the prices are occasionally recomputed by DataStream to take into account capital operations. For example, if a company executed a 2 for 1 stock split, the price of the stock will decrease by 50 percent (restricted to normal price fluctuations). All previous prices are halved by DataStream to make these prices comparable to the new prices. However, the adjusted prices are not adjusted for received dividends. The stock price falls with the amount of dividends received, restricted to normal price fluctuations. For example, if the stock price closes at 100 the day before the ex-dividend date and the declared dividend is 5, the opening price of the stock on the ex- (2) 8

dividend date is 95 (restricted to normal price fluctuations). Hence, we have to calculate the stock returns by adding the dividends paid manually, as presented in equation (1) and (2). 3.2 The conventional tests There are several versions of the Dogs of the Dow investment strategy. The most popular one picks the 10 stocks with the highest dividend yield, as we presented in the introduction. However, there are more suggested strategies. For example, you could pick the highest dividend yield stock alone or the five highest dividend yield stocks. In this thesis, we will test the strategy of picking the ten stocks with the highest dividend yield, and these two strategies to check which one has the best results. In the first place, the performance of these strategies will be tested statistically. Consequently, there is no adjustment for higher risk, no tax considerations, and no transaction costs are taken into account. To test for significance, we follow the theory (for example Da Silva (2001)) and thus we will use the Student t-test statistic. This test allows us to compare two different returns; on one hand the return from the high dividend yield portfolio and on the other, the return from the AEX-index. Furthermore, this Student t-test is the most common test used to show significance. The t-statistic is calculated as follows: t = d * n (3) s d Where d is the mean difference between the market and portfolio return each month, s d is the standard deviation of the difference between the returns each month, and n is equal to the number of months (12, 24, 60, or 120). The Student t-test follows a t-distribution denoted as t α,v where α is the significance level and v is the degrees of freedom, which is equal to n-1. Note that the mean difference between the market and portfolio return is the geometric mean. The geometric mean is used because you have to deal with percentages. The following formula expresses the calculation of the geometric mean: n (1+ a 1 ) *(1+ a 2 ) *...* (1+ a n ) 1 (4) Where n is the number of months (12, 24, 60, or 120) and a is the monthly difference between the market s return and the portfolio s return each month. By each monthly difference the value 1 is added, because this formula cannot deal with negative numbers. Each company in the high dividend yield portfolio is given an equal weight. For example, to test for the ten highest dividend yielding stocks each stock is given a weight of 10%. 9

On the 1 st of April 1999 the highest dividend yielding stocks were selected for the first portfolio in 1999. The dividend yield expresses the dividend per share as a percentage of the share price. The underlying dividend is based on an anticipated annual dividend and excludes special or once-off dividends. Dividend yield is calculated on gross dividends, thus including tax credits. As we mentioned before, we will create three different portfolios. The first portfolio consists of only one stock with the highest dividend yield. The second portfolio consists of five stocks with the highest dividend yield. The third portfolio consists of ten stocks with the highest dividend yield. Each year, on the first trading day of April, this process is repeated in order to create a new high dividend yield portfolio. The portfolios were rebalanced every year by revising the dividend yield indicators for all companies from the AEX-index. We chose to rebalance the portfolio every year in the beginning of April, because the AEX-index is rebalanced in March every year. If new stocks are added to the index, you can almost immediately take these stocks into account for the rebalancing of the new high dividend yield portfolio. Furthermore, this choice also avoids any distortion of the results, if the portfolios were rebalanced at the end of every calendar year. Rebalancing at the end of the year might result in abnormal stock volatility due to year-end stock trading motivated by various tax and/or accounting related reasons. The results obtained by the data and tests above enable me to give a judgement about the significance of the high dividend yield strategy. We will look at one-year time periods as well as multiple-year time periods. If the high dividend yield portfolio obtains significant better results than the market you can conclude that the high dividend yield portfolio outperforms the market statistically. To test the economic performance of this strategy you have to consider risk, taxes, and transaction costs also. The high dividend yield portfolio could be more or less risky than the index. With only ten stocks in the portfolio, some unsystematic risk remains, resulting in a higher standard deviation than the better-diversified AEX-index. We will use the Sharpe ratio (Sharp, 1994), the Treynor indices and Jensen s alphas to adjust for risk. The Sharpe ratio is a measure of the excess return (or risk premium) per unit of risk. This ratio provides the reward to volatility trade-off. The Sharpe measure assumes that investors hold properly diversified portfolios. It also assumes that there are appropriate amounts spent on administration and analysis. This means that the expected rate of return and the variability of each different portfolio in general lie along a straight line. 10

