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An empirical analysis of a selling policy to increase dividend income in the investment management of… Bennett, James Arthur, 1974

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AN EMPIRICAL ANALYSIS OP A SELLING POLICY TO INCREASE DIVIDEND INCOME IN THE INVESTMENT MANAGEMENT OF AN INCOME TRUST by JAMES ARTHUR BENNETT B.A., Queen's University, 1955 LL.B., Toronto University, 1958 A THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF BUSINESS ADMINISTRATION in the Faculty of Commerce and Business Administration We accept t h i s thesis as conforming to the required standard THE UNIVERSITY OF BRITISH COLUMBIA October 1975 In p resen t ing t h i s t h e s i s in p a r t i a l f u l f i l m e n t o f the requirements f o r an advanced degree at the U n i v e r s i t y of B r i t i s h Columbia, I agree that the L i b r a r y s h a l l make i t f r e e l y a v a i l a b l e f o r reference and study. I f u r t h e r agree tha t permiss ion fo r ex tens i ve copying of t h i s t h e s i s f o r s c h o l a r l y purposes may be granted by the Head of my Department or by h i s r e p r e s e n t a t i v e s . It i s understood that copying or p u b l i c a t i o n o f t h i s t h e s i s f o r f i n a n c i a l ga in s h a l l not be a l lowed wi thout my w r i t t e n pe rm iss ion . Department of The U n i v e r s i t y o f B r i t i s h Columbia Vancouver 8, Canada foteL* /97S ABSTRACT Trustees of income trusts have generally been given over the period 1959-1971 power to invest t r u s t funds i n common stocks. Their objectives are to invest t r u s t funds to produce an income for a l i f e tenant while preserving the c a p i t a l of the t r u s t for the ultimate remainderman. A cl e a r d i v i s i o n between c a p i t a l and income i s required by l e g a l rules and reference i s made to selected l e g a l decisions to i l l u s t r a t e the attitude of the courts. A trustee of an income t r u s t can-not accept the attitude o;f indifference between dividend income and c a p i t a l gains adopted by some ind i v i d u a l investors and many academic researchers. I t i s submitted that i t i s d i f f i c u l t to construct appropriate investment p o l i c i e s for an income t r u s t through reading recent l i t e r a t u r e on common stock investment strategies; trustees cannot accept the normal assumption that dividend income and c a p i t a l gains are equiva-l e n t . The general proposition that r i s k and return are p o s i t i v e l y related, which Soldofsky and M i l l e r (1969) seek to support could induce a trustee to purchase r i s k y s e c u r i t i e s . However analysis of t h e i r own data reveals a negative r e l a t i o n -ship between r i s k and return among American common stocks, roughly over the years 1955-1962. The report by Litzenberger, Joy and Jones (1971) on a p o l i c y of investing i n low P/E r a t i o American common stocks i s analysed to reveal some d i f f i c u l t i e s i n evaluating t h e i r r e s u l t s . In a t r u s t p o r t f o l i o a stock can come to produce a low dividend y i e l d through stock price appreciation. I t could be retained under a Buy and Hold Policy, or sold and the proceeds reinvested i n another stock with a larger current dividend y i e l d under an Administrative P o l i c y . An empirical evaluation of these a l t e r n a t i v e p o l i c i e s was undertaken using stock market data on 108 Canadian firms over the periods A p r i l 1960 to September 1964 and January 1965 to June 1969. Any Administrative P o l i c y requires two decision rules, one to i n i t i a t e sales and one to d i r e c t purchases. To is o l a t e the impact of the decision to s e l l , which was based upon a decline i n current dividend y i e l d , a reinvestment p o l i c y was adopted employing random se l e c t i o n from those s e c u r i t i e s then within a desired current dividend y i e l d range. For the f i r s t period, Fortran programs were used to produce discounted dividend and c a p i t a l gains s t a t i s t i c s . These were expressed as an average annual discounted y i e l d based upon the c a p i t a l o r i g i n a l l y invested, for the Buy and Hold Policy and for 9 d i f f e r i n g operational d e f i n i t i o n s of an Administrative Policy, these l a t t e r s t a t i s t i c s being grand means based upon twenty t r i a l s . From these r e s u l t s 3 hypotheses were developed for tes t i n g i n a subsequent non-overlapping period. The only hypothesis that survived t h i s t e s t was that an Administrative Policy w i l l increase the dividend y i e l d s t a t i s t i c over that produced by a Buy and Hold P o l i c y . The impact of an Administrative P o l i c y upon the c a p i t a l gains s t a t i s t i c did vary, being negative i n the f i r s t period and p o s i t i v e i n the second. i v The a b i l i t y of an Administrative P o l i c y to increase the dividend y i e l d s t a t i s t i c can be related to two proposi-tions i n current f i n a n c i a l theory: that companies are slow to translate increased earnings into larger dividends, and that widespread a n t i c i p a t i o n of larger corporate earnings i n the future may cause a share's price.to r i s e arid i t s current dividend y i e l d to f a l l . An Administrative P o l i c y may have produced an increased dividend y i e l d by not holding stocks whose current dividend y i e l d has f a l l e n , during the i n t e r v a l between the market's a n t i c i p a t i o n of increased earnings, and the payment of normal dividends upon the increased earnings. V Table of Contents Page Abstract i i Table of Contents v L i s t of Tables v i L i s t of Graphs v i i Chapter 1. Introduction 1 Chapter 2. Legal Duties of an Income Trustee. . . . . 9 Chapter 3. The Application of Fin a n c i a l Theory to the Investment Management of an Income Trust 20 Chapter 4. A S e l l i n g Policy to Increase Dividend Income—An Empirical Evaluation 39 Chapter 5. The Integration of These Empirical Results With Financial Theory 63 Bibliography 71 Appendices 74 ( v i L i s t of Tables Table Page 1 Range of Permitted Investments 18 2 Soldofsky and M i l l e r ' s Annual Total Returns, 1952-1966 23 3 Regression Equations of Risk and Return Using Soldofsky and M i l l e r ' s (1969) Data on 6 Classes of Common Stocks 25 4 Recalculation of P o r t f o l i o Values Resulting Prom Lowest P/E Ratios Over the Periods of 2.5 and 3 Years With an I n i t i a l Investment of $10,000 30 5 Average Yields Associated with a Buy and Hold Policy 44 6 Regression Equations Relating I n i t i a l Dividend Yields to Average Annual Buy and Hold l i v i d e n d Y i e l d S t a t i s t i c s . 47 7 A Comparison of Averaged Annual Yields i n Period 1, A p r i l 1960 to September 1964 . . . . 54 8 Proportion of Firms Affected by an Administra-t i v e P o l i c y i n Period 1 and Period 2 . . . . . 58 v i i L i s t of Graphs Graph Page 1 Graphical Analysis of P o r t f o l i o Return i n Terms of Dividend Income and Capital Gains or Losses . . 6 2 Graphical Analysis of a Trust P o r t f o l i o . . . . 3 Average Discounted Annual Yields, 41 Stocks With I n i t i a l Dividend Yields Greater Than 4%, Period A p r i l 1960 to September 1964 . . . 53 4 Grand Means of Discounted Annual Dividend and Capital Gains Yields, 41 Firms, Over the Period A p r i l 1960 to September 1964 57 5 Grand Means of Discounted Annual Dividends and C a p i t a l Gains Yields, 35 Firms, Over the Period January 1965 to June 1969 59 1 CHAPTER 1 Introduction The term, "Income Trust" can be used to describe a well established and commonly used arrangement whereby a personal or corporate trustee holds and invests t r u s t money and pays a l l the income thereby produced to the beneficiary of the t r u s t . I t i s our submission that the f i n a n c i a l goals of the trustee of an income t r u s t are not i d e n t i c a l to those of an i n d i v i d u a l investor, or to those of a mutual or pension fund manager and that recent f i n a n c i a l l i t e r a t u r e has not dealt s p e c i f i c a l l y with the f i n a n c i a l problems inherent i n the investment management of an income t r u s t . The object of t h i s thesis i s to examine the f i n a n c i a l problems posed by an income t r u s t , discuss the d i f f i c u l t i e s i n applying much of modern f i n a n c i a l theory to t h i s f i e l d , a r t i c u l a t e a possible formulation of the f i n a n c i a l objective of such a trustee, and f i n a l l y to propose and conduct a l i m i t e d t e s t of one proposition concerning the investment management of an income t r u s t fund. In the administration of an income tr u s t the basic l e g a l d i s t i n c t i o n between " c a p i t a l " and "income" must be understood and consistently applied. The trustee generally has two obligations: to preserve the " c a p i t a l " for the u l t i -mate remainderman and to invest the " c a p i t a l " in the meantime to produce "income" for the