The Sharpe ratio is calculated as follows: S = d 1 s d1 * n (5) Where d 1 is the monthly difference between the portfolio, or market, return and the risk-free rate, s d1 is the sample standard deviation of the monthly return differences, and n equals the number of months (12, 24, 60, or 120). The Treynor measure, also know as the reward-to-volatility ratio, provides the reward to CAPM beta risk. This measure is dependent on the characteristic-line. The return of the market is set against the risk-free rate of return. Therefore, it indicates the return earned in excess of that which could have been earned on a risk-free investment, per each unit of market risk. When two portfolios with exactly the same slope are plotted on a graph, with one line parallel but slightly higher than the other line, it means that the upper line portfolio outperforms the lower line portfolio. Reasons for large deviations of the characteristic line can be found in portfolios that are not properly diversified. The calculation of the Treynor measure is almost similar to the calculation of the Sharpe measure. The only difference is that the beta is used as the measurement of volatility. The Treynor index is calculated as follows: T = d 1 β Where d 1 is the mean monthly difference between the portfolio, or market, return and the riskfree rate, calculated over 12, 24, 60, or 120 months and β is the portfolio s beta (the market beta is equal to 1) Jensen s Alpha is based on the Sharpe-Lintner capital asset pricing model. The model is based on five assumptions; all investors have the same homogenous expectations regarding investment opportunities and decision horizons. Investors want to maximize the single periodexpected utility of terminal wealth and are risk averse. All assets are infinitely divisible. All investors have the ability to make a choice among portfolios only on the basis of expected returns and variance of returns. There are zero taxes and zero transaction costs (Naranjo, A., Nimalendran, M., Ryngaert, M., 1998). Jensen s alpha represents the average return on a portfolio over and above that predicted by the capital asset pricing model (CAPM), given the portfolio s beta and the average market return. It could be interpreted as follows: the difference between a portfolio s actual return and the one that could have been achieved on a benchmark portfolio with the same risk as measured by the beta. (6) 11

Jensen s alpha is calculated as follows: Where R p is the portfolio s return, R f is the risk-free rate, R m is the market s return, and β is the portfolio s beta. Finally, we will use the Sharpe portfolio performance measure to take risk into account and to make the economic results comparable to each other. The following formula, as used by McQueen et al. (1997), will be used to compute this portfolio performance measure: Rc p = ( Ru p r f ) * M sd + r f (8) P sd (7) Where Rc p is the return of the portfolio, corrected for risk, Ru p is the return of the portfolio uncorrected for risk, r f is the annual mean 1-month Euribor rate, M sd is the standard deviation of the market (AEX-index), and P sd is the standard deviation of the high dividend yield portfolio. However, if the average annual return of the high dividend yield portfolio is lower than the annual mean of the 1-month Euribor rate, equation (8) will give wrong answers. If this is the case, the following formula needs to be used: Rc p = 2* Ru p Ru p r f ( ) * M sd P sd + r f (9) McQueen et al. (1997) consider capital gains tax and tax on any dividends received. In the United States, capital gains are taxed only when the gain is realized, and the most common form of realization is selling. However, according to McQueen et al. (1997), a formal analysis of the tax advantages of the index over the high dividend yield portfolio is not possible because the size of the advantages depends on the individual s marginal tax rate and other considerations. The tax system in the Netherlands is different from that of the United States. In the Netherlands, the realized real gain does not matter when paying tax. You have to pay tax on the average amount of money you invested during the year. This is measured by the sum of your amount on the 1 st of January and the 31 st of December, divided by 2. Whether you realized a real gain or not does not matter. Thus, the capital gains tax is not relevant for analyzing the high dividend yield strategy in the Netherlands. The dividend tax rate is fixed and thus independent on your income or other variables. Until 2005 the dividend tax rate was 25%. From 2006 till present the dividend tax rate is 15%. This 12