present l i f e tenant or l i f e 2 tenants. In t h i s paragraph "income" and " c a p i t a l " have been placed i n quotation-marks to emphasize that these are l e g a l terms. Unfortunately these two obligations are normally i n c o n f l i c t and a trustee faced with t h i s c o n f l i c t , should keep an even hand between l i f e tenant and remainderman and not benefit one at the expense of the other. This l e g a l duty implies that a trustee of an income tru s t must always be concerned about r e a l i z e d c a p i t a l gains and losses and about the nature of income payments. Capital gains r e a l i z e d on the sale of t r u s t assets are c a p i t a l receipts and must be held, reinvested and ultimately paid to the remainderman upon the termination of the t r u s t ; they cannot be considered to be income and paid to the l i f e tenant. Therefore unlike the ind i v i d u a l investor or mutual fund or pension fund manager, the trustee of an income t r u s t cannot be i n d i f f e r e n t between c a p i t a l gains and dividend income, as the nature of the payment determines who s h a l l receive i t . From the viewpoint of an income tr u s t , one cannot accept the hypothesis of indifference between c a p i t a l gains and dividend income that underlies much of modern f i n a n c i a l theory and many empirical studies. Since 1951 empirical studies i n Finance have normally used one-period return^- as a measurement variable and i t has been calculated generally as the sum of c a p i t a l gains (or losses) and dividends received, divided by the market pr i c e at the beginning of the period. This summation i m p l i c i t l y assumes that the researcher i s i n d i f f e r e n t between dividends 3 and c a p i t a l gains. There has been a lengthy t h e o r e t i c a l discussion i n the f i n a n c i a l l i t e r a t u r e as to whether a r a t i o n a l i n d i v i d u a l investor should be i n d i f f e r e n t between c a p i t a l gains and dividend income. Other l i t e r a t u r e points out that considerations of r e l a t i v e tax rates, and brokerage commissions,^ may cause an in d i v i d u a l investor to prefer either c a p i t a l gains or dividend income depending upon h i s p a r t i c u l a r status. The writer wishes to point out that there i s in addition a class of investment managers—trustees of income trusts—who must dis t i n g u i s h c a p i t a l gains from 4 income. In order to c l a r i f y the leg a l d e f i n i t i o n s of " c a p i t a l " and "income" the writer proposes i n Chapter 2 to discuss leading l e g a l p r i n c i p l e s and some recent cases i n which they have been applied. D i f f i c u l t i e s encountered i n applying some recent f i n a n c i a l a r t i c l e s to the management of an income trus t , w i l l be considered i n Chapter 3. The basic f i n a n c i a l problem of a trustee of an income t r u s t i s to determine what in t e r e s t and dividend income he wishes for h i s l i f e tenant and what t o t a l rate of c a p i t a l gain or loss w i l l , i n the event, be associated with that dividend income. A trustee could be v i s u a l i z e d as tryi n g to po s i t i o n his p o r t f o l i o i n an anticipated dividend income and anticipated c a p i t a l gains-loss space, as i l l u s t r a t e d on Graph 1 at page 6. The trustee should also be aware of the tax p o s i t i o n of the beneficiary of the t r u s t and of the 4 probable e f f e c t s of i n f l a t i o n i n reducing the purchasing power of both c a p i t a l funds and future income. In the balance of t h i s thesis one problem often encountered i n the investment management of an income t r u s t i s posed for empirical evaluation. When a common stock invest-ment enjoys market appreciation such that i t s current dividend y i e l d f a l l s , which i s the best course to follow: (a) continue to hold the stock i n a n t i c i p a t i o n of additional c a p i t a l gains; or (b) s e l l i t and reinvest the proceeds i n another stock with a larger current dividend y i e l d ? In order to make t h i s comparative evaluation relevant to the investment management of an income t r u s t i n Canada, an allowance was made for the impact of brokerage commissions on the purchase and sale of s e c u r i t i e s and the p o l i c i e s were tested using Canadian stock market data.^ The p o l i c y of continuing to hold stocks despite a decline i n the current dividend y i e l d was interpreted as a simple Buy and Hold Policy, and the investment r e s u l t s of t h i s p o l i c y both for dividends and c a p i t a l gains were c a l -culated for each stock and an average prepared for a group of higher y i e l d i n g stocks treated as a p o r t f o l i o . I t was more d i f f i c u l t to devise a computer algorithm to imitate the actions of a trustee s e l l i n g stocks when th e i r current dividend y i e l d declines and selecting other higher y i e l d i n g stocks as replacements. This type of administration involves two p o l i c i e s — o n e p o l i c y d i r e c t s stocks to be sold 5 due to a decline i n current y i e l d and another p o l i c y selects stocks for purchase. The investment r e s u l t s of any admin-i s t r a t i v e p o l i c y w i l l i n evitably be a j o i n t product of both the ' s e l l i n g ' p o l i c y and the 'buying* p o l i c y . In order to isola t e the ef f e c t s of a ' s e l l i n g ' p o l i c y based upon a decline in current dividend y i e l d , i t was advisable to adopt as neutral a re-investment p o l i c y as possible. After d i v i d i n g a l l stocks into 14 y i e l d categories based upon t h e i r current dividend y i e l d , each with a range of .5%, a desired dividend y i e l d range was selected based upon the stock's i n i t i a l dividend y i e l d , and then a replacement stock was chosen at random from those stocks within the desired dividend y i e l d range. Thus when a stock i s sold due to a decline i n i t s current dividend y i e l d , the only known attribute of i t s replacement i s that the replacement has a larger current dividend y i e l d . This b l i n d stock selection p o l i c y i s not an appropri-ate investment p o l i c y for a trustee of an income t r u s t and i t was devised only as a method of i s o l a t i n g the investment consequences, both for the l i f e tenant and for the remainder-man, of a p o l i c y of r e a l i z i n g c a p i t a l gains when current dividend y i e l d s f a l l to unsatisfactory l e v e l s . G R A P H 1 GRAPHICAL ANALVSIS OP PORTFOLIO RETURN IN T E R M S O F D I V I D E N D I N C O M E A N D CAPITAL G A I N S 2 7-6-S -V 3-Z -I M - / - 2 - 3 1 ore ••-%> C A P I T A L G A I N OR L o s s e s + 4 %> D I V I D E N D RBTORH . P E R A N N O K — r -3 -i— 1 —r~ 5 7 e 9 — i — to % CAPITAL LOSS P E R A N N U M T H I S G E o M E T f i l C f t L ANflirsiS O F poRr FoUO RGTURHS I S / ? N ^ P A P T I O H O P + - M / 0 f = A C T o R -4A//PUV5IS , HKPLor'/NCV ANNUAL DIVIPEHO Y\EuD ANO ANNUAL CAPITAL G / * lNS Vl^kD i N P W A c £ O F T H E £ * P E c r F O R E T ^ / e M F O R A peRioD / ? A / 0 ft M BA 5 w f ? E . O F R I S K " . 7 Footnotes to Chapter 1 1. The one-period return on an asset or p o r t f o l i o can be defined as the change i n wealth during the horizon period divided by the i n i t i a l wealth invested i n the asset or p o r t f o l i o . This d e f i n i t i o n was employed by Eugene F. Fama i n his a r t i c l e Risk, Return and Equilibrium Some C l a r i f y i n g Comments. Journal of Finance. March, 1968, p. 29. ** 2. Elton, E.J. and Gruber, M.J. i n "Marginal Stockholder Tax Rates and The C l i e n t e l e E f f e c t " , Review of Economicsand  S t a t i s t i c s , (Feb. 1970), pv c68, provide evidence that investors' preference for dividends i s l o g i c a l l y associated with th e i r implied tax bracket. 3. The impact of brokerage costs and new issue financing costs on investors' preference for dividends i s reviewed by James C. VanHorne and John G. McDonald i n "Dividend Po l i c y and New Equity Financing," Journal of Finance, May, 1971, p. 507. 4. The t o t a l asset value of a l l income trusts administered by trustees i n Canada, i s not r e a d i l y a v a i l a b l e . S t a t i s t i c s Canada i n i t s publication 61-006 "Financial I n s t i t u t i o n s , F i n a n c i a l S t a t i s t i c s " reports only the common and preferred stock holdings of Canadian t r u s t companies on t h e i r own account. The assets held i n estate, t r u s t and agency accounts by f i v e Canadian t r u s t companies were reported i n t h e i r 1974 annual reports to be: Canada Permanent Trust and Mortgage 2.38 B i l l i o n Guaranty Trust .62 Canada Trust Co. 2.72 National Trust 2.72 Royal Trust 10.47 18.91 (Note: The annual report of the Montreal Trust Co. did not reveal the t o t a l value of estate, t r u s t and agency accounts.) However what proportion of these sums i s held i n s t r i c t income trusts i s not r e a d i l y ascertainable. There are also many private trusts administered by i n d i v i d u a l trustees i n Canada but only the Department of National Revenue would have an accurate record of t h e i r existence. As w e l l , one public corporation—The Fulcrum Investments Co. L t d . — with ten m i l l i o n d o l l a r s i n assets approximates a t r u s t as the preferred shareholders are e n t i t l e d to a l l net income u n t i l 1987-9 when the preferred shares w i l l be redeemed and the residue paid to the common shareholders who form the remaindermen. The size of American Trust holdings was reported by H. Sauvain (1967) as follows: Trust Departments of Commercial Banks (1964) 67.3 B i l l i o n University and College Endowment Funds (1962) 8.0 " Charitable Foundations (1962) 14.0 " 8 5 . In the writer's view i t i s probable that only Canadian common stocks are purchased by most trustees of Canadian income t r u s t s . In B r i t i s h Columbia and Manitoba the broader d e f i n i t i o n of trustee s e c u r i t i e s does not extend to foreign common stocks. In other Provinces such as Ontario and New Brunswick and under trusts with a d i s -cretionary investment power, foreign dividend paying common stocks are not excluded as trustee investments. However convenience, habit and the tax reduction flowing from the Federal dividend tax c r e d i t are factors that could lead trustees to prefer Canadian common stocks. 9 CHAPTER 2 Legal Duties of the Trustee of an Income Trust A t r u s t , i n j u r i s d i c t i o n s based on English Common Law, i s the relat i o n s h i p which ex i s t s when one person, the trustee, holds the property of another person, the "cestui que t r u s t " . I f the trustee has active duties to perform, such as investing money in his d i s c r e t i o n , then he w i l l normally be l e f t in possession of the t r u s t property as long as he f a i t h f u l l y performs h i s duties. A t r u s t i s a f l e x i b l e mechanism whereby righ t s i n the t r u s t property may be shared by many people; the current income from investments or current possession of r e a l property may be given to named individuals for t h e i r l i f e t i m e , either j o i n t l y or i n succession and upon the death of the l a s t survivor, the t r u s t property given absolutely to other i n d i v i d u a l s — t h e remaindermen. The f l e x i b i l i t y of a t r u s t i s one of i t s great advantages and explains i t s use i n many d i f f e r e n t s i t u a t i o n s . In addition, trusts are often used to reduce the l i a b i l i t y for income tax and succession duties as property i s handed from one generation to another. In the t y p i c a l case property i s given unto a trustee for investment with a l l income to be paid to a l i f e tenant during h i s l i f e t i m e and thereafter the corpus i s to be given to named remaindermen. Here both the l i f e tenant and the remaindermen have le g a l and enforceable 10 interests i n the t r u s t property, interests which are normally in c o n f l i c t . The l i f e tenants may wish the largest possible current income and request investment i n speculative second mortgages which carry with them the danger of large c a p i t a l losses. The remaindermen may recommend investments in "growth companies" with small current y i e l d i n the hope of future c a p i t a l appreciation. I t i s the duty of the trustee to balance these c o n f l i c t i n g interests and i n so doing, the trustee w i l l purchase a p o r t f o l i o of securities.^" As an aid in analysing such a p o r t f o l i o , i t could be considered as a point in an income y i e l d — c a p i t a l gains >;;(loss) y i e l d space as shown on Graph #1 at page 6. Such an analysis seems more appropriate for an income t r u s t rather than the one-period return—standard deviation of return graphical analysis used in recent c a p i t a l asset p r i c i n g theory. Ii P r i o r to World War I I , trustees of income trusts normally had very l i m i t e d d i s c r e t i o n i n the choice of invest-ments as the applicable P r o v i n c i a l Trustee Act s p e c i f i e d a narrow range of f i r s t mortgages and government bonds as per-mitted investments. Settlors and lawyers were s a t i s f i e d with such a l i m i t e d d i s c r e t i o n and the Courts r e s t r i c t i v e l y i n t e r -preted words in w i l l s which could have conferred a wider d i s c r e t i o n . In Re Lennox Estate 1949 SCR 446 the Supreme Court of Canada interpreted a d i r e c t i o n "that the r e s t and residue of my estate s h a l l be invested i n such s e c u r i t i e s as my executor may deem advisable. . . " a s conferring a d i s c r e -t i o n to choose among trustee investments only. 11 The Courts have a special function i n supervising the administration of t r u s t s and w i l l act to replace trustees, regulate t h e i r remuneration and may approve on behalf of minors and others, agreements a l t e r i n g the terms of the t r u s t . In the recent case of Re K i e l y 1972 IOR 845 a change i n the terms of the t r u s t was sought permitting the trustees to invest up to 65 percent of the t r u s t assets i n i t s uncontrolled d i s c r e -t i o n . The v a r i a t i o n was approved as being for the advantage of the infant b e n e f i c i a r i e s and as being "an e n t i r e l y appropri-ate way i n which to meet the challenges presented by i n f l a t i o n a r y times and eroding monetary values" (p. 848). U n t i l recently, the basic investments authorized by the Trustee Acts were f i r s t mortgages and Government bonds. In times of f l u c t u a t i n g i n f l a t i o n and d e f l a t i o n , such fixed investments preserved the c a p i t a l of the t r u s t and produced intere s t income for the l i f e tenant. This balance between preservation of c a p i t a l and customary i n t e r e s t y i e l d s was so accepted that s p e c i a l rules were' developed for cases where other assets were held. In Howe vs E a r l of Dartmouth (1802) 7 Ves Jun 137, part of an estate was held i n stocks y i e l d i n g higher than the return on Government bonds and the remaindermen successfully sought an order d i r e c t i n g payment to him of the excess income. In Re E a r l of Chesterfields Trusts 1883 24 Ch.D0643, the converse s i t u a t i o n arose. By force of circum-stance c e r t a i n personal property which produced no income was not r e a l i z e d within the executor's year (the time normally a l l o t t e d for conversion into trustee s e c u r i t i e s ) , but ultimately 12 was sold for a large sum when i t s maximum p o t e n t i a l had been r e a l i z e d . As the postponement of the ge t t i n g - i n and conver-sion of the asset was i n the i n t e r e s t of both the l i f e tenant and the remainderman, the p r i n c i p l e of apportionment as between c a p i t a l and income was applied. The l i f e tenant received compound in t e r e s t on the computed value of the asset as of the creation of the t r u s t , the balance being treated as c a p i t a l . Wasting assets, such as quarries or coal mines, are enterprises whose c a p i t a l value i s exhausted as i t produces income; they are unsuitable as t r u s t assets and are always sold unless the t r u s t instrument s p e c i f i c a l l y d i r e c t s t h e i r retention. These rules of equity can be interpreted as an attempt to balance the i n t e r e s t of l i f e tenants and remaindermen during times of monetary s t a b i l i t y . The equitable rules and statutory arrangements developed i n the 19th Century have been outmoded by the onset of secular i n f l a t i o n . During times when p r i c e l e v e l changes e x i s t only as fluctuations around a horizontal trend, the preservation of monetary c a p i t a l i s the legitimate goal of a prudent trustee. However i n times of rapid p r i c e i n f l a t i o n the mere avoidance of c a p i t a l losses penalizes the ultimate remainderman. The writings of Fisher (1930) and Meiselman (1963 and Sargent (1973) present evidence that i n t e r e s t rates adjust to present and anticipated rates of price i n f l a t i o n . The l e g a l d e f i n i t i o n of income therefore gives to the l i f e tenant both the "true" rate of i n t e r e s t 13 and as well, the i n f l a t i o n a r y premium. The balance between the interests of l i f e tenant and remainderman i s disrupted as the l i f e tenant gains purchasing power at the expense of the remainderman. In i n f l a t i o n a r y times, fixed income s e c u r i t i e s become in e f f e c t , wasting assets. Under the present international monetary system, i t i s d i f f i c u l t for one country to avoid the e f f e c t of a r i s e of the price of i n t e r n a t i o n a l l y traded commodities i f i t engages in international trade to a s i g n i f i c a n t extent. Secular i n f l a t i o n can be countered by exchange rate revaluations but as that endangers export industries, i t i s often easier to permit p a r a l l e l domestic i n f l a t i o n . Harry G. Johnson (1973) argues that i n the recent