tax rate matters since the high dividend yield portfolio will pay more dividends compared to the index. Hence, this dividend tax is unfavourable for the high dividend yield portfolio. To correct the high dividend yield portfolios for tax disadvantages the following formula will be used: R i = R e DY *TR (10) Where R i is the return of the portfolio or market including tax disadvantages, R e is the return of the portfolio or market excluding tax disadvantages, DY is the dividend yield, and TR is the tax rate on dividends paid (25% until 2005, 15% from 2006) Following the high dividend yield strategy will probably result in higher transaction costs. McQueen et al. (1997) assumed one-way transaction costs to be 1.00 percent. We will also assume 1.00 percent transaction costs in my thesis. The turnover is used to calculate these transaction costs. Transaction costs for the portfolio are calculated as follows: TC = 2 * AT n *1.00% (11) Where TC is the transaction costs, AT is the average turnover, and n is the number of stocks hold in the portfolio. We present a short summary of what to test using the conventional tests. Firstly, the Student t- test is used to test for significant differences in the returns of the AEX-index on one hand and the top-one, top-five, and top-ten portfolios on the other hand. These tests do not include any risk measures, taxes, and/or transaction costs. Subsequently, the returns of the AEX-index and the returns of the high dividend yield portfolios are measured by several risk measures. These risk measures are the Sharpe measure, the Treynor measure, and Jensen s alpha. These measures present a ratio. Using that ratio you can compare the performance of each portfolio as corrected for risk. McQueen et al. (1997) developed a formula to compute the return corrected for risk, instead of calculating a ratio. We will use this formula. Thereafter, we will correct the returns for taxes and transaction costs as well. All tests are performed on a single year basis as well as on a multiple year basis. 3.3 Regression analysis In addition, we will perform several regression tests to analyse the performance of the high dividend yield strategy. Firstly, we will test the relation between the dividend yield and stock returns. If the coefficient of the dividend yield is positive and significant, we can conclude that a higher dividend yield results in higher stock returns. The influence of the level of the dividend yield is thus tested. We will describe this part in Section 3.3.1. Secondly, we will 13

test the influence of the existence of dividend. A dummy variable is created that is equal to 1 if the stock has a dividend yield higher than zero and is equal to 0 otherwise. This part is described in Section 3.3.2. 3.3.1 The level of the dividend yield We will run the regression on the full sample. The econometric program Eviews helps us to create a simple regression of the following form: R i,t = α i, + d i DY t 1 + ε t (12) Where R i,t is the return at t, DY is the dividend yield at t-1, and ε t is the disturbance term. However, we would like to control risk like Naranjo et al. (1998). They emphasize the importance of risk control. In their opinion, the best way to control risk is using the three Fama-French factors. Fama and French (1996) form portfolios on the basis of various stock attributes (book-to-market, price-earnings ratio, sales growth, and size) that have historically produced abnormal returns in a CAPM framework. We will control for risk using the three Fama-French factors too. Naranjo et al. (1998) controlled for taxes too. They infer the implied tax rate from the ratio of the one-year prime grade municipal yield to the one-year T-bill yield. However, Naranjo et al. (1998) found that the size of the yield effect appears to be unrelated to the level of the implied tax rate, and hence the potential tax penalty from receiving taxable dividend income. They also examine shocks to the implied tax rate series. To the extent that it is costly for high dividend yield firms to adjust their dividend policy, they would expect that an unanticipated increase in the implied tax rate would lead to worse performance for higher dividend yield stocks. However, they cannot find such result. Consequently, it is difficult to attribute our documented yield effects to tax effects. Knowing these results, we decide to not take taxes into account on the regression model. Hence, the following regression will be tested: R i,t = α i + s i SMB t + h i HML t + d i DY t 1 + ε i,t (13) Where R i,t is the return on a portfolio at t, SMB t is the difference between the return on a portfolio of small stocks and the return on a portfolio of large stocks (market value is the measure for the size of stocks) at t, HML t is the difference between the return on a portfolio of high book-to-market stocks and the return on a portfolio of low book-to-market stocks at t, DY t-1 is the dividend Yield at t-1, and ε i,t is the disturbance term. 14