past, secular i n f l a t i o n has resulted from the use of the American d o l l a r as a reserve currency and the American Government's decision to pursue i n f l a t i o n a r y p o l i c i e s for reasons of domestic p o l i c y . As the Canadian government i s now adjusting tax rates, s o c i a l and pension benefits to allow for price i n f l a t i o n , i t appears that i n Canada price s t a b i l i t y may now be sought only i n a r e l a t i v e sense. In the management of an income t r u s t , secular p r i c e i n f l a t i o n should be e x p l i c i t l y considered; strategies designed to preserve the purchasing power of the trust's c a p i t a l are required. I t has long been apparent to lawyers and t r u s t companies that the narrow range of trustee investments works a hardship on b e n e f i c i a r i e s and many w i l l s and t r u s t i n s t r u -ments have given wide investment powers to trustees. I t i s 14 easier to confer an absolute d i s c r e t i o n on trustees as more li m i t e d powers may be held void due to uncertainty. In Re Peczeuk 1964 2 A l l E.R. 339, the phrase "in the blue chip category" was held to be too uncertain to be enforceable. Ancoften used volume of W i l l precedents by Sheard and H a l l contains the following paragraph at page 26: "I hereby declare that my Trustee when making investments for my estate s h a l l not be limi t e d to investments authorized by law for trustees but may make any investments which i n his uncontrolled d i s -c r e t i o n he considers advisable and my said Trustee s h a l l not be l i a b l e for any loss that may happen to my estate i n connection with any such investment made by him in good f a i t h . " In addition to the absolute d i s c r e t i o n incorporated i n many w i l l s , P r o v i n c i a l Trustee Acts have been amended recently to give a lim i t e d r i g h t to invest i n common stocks. The present range of permitted investments in the Canadian Provinces are summarized on Table 1 at page 18. . I t i s submitted that the task of balancing the c o n f l i c t i n g interests of l i f e tenants and remaindermen through the choice of trustee investments can u s e f u l l y be studied from the viewpoint of f i n a n c i a l theory and the re s u l t s of various strategies calculated using h i s t o r i c a l data. Another l e g a l d i f f i c u l t y l i e s i n the path of a trustee seeking to balance the interests of the b e n e f i c i a r i e s , for the type of security purchased w i l l determine the amount of income produced. Normally a corporation declares dividends to shareholders out of i t s accumulated earnings and only on f i n a l d i s s o l u t i o n does i t d i s t r i b u t e i t s c a p i t a l . But what i s the l e g a l status df redeemable preference shares or of 15 r i g h t s to subscribe for shares at an advantageous price which are sometimes issued to shareholders? These unusual corporate acts do occur and some corporations u t i l i z e them to d i s t r i b u t e accumulated earnings and to r a i s e additional equity c a p i t a l . The Courts have determined who s h a l l b e n e f i t from these types of corporate arrangements. In p r i n c i p l e , the tenant for l i f e takes a l l dividends and bonuses declared by a corporation upon i t s shares during his l i f e t i m e . Even extraordinary dividends, such as a d i s t r i b u t i o n in 1946 of pre-1939 undistributed income was held i n Re Thomson 1947 OR 469 to be a dividend and therefore payable to the l i f e tenant. However a corporation may by proper procedures convert retained earnings into paid-up shares and d i s t r i b u t e these to i t s share-holders as a stock dividend. The nature o f such dividends has been a much l i t i g a t e d issue which was s e t t l e d i n Canadian law by the decision of the Supreme Court of Canada i n Re  Waters 1956 S.C.R. 889 which held that preferred shares and the proceeds on t h e i r redemption are c a p i t a l i n the hands of trustees. This decision may deter a trustee from investing t r u s t assets in companies that customarily d i s t r i b u t e retained earnings through the mechanism of redeemable preference shares. A s i m i l a r problem occurs with those banks and u t i l i t i e s which have p e r i o d i c a l l y issued rights to t h e i r present shareholders to subscribe for additional shares at an advantageous p r i c e . I f a trustee s e l l s these r i g h t s , are the proceeds c a p i t a l or income? Financial theory would regard the proceeds from the sale of the r i g h t s , as compensation for the d i l u t i o n suffered by the o r i g i n a l shares and therefore r i g h t l y considered as c a p i t a l . This issue has been l i t i g a t e d i n the Courts. In Re Malan, 1894 3 Ch. D. 587 St e r l i n g J . discussed the e f f e c t of an issue of rights to a l l shareholders to subscribe for additional shares as follows: "If an o f f e r were made to trustees unconnec-ted with the payment of any dividend the option would have to be exercised on behalf of a l l b e n e f i c i a r i e s , and i f the instrument creating the tr u s t did not authorize the retention of the shares, i t would be the duty of the trustees to s e l l them and deal with the proceeds of the sale as c a p i t a l . . . Falconbridge, C.J. followed the above decision i n Re S i n c l a i r 1901 O.L.R. 2, P 349 i n holding that the l i f e tenant was not e n t i t l e d to new stock issued to the trustee below the then market p r i c e . The 1972 Income Tax Act S83 permits "tax free" dividends to shareholders i n ce r t a i n cases and several Canadian Corporations have created " B " common shares to s a t i s f y the statutory provisions. A trustee of an income tr u s t may therefore hold either *A" or " B " shares and i n choosing, the e f f e c t on a l l b e n e f i c i a r i e s should be considered. I f a trustee e l e c t s to hold " B " shares and receive dividends free of current income taxes, the l i f e tenant may receive a benefit; but the adjusted cost base of the shares i s reduced by the amount of the dividend and the prospective burden of income taxes on future c a p i t a l gains i s increased. I t i s our view that the equitable p r i n c i p l e of even-handed t r e a t -ment of a l l b e n e f i c i a r i e s i s consistent with the l i f e tenant 17 paying normal taxes on his income and therefore only the 2 "A" shares are suitable trustee investments. The importance of a trustee honestly seeking to keep an even hand between competing b e n e f i c i a r i e s can be seen i n the case of Re Smith 1971 O.R. Vol. 2 541. In t h i s case a corporate trustee declined to answer the request of the t e n a n t - f o r - l i f e that low-yielding Imperial O i l shares be sold and other higher y i e l d i n g s e c u r i t i e s bought. The Court found that the Trustee was i n breach of i t s duty as a trustee to maintain an even hand between the l i f e tenant and remainder-men, removed the trustee and directed i t to pay the s o l i c i t o r and c l i e n t costs of the l i f e tenant. We submit that a trustee should be aware of the l e g a l consequences associated with the d i f f e r e n t types of s e c u r i t i e s and exercise his d i s c r e t i o n to t r y to preserve the purchasing power of the c a p i t a l while producing a reasonable current income to the l i f e tenant. 18 Table 1 The Range of Permitted Investments P r i o r to recent amendments, the permitted investments of trustees under Pro v i n c i a l l e g i s l a t i o n were b a s i c a l l y l i m i t e d to the following: a) Securities issued by or guaranteed by the Government of Canada, U.S.A., B r i t a i n , or a Canadian Province. b) F i r s t mortgages on Canadian r e a l estate. Common and preferred stocks and corporate bonds and debentures of Canadian Corporations are now trustee investments in most Provinces; the date of the l e g i s l a t i v e amendments and the extent that they are now allowed are shown below: Province B r i t i s h Columbia Alberta Saskatchewan Manitoba Ontario Quebec Nova Scotia P.B.I. New Brunswick Date Introduced 1959 Statutes of B.C. 1966 Statutes of Alberta 1965 Statutes of Saskatchewan 1965 Statutes of Manitoba 1960 Statutes of Ontario 1967 Statutes of Quebec 15-16 E l i z 11 1957 Statutes of Nova Scotia 1971 Statutes of P.E.I. Percentage 35% 35% 35% 15% common stock 35% preferred stock and corporate debentures 35% 35% 30% but "common stocks l i m i t e d to 15% 30% 1971 Statutes of New Brunswick 100% but subject to the reasonable man rule Newfoundland No change N i l 19 Footnotes to Chapter 2 Halsbury Laws of England, 3rd. E d i t i o n Vol 38 Section 1683. "Except when the instrument creating the t r u s t expressly gives him a d i s c r e t i o n as to adopting a course which w i l l benefit one beneficiary at the expense of the others, i t i s the duty of a trustee to hold an even hand between the parties interested under the t r u s t and to look at the interests of a l l and not to those of any p a r t i c u l a r beneficiary or class of b e n e f i c i a r i e s . " A similar problem was posed by the Nov. 1974 Canada Savings Bond campaign. Holders of e a r l i e r C.S.B.'s had the option of holding old issues t i l l Nov. 1979 or maturity to receive a cash premium calculated to make the t o t a l y i e l d equivalent to a 10.5% y i e l d , or of r o l l i n g them over into the new 1974 issue y i e l d i n g 9.75%. For tax purposes the Government has said that the bonus when received may be treated by the holder as a c a p i t a l gain or as ordinary income. However in a trustee's hands the bonus w i l l be either payable to the l i f e tenant as income or w i l l be held by the trustee as c a p i t a l and l i t i g a t i o n may be needed to s e t t l e the issue. A prudent trustee might have preferred to purchase the new issue y i e l d i n g 9.75% i n order to avoid t h i s d i f f i -c u l t determination. 