Note that we will use the same definition for market value as used in DataStream, which is as follows; the market value is the share price multiplied by the number of ordinary shares in issue. The amount in issue is updated whenever new tranches of stock are issued or after a capital change. The market value is displayed in millions of Euros. The book-to-market ratio is calculated manually by DataStream and provides only the market value to book value ratio. This is a contra ratio compared to the book-to-market ratio. Another characteristic that is tested in several other studies is whether there is a seasonal factor in the timing of the stocks with the highest dividend yield strategy. Investing at the start of the year could be critical to the success of the strategy (Da Silva, 2001). However, we decided not to pay attention to this phenomenon. 3.3.2 The existence of dividend yield To test for the influence of the existence of dividend yield a dummy variable will be created, which results to the following regression: R i,t = α i, + d i DYdummy t 1 + ε t (14) Where R i,t is the return at t, DYdummy is the dummy variable for the dividend yield at t-1, and ε t is the disturbance term This regression will also be controlled for risk, as described above. Hence, the following regression will be tested: R i,t = α i + s i SMB t + h i HML t + d i DYdummy t 1 + ε i,t (15) Where R i,t is the return on a portfolio at t, SMB t is the difference between the return on a portfolio of small stocks and the return on a portfolio of large stocks (market value is the measure for the size of stocks) at t, HML t is the difference between the return on a portfolio of high book-to-market stocks and the return on a portfolio of low book-to-market stocks at t, DYdummy t-1 is the dummy variable for the dividend yield at t-1, and ε i,t is the disturbance term. These regressions will help us to come to a comprehensive conclusion about the effects of dividend yield on stock returns. 15

4. Data As we mentioned before, the thesis will be about the dividend yield strategy in the Dutch market. The Amsterdam Exchange Index (AEX-index) is used as the benchmark. The AEXindex consists of the 25 most traded stocks in the Netherlands. This index is chosen as a benchmark for the Netherlands because it is the most important index in this country. For every stock in the index the price and the dividend yield is obtained using DataStream timeseries request. Furthermore, we have to collect the monthly returns of the portfolio and of the index in order to calculate the Sharpe ratio. The beta is also needed to calculate the Treynor index. This data is available at DataStream. The monthly returns will be used to measure the performance of the strategy too. To control for risk using the Fama-French model (1996) we also have to obtain the risk-free interest rate, the market value, and the market to book value. DataStream provides the market value and the market to book value for the stocks. In the United States a short-term government bond is used in practice to indicate the risk-free rate. In EUR countries, it is most common to use the 1-month EURIBOR to indicate the risk-free rate. This interest rate can be found at the website of the European Central Bank (ECB). Note that the 1-month Euribor that is given by the ECB is annualized. However, to make it comparable to the other data we have calculated this rate per month, by the following formula: rf m,t = 121+ rf y,t 1 (16) Where rf m,t is the 1-month Euribor rate per month at t and rf y,t is the 1-month Euribor rate per year at t. 5. Empirical results In this section we present the empirical results. The theory described in the literature review is tested on a sample of stocks from the AEX-index during the years 1999-2008. Section 5.1 starts with the statistical results from the conventional tests on a single year basis. In Section 5.2 the same statistical results are presented. However, these results are on a multiple year basis. The economical results are presented in Section 5.3. Several subsections treat the different risk measures. Finally, Section 5.4 comes with the regression results. 16