20 CHAPTER 3 The Application of Financial Theory To The Investment Management  Of An Income Trust As a part of economics, modern f i n a n c i a l theory has the broad objective of studying and understanding the f i n a n c i a l sector of a modern economy. The extensive analysis of the structure of c a p i t a l asset p r i c e s , ^ and studies of the e f f i c i -ency of e x i s t i n g c a p i t a l markets,^ are i n t h i s t r a d i t i o n . Other contributions to recent f i n a n c i a l theory deal with problems of i n t e r e s t to an i n d i v i d u a l investor or investment fund manager. H i s t o r i c t o t a l returns of a wide range of assets have been calculated, the e f f e c t s of d i f f e r i n g combinations of s e c u r i t i e s have been computed and the r e s u l t s of various investment techniques estimated. These range from d o l l a r A 5 6 averaging, formula planning, short s e l l i n g , and p o r t f o l i o 7 maintenance strategies to the minimum size of a d i v e r s i f i e d p p o r t f o l i o . Many of these studies use one-period return as a measurement variable and by summing dividends and c a p i t a l gains, i m p l i c i t l y assume that they are equivalent. In t h e i r 1961 a r t i c l e proposing the n e u t r a l i t y of dividend p o l i c y , Modigliani and M i l l e r wrote on page 411: "Rational behavior means that investors always prefer more wealth to less and are i n d i f f e r e n t as to whether t h e i r wealth takes the form of cash payments or an increase in the market value of t h e i r 21 holdings." Myron J . Gordon (1963) has attacked t h e i r d e f i n i -t i o n arguing that r a t i o n a l investors may prefer current dividends as they a i d i n reducing the uncertainty of future r e t u r n s . 9 Van Home and McDonald (1971) have mentioned other factors such as transaction costs, f l o t a t i o n costs, d i f f e r -e n t i a l borrowing and lending rates, and d i f f e r e n t i a l income and corporate tax rates that may lead investors to prefer either dividends or c a p i t a l gains. They wrote on page 508: "Some i n s t i t u t i o n a l investors may favour dividends, owing to l e g a l constraints or tax considerations. For example, u n i v e r s i t i e s often prefer dividend income to c a p i t a l gains on endowment investments because of r e s t r i c t i o n s on expenditures of c a p i t a l gain." This writer has sought to e s t a b l i s h the c r u c i a l difference between dividends and c a p i t a l gains i n the hands of a trustee of an income t r u s t . By law such trustees cannot be i n d i f f e r e n t between dividends and c a p i t a l gains and there-fore they cannot accept one of the assumptions i m p l i c i t in most recent t h e o r e t i c a l and empirical work.^ Propositions derived from that theory are therefore not necessarily a p p l i c -able to the management of an income t r u s t . To i l l u s t r a t e some of the d i f f i c u l t i e s which ari s e when empirical work using one-period return as a measurement variable i s approached from the viewpoint of a trustee of an income t r u s t , the writer proposes to refer to two published papers. V 2 2 In t h e i r 1969 a r t i c l e , Professors Soldofsky and M i l l e r sought to develop the r i s k premium curve for long term American s e c u r i t i e s over the period 1950-1966 and for shorter periods. They concluded that Sharpe's hypothesis of a p o s i t i v e l i n e a r relationship between r i s k and return was supported by the l e a s t square regression equation reported on page 438: standard deviation _ 0 3 5 8783 geometric mean of annual return * * . annual return 9 12 for which the c o e f f i c i e n t of determination, R , was .9099: In interpretation of t h i s equation they wrote on page 435: "During the 1950-1966 period, investors obtained an additional 1.148 per cent annual y i e l d for each 1 per cent increase i n standard deviation." What conclusions relevant to the manage-ment of an income t r u s t can be drawn from t h e i r analysis? The increase i n return from investing in common stocks rather than government or corporate bonds i s clear and provides a h i s t o r i c a l j u s t i f i c a t i o n for the broadening of trustee invest-ment to include common stocks. However a d i r e c t a p p l i c a t i o n of t h e i r proposition to the s e l e c t i o n of common stocks as trustee investments encounters two d i f f i c u l t i e s . Soldofsky and M i l l e r e x p l i c i t l y use one-period return as a measurement variable; they present no evidence whether the annual dividend r e t u r n — t h e variable of primary i n t e r e s t to t r u s t e e s — also has a p o s i t i v e c o r r e l a t i o n with r i s k . In the absence of evidence, one can only note that i t i s possible that a nega-t i v e r e l a t i o n s h i p e x i s t s between r i s k and dividend y i e l d s . 23 Table 2 Soldofsky and M i l l e r ' s Annual Total Returns 1952 - 1966 Period Gov't. Bonds Corporate AAC Medium Pre-ferred Stock 1952-56 .009 .006 .048 1957-61 .023 .021 .047 1962-66 .031 .023 .046 Common Stocks 10 11 12 13 14 15 Conservative- - - Speculative .203 .237 .158 .179 .138 .068 .291 .255 .263 .226 .146 -.32 .032 .109 .098 .059 .092 .087 24 In addition, from a v i s u a l inspection of t h e i r Charts 1, 2 and 3, i t appeared that even when one-period return i s measured, the pri c e of r i s k in the stock market could be negative. To v e r i f y t h i s observation, simple regression equations were derived for the 12 five-year periods covered by Soldofsky and M i l l e r ' s data and they appear on Table 3, page 25. From these equations i t appears that during the years 1954 to 1963, conservative common stocks dominated speculative stocks i n that they produced a larger one-period return and a smaller standard deviation of return than speculative stocks. This conclusion i s supported by the tests by Blume and Friend (1973) of the c a p i t a l asset p r i c i n g model. They regressed 12 mean returns from p o r t f o l i o s of approximately 80 s e c u r i t i e s on t h e i r respective mean Beta c o e f f i c i e n t s for three periods, 1955-59, 1960-64 and 1965 to June 1968. While a p o s i t i v e r e l a t i o n s h i p between r i s k and return was found for the l a s t period, for the 5 year period 1960-64 a negative r e l a t i o n s h i p was revealed between return and r i s k as interpreted by average Beta c o e f f i c i e n t s of the p o r t f o l i o s . For the e a r l i e r period i n the i r data, r i s k and return were poorly related, with the slope of the equation being determined by d i f f e r e n t averaging techniques. Empirical tests of the c a p i t a l asset p r i c i n g model as reported by Fama and MacBeth (1973) are inter e s t i n g as they describe i n general terms the c h a r a c t e r i s t i c s of common stocks l i s t e d on the New York Stock Exchange. They sought to 25 Table 3 Regression Equations of Risk and Return Using  Soldofsky and M i l l e r ' s (1969) Data on Six Classes of Common Stocks li Equation: S.D. of return = a + b Geometric + error Mean Return Period R2_ 1951-55 tt = -.04 + .18 II .06 1952-56 II .11 + .45 II .004 1953-57 II = .69 - .45 II .39 1954-58 II = .77 - .43 II .44 1955-59 II = .80 - .49 •I .89 1956-60 II .77 - .46 II .94 1957-61 II = .74 - .41 II .95 1958-62 II .49 - .18 II .74 1959-63 II = .41 - .18 H .45 1960-64 II .35 - .14 II .16 1961-65 II = -.25 + .38 a .16 1962-66 II — -.46 .59 .11 26 t e s t three hypotheses—that a l i n e a r r e l a t i o n s h i p holds between r i s k and return, that the Beta c o e f f i c i e n t captures a l l of the systematic r i s k , and that the rel a t i o n s h i p between r i s k and return i s p o s i t i v e . The f i r s t two hypotheses were not disproved by t h e i r results but the t h i r d was not uniformly borne out. Over the whole period studied and for f i v e shorter periods, a p o s i t i v e r e l a t i o n s h i p between r i s k and return was revealed. However for the fiv e year period—1956 to 1960— a negative r e l a t i o