5.1 Statistical results on a single year basis We have examined the stocks with the highest dividend yield. In the first place we tested for a significant difference between this portfolio and the market on a single year basis. In Table 1 we find the yearly performance of the AEX-index and the portfolio of the one stock with the highest dividend yield (Top-one). Discussion Table 1. The yearly performance of the one stock with the highest dividend yield is better in six out of ten years. The yearly performance of the AEX-index is better in four out of ten years. The performance of the one stock with the highest dividend yield is statistically only better in 2006, at 1% level. This is an extremely significant result. However, no other significant results are obtained. The explanation for this can be found in the relatively high standard deviation of the top-one portfolio versus the market. Worth noting is that the average annual return of the top-one portfolio is 3.79% lower than the AEX-index during the years 1999-2008. The bad performance of the top-one portfolio is mainly caused by the yearly returns in 2002 and 2008, as you can see in Table 1. Table 1. Top-one dividend yield strategy comparison of compounded returns in years 1999-2008. Year AEXindex (yearly return) Top-one (yearly return) Winner Mean difference of market versus top-one a Standard deviation of market versus topone T-test 1999 24.53% 58,61% Top-one 0.0212 0.2009 0.3662 2000-12.71 16.25 Top-one 0.0273 0.2404 0.2495 2001-2.77-43.53 AEX-index -0.0438 0.2408-0.6293 2002-50.98-71.52 AEX-index -0.0456 0.1342-1.1769 2003 40.43 170.64 Top-one 0.0569 0.1995 0.9880 2004 11.65 10.86 AEX-index -0.0001 0.1102-0.0038 2005 33.00 35.37 Top-one 0.0023 0.0226 0.3531 2006 12.26 31.34 Top-one 0.0140 0.0178 2.7313**** 2007-8.34-5.66 Top-one 0.0000 0.0742 0.0013 2008-48.99-87,38 AEX-index -0.0857 0.03154-0.9407 **** Statistically differing results at 1% level In Table 2 we find the yearly performance of the AEX-index and the portfolio of the five stocks with the highest dividend yield (Top-five). Discussion Table 2. The yearly performance of the five stocks with the highest dividend yield is better in seven out of the ten years. The yearly performance of the AEX-index is better in only three out of the ten years. The performance of the five stocks with the highest dividend yield is statistically better in the years 2000, 2005, and 2006 at 10% level, 10% level, and 5% level respectively. It is worth noting that the performance of the AEX-index is statistically better in 2007, at 5% level. 17

The average annual return of the top-five portfolio is equal to 0.91% and the average annual return of the AEX-index is -4.33%. Hence, the top-five portfolio has a 5.24% higher average annual return than the AEX-index. However, the standard deviation of the top-five portfolio is higher than the standard deviation of the AEX-index, with 9.40% and 6.67% respectively. Table 2. Top-five dividend yield strategy comparison of compounded returns in years 1999-2008 on a single year basis. Year AEXindex (yearly return) Top-five (yearly return) Winner Mean difference of market versus top-five Standard deviation of market versus top-five T-test 1999 24.53% 57.63% Top-five 0.0178 0.0557 1.1083 2000-12.71 16.95 Top-five 0.0233 0.0611 1.3199 2001-2.77 3.88 Top-five 0.0070 0.0489 0.4920 2002-50.98-58.05 AEX-index -0.0114 0.0424-0.9278 2003 40.43 84.07 Top-five 0.0238 0.1056 0.7795 2004 11.65 11.96 Top-five 0.0003 0.0289 0.0418 2005 33.00 46.27 Top-five 0.0080 0.0197 1.4077* 2006 12.26 24.52 Top-five 0.0090 0.0149 2.0827** 2007-8.34-20.33 AEX-index -0.0114 0.0197-1.9984** 2008-48.99-54.53 AEX-index -0.0030 0.0761-0.1362 * Statistically differing results at 10% level ** Statistically differing results at 5% level Discussion Table 3. In Table 3 we find the yearly performance of the AEX-index and the portfolio of the ten stocks with the highest dividend yield (Top-ten). The yearly performance of the ten stocks with the highest dividend yield is better in eight out of the ten years. The yearly performance of the AEX-index is better in only two out of the ten years. The performance of the ten stocks with the highest dividend yield is statistically better in the years 1999, 2000, and 2003 at 5% level, 2.5% level, and 10% level respectively. It is worth noting that the performance of the AEX-index is statistically better in 2002, at 10% level. The average annual return of the top-ten portfolio is 6.14% higher than the AEX-index. However, the standard deviation of the top-ten portfolio is higher than the standard deviation of the AEX-index, with 8.29% and 6.67% respectively. If we compare these figures with the figures in Table 5, it suggests a better performance for a portfolio including ten stocks with the highest dividend yield compared to a portfolio including five stocks with the highest dividend yield. 18

Table 3. Top-ten dividend yield strategy comparison of compounded returns in years 1999-2008 on a single year basis. Year AEXindex (yearly return) Top-ten (yearly return) Winner Mean difference of market versus top-ten Standard deviation of market versus top-ten T-test 1999 24.53% 45.74% Top-ten 0.0150 0.0283 1.8366** 2000-12.71 21.17 Top-ten 0.0266 0.0356 2.5668*** 2001-2.77 0.93 Top-ten 0.0034 0.0384 0.3112 2002-50.98-62.58 AEX-index -0.0192 0.0387-1.7206* 2003 40.43 89.10 Top-ten 0.0266 0.0605 1.5255* 2004 11.65 17.17 Top-ten 0.0041 0.0176 0.8160 2005 33.00 38.36 Top-ten 0.0032 0.0087 1.2912 2006 12.26 15.48 Top-ten 0.0025 0.0068 1.2713 2007-8.34-10.41 AEX-index -0.0023 0.0165-0.4855 2008-48.99-45.31 Top-ten 0.0081 0.0411 0.6863 * Statistically differing results at 10% level ** Statistically differing results at 5% level *** Statistically differing results at 2.5% level From 1999 till 2008 the market has gone up over five years and has gone down over five years. Hence, we have five years of a bull market (market has gone up) and five years of a bear market (market has gone down). In Table 3 you can see that if the ten stocks with the highest dividend yield are outperforming, five out of the eight years are bull markets. Furthermore, the two years that the AEX-index was outperforming were both years of a bear market. These results may suggest that the high dividend yield strategy is better performing in a bull market. However, no statistical evidence is provided in this thesis. The portfolio of one stock with the highest dividend yield outperforms the market in six years. The portfolio of 5 stocks with the highest dividend yields outperforms the market in seven years. Finally, the portfolio of ten stocks with the highest dividend yield outperforms the market in eight years. The top-one portfolio has an average annual return of -8.12%, the topfive portfolio has an average annual return of 0.91%, and the top-ten portfolio has an average annual return of 1.81%. The top-one portfolio has only one year reporting a positive statistically difference. The top-five portfolio and the top-ten portfolio have three years reporting a positive statistically difference. Hence, using these figures, the portfolio with ten stocks with the highest dividend yield is performing best on a single year basis. 5.2 Statistical results on a multiple year basis This section provides the statistical results on a multiple year basis. A 10-year, 5-year, and 2- year time period is created. 19