n s h i p was indicated. That r i s k does not always carry with i t a higher return (thought i t often may) when measured over as long a period as f i v e years i s an important conclusion. Trustees cannot accept without question the often stated hypothesis that r i s k and return are p o s i t i v e l y r e l a t e d . These studies may j u s t i f y a conservative common stock investment strategy i n an income t r u s t quite apart from the need for a s u f f i c i e n t dividend income. A group of f i n a n c i a l researchers have experimented with sort-rank routines using current f i n a n c i a l information with the objective of maximizing one-period returns over a given time horizon. This technique i n a way approximates the mental process of individual investors as they formulate buy and s e l l decisions based upon recent f i n a n c i a l information that they are exposed to through deliberate search or chance. As the measurement variable used i n these studies—one-period r e t u r n — i s not appropriate to an income tr u s t , these r e s u l t s cannot be d i r e c t l y applied. However the technique could be 27 reformulated to coincide with a trustee's goals. For example, a sort-rank routine,could s e l e c t a l l stocks with a minimum threshold dividend y i e l d , rank these s e c u r i t i e s according to an investment strategy based upon P/B r a t i o s , rate of change of earnings or beta c o e f f i c i e n t s and examine the re s u l t i n g dividend y i e l d and c a p i t a l gains over the trustee's chosen time horizon. The re s u l t s reported by Litzenberger;^Joy and Jones (1971) i l l u s t r a t e the d i f f i c u l t i e s i n applying current work with sort-rank routines to the investment s i t u a t i o n of a trustee of an income t r u s t . They sought to obtain improved investment returns by employing sort-rank routines based on earnings/price r a t i o s and beta c o e f f i c i e n t s , to 261 common stocks selected from the 425 common stocks that made up the Standard and Poor's Industrial Index, over the period October 1965 to June 1968. The market strategy of purchasing the 25 se c u r i t i e s with the lowest P/E r a t i o s (or the largest E/P ra t i o s to use the i r terminology) and holding them for s i x months was evaluated using one-period return. They concluded that the ranking based upon price/earnings r a t i o s was useful as the average reward to v a r i a b i l i t y r a t i o for a l l 25 stocks was .68 compared to .28 for the Standard and Poor's 425 Industrial Index. When the 25 stocks with low P/E r a t i o s were ranked according to their systematic r i s k as measured by thei r beta c o e f f i c i e n t s , the ten stocks with smaller beta c o e f f i c i e n t s outperformed the ten stocks with larger beta c o e f f i c i e n t s . This a r t i c l e considers what could be an 28 a t t r a c t i v e p o l i c y for a trustee—maintaining a stock port-f o l i o of low P/E s e c u r i t i e s , but i n an a r t i f i c i a l environment, without brokerage costs and employing overlapping periods. In an attempt to overcome these d i f f i c u l t i e s , the author re-calculated their data using two periods, one of s i x consecutive h a l f - y e a r l y periods and one of f i v e consecutive half-yearly periods, thus removing any overlap; and brokerage commissions at a f l a t rate of one percent were deducted on each purchase and sale. The terminal value of an i n i t i a l p o r t f o l i o investment of $10,000 was calculated using the price r e l a t i v e s given i n Table 2 at page 1065 of t h e i r report. The r e s u l t i n g f i n a l p o r t f o l i o valuations and geometric mean annual returns appear i n Table 4, page 30; they simply confirm the o r i g i n a l r e s u l t s of Litzenberger, Joy and Jones that a p o l i c y of maintaining an investment i n the 25 stocks with the lowest P/E r a t i o s , with p o r t f o l i o re-establishment every s i x months, produced a larger return than the Standard and Poor's Indu s t r i a l Index. However th i s may not be a f a i r comparison as the 25 stocks were selected from the 261 stocks that were known to have provided complete data on prices, earnings and dividends during the :entire three year period. The average return for t h i s parent population of 261 companies may vary from the average return of the 425 stocks incorporated i n the Standard and Poor's Industrial Index. A more appropriate comparison would have been to compare the mean return of the various p o r t f o l i o s of 25 stocks, with the mean return of 261 stocks from which they were selected. 29 The larger y i e l d associated with the strategy of investing i n s e c u r i t i e s with low P/E r a t i o s may also be due to the pre-screening process. Companies that declared bank-ruptcy or that were d e l i s t e d , were eliminated i n s e l e c t i n g the parent population of 261 s e c u r i t i e s . Risk of f i n a n c i a l f a i l u r e i s p e c u l i a r l y acute among stocks with low P/E r a t i o s and therefore pre-screening may be the true source of the higher period return. During t h i s three year span and using these techniques, the low beta s e c u r i t i e s did outperform the high beta s e c u r i t i e s ; however the short time span makes any evaluation of t h i s r e s u l t very d i f f i c u l t . This evaluation of a p o l i c y of maintaining a port-f o l i o of s e c u r i t i e s with low P/E r a t i o s i s not d i r e c t l y applicable to the investment problems of a trustee of an income t r u s t because the e f f e c t on dividend income i s not separately delineated. Overlapping time periods, pre-screening to ensure continuous data, and the assumption of costless trading, a l l make i t d i f f i c u l t to estimate the actual e f f e c t of t h i s p o r t f o l i o p o l i c y . Our reworking of t h e i r data as recorded in Table 4 incorporates brokerage charges and elim-inated the overlapping time periods but could not resolve the basic d i f f i c u l t y of pre-screening or decompose the period return into a dividend y i e l d and a c a p i t a l gains component. One submission t h i s thesis seeks to make i s that much of recent f i n a n c i a l theory and empirical analysis con-cerning the stock market i s d i f f i c u l t to apply to the investment problems of an income t r u s t because the assumption of 30 Table 4 Recalculation of p o r t f o l i o values r e s u l t i n g from  lowest P/E r a t i o s over the period of 2.5 and 3 years  with an i n i t i a l investment of $10,000 Three year period - March 1966 to March 1969 Strategy Lowest 10 P/E Ratio Lowest 15-25 P/E Ratio Highest 10 Beta Co e f f i c i e n t s Lowest 10 Beta Coef f i c i e n t s Entire 25 Stocks S & P Industrial Index P o r t f o l i o Valuation a f t e r 12 Commission Charges $ 18,383.71 $ 17,437.71 $ 15,764.53 $ 18,304.27 $ 17,031.24 $ 12,025.07 Geometric Annual Mean Return 1.129 1.119 1.101 1.128 1.115 1.058 2.5 Year Period, July 1966 to December 1968 P o r t f o l i o Valuation a f t e r 10 Commission Charges Lowest 10 P/E Ratio Lowest 15-25 P/E Ratios Highest 10 Beta Coef f i c i e n t s Lowest 10 Beta Coefficients Entire 25 Stocks S & P Industrial Index $ 17,527.25 $ 17,604.02 $ 14,798.41 $ 20,175.51; $ 17,007.90 $ 12,123.10 1.1415 1.1425 1.1035 1.1741 1.1346 1.0536 Note: Brokerage commissions on purchases and sales were calculated at a one per cent rate. 31 indifference between dividends and c a p i t a l gains no longer applies. One-period return i s not a s a t i s f a c t o r y measure-ment variable to such a trustee. A prime objective of such a trustee i s to invest the c a p i t a l of the t r u s t to produce income for the l i f e tenant. I f a trustee sought simply to maximize the one-period return from a t r u s t p o r t f o l i o , an ade-quate income to the l i f e tenant would not necessarily r e s u l t . I t would be necessary to impose as a constraint, a minimum dividend y i e l d . With t h i s addition an income t r u s t could be handled using the tools devised for p o r t f o l i o construction and analysis. However the imposition of a minimum dividend y i e l d would be a r b i t r a r y i f the trade-off between dividends and c a p i t a l gains were not known when the income constraint was imposed. Using the terminology of l i n e a r programming, 14 i f the shadow cost of the income constraint was large, a trustee might prefercto relax t h i s constraint and accept a smaller dividend income. More generally i n s e t t i n g an income constraint, i t would a i d a trustee i f he knew the cost of the constraint in terms of the c a p i t a l gains foregone. An analysis to delineate the trade-off between dividend income and c a p i t a l appreciation over recent periods would be of i n t e r e s t to trustees of income t r u s t s . I f a t r u s t ' s p o r t f o l i o return were analysed i n terms of dividend y i e l d and c a p i t a l gains (loss) y i e l d , i n the place of port-f o l i o return and a measure of r i s k , the concept of an e f f i c i e n t f r o n t i e r can s t i l l be applied and a form of port-f o l i o analysis c a r r i e d out. Graph 2 at page 35 sketches 32 such an analysis. The addition of a rate of price i n f l a t i o n to t h i s graphical analysis poses some problems. The rates of price i n f l a t i o n and appreciation through c a p i t a l gains can be equated as they both measure the rate of change of a stock. A horizontal l i n e can therefore represent the assumed rate of p r i c e i n f l a t i o n over the period. A p o r t f o l i o return located above that l i n e indicates that the corpus of the trust i s growing i n r e a l terms. However dividend y i e l d measures the rate of flow of income from a stock of c a p i t a l and so long as that stock of c a p i t a l i s constant or growing i n r e a l terms, then the dividend y i e l d i s also expressed i n r e a l terms. However i f the rate of c a p i t a l appreciation via c a p i t a l gains does not equal the rate of price i n f l a t i o n , then the nominal dividend y i e l d w i l l be larger than the r e a l 15 dividend y i e l d . Any p o r t f o l i o under consideration would occupy a point in the dividend y i e l d , c a p i t a l gains y i e l d space and an e f f i c i e n t f r o n t i e r could be formed by those p o r t f o l i o s having the largest c a p i t a l y i e l d for a given dividend y i e l d or vice versa. To enrich the analysis other assets such as bonds and mortgages could be represented and as well a market index such as the Toronto Stock Exchange Ind u s t r i a l Share Index. By t h i s means the actual performance of an income t r u s t could be analysed i n terms of d i r e c t relevance to i t s b e n e f i c i a r i e s and alternative p o r t f o l i o s evaluated. Considered i n these terms, i t i s submitted that a trustee's objective could be to p o s i t i o n h i s t r u s t at a point 33 on the e f f i c i e n t f r o n t i e r . P o r t f o l i o s which do not form part of the e f f i c i e n t set can be improved to the benefit of one set of b e n e f i c i a r i e s without harm to the other. Which point on the e f f i c i e n t f r o n t i e r the trustee should s e l e c t i s indeterminate i n t h i s analysis and must be chosen with regard to other factors such as the need for l i q u i d i t y , the rate of anticipated i n f l a t i o n , the f i n a n c i a l needs of the l i f e tenant and the a b i l i t y of the p o r t f o l i o and i t s trustee to ignore fluctuations i n market value. In t h i s chapter two recent studies have been examined c r i t i c a l l y , to i l l u s t r a t e some d i f f i c u l t i e s i n applying such studies to the investment management of an income t r u s t . The writer has suggested that an empirical analysis to delineate the trade-off between dividend y i e l d and c a p i t a l gains y i e l d would be of d i r e c t relevance to the management of an income tr u s t . However t h i s idea was developed during the evaluation of the empirical work to be outlined i n Chapter 4 and the empirical development of an e f f i c i e n t f r o n t i e r i s beyond the scope of t h i s t h e s i s . We have suggested that analysis i n terms of r i s k and one-period return, though applicable to an i n d i v i d u a l investor and pension and mutual funds, i s not appropriate to an income t r u s t ; while analysis i n terms of dividend y i e l d and c a p i t a l gains y i e l d separates the factors relevant to an income t r u s t and f a c i l i t a t e s d i r e c t considera-t i o n of the c o n f l i c t i n g interests they represent. In selecting a f i n a n c i a l aspect of a t r u s t p o r t f o l i o for analysis using these measurement variables, a simple comparison of two competing p o l i c i e s was desirable. The i n i t i a l s e l e ction of a t r u s t p o r t f o l i o , involving as i t does both i n d i v i d u a l security analysis and the range of p o r t f o l i o construction techniques, does not lend i t s e l f to a l i m i t e d analysis. In almost any p o r t f o l i o over time, some investments w i l l be found to be s a t i s f a c t o r y and others not. When the unsatisfactory investments should be sold i s a d i f f i c u l t problem for most investors; for trustees the problem i s complicated by a legitimate fear that r e a l i z e d c a p i t a l losses may lead the remainderman to vocal c r i t i c i s m or l e g a l action, and may also jeopardize the trustee's claim for compensation for his time, trouble and expense i n managing 16 the t r u s t . However even successful investments may pose problems for a trustee of an income t r u s t as a r i s i n g share price may cause the current dividend y i e l d to f a l l . Should the c a p i t a l gain be r e a l i z e d and reinvested i n a higher y i e l d i n g security? This l a s t and simplest problem was selected for detailed analysis. 35 G R A P H 2 GRAPHICAL A N A L V 5 I S OF A T l ? i y s T PORTFOLIO % CAPITAL G-AIM P E R A N N U M * 4 7-6 4-3-- / -+ - Z - 3 - V--5 -% L o s s X ^ b F F I C I E N T FdON T I E / ? s V + \ s RATE OF CONSUMER PRICE INFLAT IOW — A — t b t / l V I D E N D - i 1 1 1 1 — — i 1— 2 ?> H 5 6 7 ? * \ / o \ RETURM Pel? + •+ \ /) N hi u M . \ P e r ? A N N U M 3 6 Footnotes to Chapter 3 1. Page 20. Sharpe (1964) at page 428 assumes that investors view the outcome of any investment i n terms of expected value and that value's standard deviation. As no mention i s made of when wealth accrues i n cash to the investor, an i m p l i c i t assumption of indifference between dividends and c a p i t a l gains i s made. 2. Page 20. Fama, E.F. and MacBeth, J.D., Risk, Return and Equilibrium, Empirical Tests. J . of P o l i t i c a l  Economy, May/June 1973, p. 607. 3. Page 20. Fisher, L. and Laurie, J.H., Rates of Return on Investments i n Common Stocks. Journal of Business. January 1964, p. 1. Dividends were assumed to have been immediately reinvested in the stock that paid them. This : i s a feasible investment p o l i c y only i f there i s no need for cash dividends and as a consequence, i t i m p l i c i t l y assumes indifference between dividends and c a p i t a l gains. 4. Page 20. Ascher, L.W., Dollar Averaging in Theory and Practice. Financial Analysts Journal, September, 1960, p. 51. 5. Page 20. Dince, R.R., Another View of Formula Planning. J . of Finance, 1964, p. 678. 6. Page 20. MacDonald, J.C. and Baron, D.C., Risk and Return on Short Positions i n Common Stocks. J . of Finance, March, 1973, p. 97. The authors do not refere to dividends in t h e i r c a l c u l a t i o n of the returns from short p o s i t i o n s . As holders of a short p o s i t i o n are charged for any d i v i -dends that are declared while t h e i r short p o s i t i o n i s held, t h e i r s t a t i s t i c Wi must overstate the mean return from short p o s i t i o n s . 7. Page 20. Evans, J.L., Analysis of P o r t f o l i o Maintenance Strategies. Journal of Finance, June 1970, p. 561. 8. Page 20. Evans, J.L. and Archer, S.H., D i v e r s i f i c a t i o n and the Reduction of Dispersion. An Empirical Analysis. Journal of Finance, December 1968. Returns were expressed as p r i c e r e l a t i v e s with any dividend being simply added to the end-of-period p r i c e . 9. In "Optimal Investment and Financing P o l i c y , " Journal of  Finance, May 1963, p. 264. M.J. Gordon has argued that i t i s possible that the required rate of return employed by r a t i o n a l investors i n discounting future dividends increases as the dividend payments are postponed. 37 10. Page 21. Recognition i n f i n a n c i a l theory of a preference for cash dividends by some i n v e s t o r s — f o r example trustees of income trusts and conservative individuals l i v i n g on investment income, while speculatively i n c l i n e d individuals and those subject to heavy marginal rates of tax on d i v i -dend income may prefer c a p i t a l gains, could lead to e x p l i c i t recognition of a c l i e n t e l e e f f e c t whereby each corporation over time a t t r a c t s shareholders pleased with i t s dividend p o l i c y . Shareholder's attitude towards dividends could be considered a dimension ranging from an absolute preference for dividends, through indifference to an absolute preference for retained earnings. An attempt to measure a net preference for current dividends or c a p i t a l gains, may be misdirected as shareholders's pre-ferences may not be stable but s h i f t with the business c y c l e . 11. Page 21. The danger of drawing investment p o l i c i e s from t h e o r e t i c a l economic propositions, has been noted before. Lemont K. Richardson i n his a r t i c l e , "Do High Risks Lead to High Returns?", Financial Analysts Journal, March/April 1970, p. 88, argues that r i s k y s e c u r i t i e s do not necessarily have a high return. 12. Page 22. Richard W. McEnally i n his 1972 Comment suggested that t h i s large regression c o e f f i c i e n t i s more properly explained by the dichotomized nature of the data. Soldofsky and M i l l e r seem to have agreed with him at p. 941 of t h e i r Reply (1972). 