Discussion Table 4. In Table 4 we find the yearly performance of the AEX-index and the portfolio of the one stock with the highest dividend yield (Top-one). During the 10-year time period (from 1999 till 2008) the AEX-index has a better performance than the top-one portfolio. However, this result is not significant. From this table we see that the standard deviation of the difference of the market minus the top-one portfolio is relatively high in almost all the years, except in 2005-2006. This means that the volatility of the top-one portfolio is relatively high compared to the market. During the 5-year time periods the top-one portfolio outperforms the market in three time periods and underperforms the market in three time periods as well. Again, none of the results are significant. Table 4. Top-one dividend yield strategy comparison of compounded returns in years 1999-2008 on a multiple year basis. Year AEXindex (yearly return) Top-one (yearly return) Winner Mean difference of market versus top-five Standard deviation of market versus top-one T-test 10-year time period 1999-2008 -5.51% -15.38% AEX-index -0.0061 0.1783-0.3769 5-year time period 1999-2003 -6.16% -4.30% Top-one 0.0024 0.2039 0.0902 2000-2004 -8.19% -10.92% AEX-index -0.0019 0.1905-0.0753 2001-2005 -0.12% -8.16% AEX-index -0.0068 0.1591-0.3286 2002-2006 2.79% 8.72% Top-one 0.0050 0.1459 0.2641 2003-2007 16.50% 38.155 Top-one 0.0144 0.1077 1.0360 2004-2008 -4.86% -25.175 AEX-index -0.0146 0.1493-0.7562 2-year time period 1999-2000 4.26% 35.79% Top-one 0.0242 0.2167 0.5480 2000-2001 -7.87% -18.98% AEX-index -0.0089 0.2376-0.1831 2001-2002 -30.96% -59.90% AEX-index -0.0447 0.1910-1.1460 2002-2003 -17.03% -12.20% Top-one 0.0044 0.1754 0.1217 2003-2004 25.22% 73.21% Top-one 0.0280 0.1613 0.8506 2004-2005 21.86% 22.50% Top-one 0.0011 0.0778 0.0686 2005-2006 22.19% 33.34% Top-one 0.0081 0.0208 1.9233** 2006-2007 1.44% 11.31% Top-one 0.0070 0.0531 0.6462 2007-2008 -31.62% -65.49% AEX-index -0.0438 0.2249-0.9535 ** Statistically differing results at 5% level During the 2-year time periods the top-one portfolio outperforms the market in six time periods and underperforms the market in three time periods. During the time period 2005-2006 the top-one portfolio performance is statistically better than the market performance. The low standard deviation in the time period 2005-2006 is remarkable. During the other time periods no statistical differences are obtained. 20

Discussion Table 5. In Table 5 we find the yearly performance of the AEX-index and the portfolio of five stocks with the highest dividend yield (Top-five). During the 10-year time period the top-five portfolio has a better performance than the AEX-index. However, the critical t-value at 10% level is 1.289, which is slightly higher than 1.2690. Hence, this result is not significant. During the 5-year time periods the top-five portfolio outperforms the market in five time periods and underperforms the market in one time period. During the time period 1999-2003 the top-five portfolio performs statistically better than the market at 5% level. During the other time periods no significant results can be found. Table 5. Top-five dividend yield strategy comparison of compounded returns in years 1999-2008 on a multiple year basis. Year AEXindex (yearly return) Top-five (yearly return) Winner Mean difference of market versus top-five Standard deviation of market versus top-five T-test 10-year time period 1999-2008 -5.51% 0.88% Top-five 0.0063 0.0541 1.2690 5-year time period 1999-2003 -6.16% 8.11% Top-five 0.0120 0.0659 1.4115* 2000-2004 -8.19% 0.96% Top-five 0.0085 0.0627 1.0503 2001-2005 -0.12% 5.61% Top-five 0.0055 0.0571 0.7431 2002-2006 2.79% 9.51% Top-five 0.0059 0.0534 1.8524 2003-2007 16.50% 24.50% Top-five 0.0059 0.0509 0.8931 2004-2008 -4.86% -5.88% AEX-index 0.0006 0.0384 0.1124 2-year time period 1999-2000 4.26% 35.70% Top-five 0.0205 0.0573 1.7582** 2000-2001 -7.87% 10.16% Top-five 0.0151 0.0548 1.3478* 2001-2002 -30.96% -33.99% AEX-index -0.0022 0.0458-0.2406 2002-2003 -17.03% -12.12% Top-five 0.0060 0.0812 0.3647 2003-2004 25.22% 43.55% Top-five 0.0120 0.0770 0.7622 2004-2005 21.86% 27.97% Top-five 0.0042 0.0245 0.8340 2005-2006 22.19% 34.96% Top-five 0.0085 0.0171 2.4323*** 2006-2007 1.44% -0.39% AEX-index -0.0013 0.0200-0.3094 2007-2008 -31.62% -39.81% AEX-index -0.0072 0.0547-0.6450 * Statistically differing results at 10% level ** Statistically differing results at 5% level *** Statistically differing results at 2.5% level During the 2-year time periods the top-five portfolio outperforms the market in six time periods and underperforms the market in three time periods. During the time periods 1999-2000, 2000-2001, and 2005-2006 the top-five portfolio performs statistically better than the market at respectively 5%, 10%, and 2.5% level. During the other time periods no statistical differences are obtained. 21