13. On page 432, the authors define the annual rate of return on a security to be K + ~ B T + P T ~ P T - 1 = B T + P % - l T PT-1 where K T = the rate of return i n the year T P T = price of a uni t of the security a t the end of the year P r p _ l = price of a unit of the security at the beginning or i n i t i a l point of the year B T = i s r e s t r i c t e d to being the dividend or i n t e r e s t for one year as required by the security being used •Through a typographical error t h i s was printed as B T . 14. A shadow cost could be defined as the change i n the ;; value of the objective function produced by a one uni t change i n a binding constraint. 15. Page 32. The impact of i n f l a t i o n on a trust's dividend y i e l d for a period, when the corpus of the t r u s t i s decreasing i n r e a l terms, would appear to be obtained 38 by multiplying the nominal dividend y i e l d by a factor obtained by substracting from one, the difference between the rate of pr i c e i n f l a t i o n and the trust's rate of c a p i t a l appreciation. For example assuming a 12% rate of pr i c e i n f l a t i o n , a 10% nominal dividend y i e l d and c a p i t a l appreciation of 2%, then i n r e a l terms the dividend y i e l d would be reduced from 10% to 10% times (1- (.12 - .02)) or 9%. Page 34. The determination of the compensation payable to a trustee for h i s time, trouble and expense i n the management of a tr u s t , i n the absense of agreement, w i l l be made by a Judge. In Ontario i t has been held i n Re Toronto General Trusts and Central Ont. Ry. 6 OWR 350 that the proper things to be considered i n f i x i n g the remuneration of trustees are: a) the magnitude of the t r u s t , b) thea care and r e s p o n s i b i l i t y springing therefrom, c) the time occupied i n performing i t s duties, d) the s k i l l and a b i l i t y displayed, e) the success which attended i t s administration. The f a c t that a trustee has r e a l i z e d losses i n h i s admin-i s t r a t i o n of the investments of- the t r u s t i s relevant to the l a s t two factors and can form the factual foundation for a l e g a l argument that the usual care and management fee should be reduced. In addition a trustee i n Ontario i s normally allowed a 2% commission upon c a p i t a l receipts and disbursements; however r e a l i z e d losses on investments should be applied to reduce each of these figures and so reduce the compensation payable to the trustee. 39 CHAPTER 4 An Empirical Evaluation of a Policy of Requiring a Minimum  Current Dividend Y i e l d The eroding e f f e c t of i n f l a t i o n on the fixed income produced by bonds and mortgages and the broadening of trustee investments to include common stocks, are two factors which could lead a trustee of an income t r u s t to purchase common stocks.^" In t h i s chapter i t w i l l be assumed that common stocks form part of the investment p o r t f o l i o of some income trusts and t h i s writer's attention w i l l be directed towards one aspect of t h e i r investment management. What approach should be taken to those stocks whose current dividend y i e l d has declined as the i r market value has increased? They could be retained i n a n t i c i p a t i o n of continuing c a p i t a l appreciation and future increases i n declared dividends; t h i s w i l l be ca l l e d a Buy and Hold Po l i c y . A l t e r n a t i v e l y , such stocks could be sold and the proceeds reinvested i n another common stock with a larger current dividend y i e l d . As t h i s approach involves a check on the current dividend y i e l d at the end of each quarter, i t w i l l be c a l l e d i n t h i s paper an Administrative P o l i c y . Both of these p o l i c i e s are feasible and i n the course of the management of an income t r u s t , both w i l l normally be employed. The choice between them being made i n the l i g h t of the economic prospects of each p a r t i c u l a r firm and the trustee's attitude towards dividend income for an administra-ti v e p o l i c y has as an immediate objective, increased dividend income. The empirical research reported herein, had as i t s objective the measurement of the average e f f e c t of these competing p o l i c i e s on dividend income and c a p i t a l appreciation over two time periods, A p r i l 1960 to September 1964 and 2 January 1965 to June 1969. No attempt was made to pre d i c t the r e l a t i v e e f f e c t of these p o l i c i e s on ar>priori basis. The closing price of the l a s t board l o t traded at the end of March, June, September and December, from March 1959 to June 1969 was obtained from the Toronto and Montreal Stock Exchange monthly publications together with the cash dividends payable during the preceding three months. This data was o r i g i n a l l y obtained on a l l Canadian common stocks held by Canadian trusteed pension funds; however, those companies that did not have a complete sequence of clos i n g stock prices were eliminated to avoid a range of apprehended mathematical and s t a t i s t i c a l d i f f i c u l t i e s . Thus companies that were d e l i s t e d or went into l i q u i d a t i o n were omitted and the end r e s u l t of t h i s dual s e l e c t i o n process was a l i s t of 108 Canadian companies. The bias introduced by these selec-t i o n procedures, though preventing meaningful external contrasts, should not a f f e c t i n t e r n a l comparisons. Many of these companies had had their stock s p l i t once or several times during t h i s 10 year period, producing d i s c o n t i n u i t i e s i n the i r price and dividend records. Using a Fortran program prepared by Richard Osborne, these 41 d i s c o n t i n u i t i e s were removed, s t a r t i n g at June 1969 and working backwards in time, to produce a series of 41 quarterly observations on closing prices and quarterly dividend payments for each of the 108 companies. In order to compare the r e l a t i v e merits of d i f f e r -ing streams of income, i t was desirable to compare them at one point i n time, using a present value technique. The commencement of each period was chosen, as i t was the point when a choice between the competing investment p o l i c i e s could have u s e f u l l y been made. A discount rate of 3% compounded quarterly was selected as i t approximates the rate of p r i c e i n f l a t i o n experienced over the period. The use of t h i s d i s -count rate implies that dividends are recorded i n 1959 or 1964 d o l l a r s and no preference i s expressed for early as against late dividend r e c e i p t s . A thousand d o l l a r s was applied towards the purchase of each stock on A p r i l 1st, 1960 and January 1st, 1965 with brokerage commissions calculated at a f l a t rate of 1.5% of the purchase p r i c e . Fractions of shares were not held, and any surplus monies were simply held uninvested. This was done for computational ease as the sums are necessarily small, less than the price of one share plus commission. As the main objective was to contrast the investment r e s u l t s of the two strategies, the c a l c u l a t i o n of an i n t e r e s t payment to the l i f e tenant for t h i s small cash balance was omitted. Under the Buy and Hold Policy, the discounted dividends received from each company over the 4.5 year period 42 were summed and expressed as an average annual y i e l d based upon the o r i g i n a l investment of one thousand d o l l a r s . Buy and Hold Dividend Y i e l d = SUM P.V. DIV x 100 $1000 x 4.5 At the end of the period the stock was sold and the present value of the net cash proceeds as of the beginning of the period calculated. The net cash proceeds was the proceeds of the sale l e s s brokerage commission at 1.5% plus uninvested cash. This present value was also expressed as an average annual c a p i t a l gains y i e l d : Buy and Hold Capital Gains Y i e l d = 100 x (P.V. Net Cash Proceeds-1000). $1000 x 4.5 Calculated i n t h i s manner, the c a p i t a l gains y i e l d contains a 3% allowance for i n f l a t i o n ; thus a c a p i t a l gains y i e l d of zero indicates that c a p i t a l appreciation has o f f - s e t the assumed rate of price i n f l a t i o n over the period. As these y i e l d s are a l l related to the same i n i t i a l c a p i t a l investment of one thousand d o l l a r s , they can be con-verted into actual dividend payments and c a p i t a l gains, and comparisons among d i f f e r e n t y i e l d s s t a t i s t i c s can legit i m a t e l y be made. In addition an averaged y i e l d s t a t i s t i c can be calculated for a group of s e c u r i t i e s as they a l l commence with the same i n i t i a l investment and thus have the same weight. These buy and hold dividend and c a p i t a l gains y i e l d s have some i n t e r e s t i n themselves and averaged y i e l d s for d i f f e r e n t groups of stocks based upon the i r i n i t i a l dividend y i e l d appear as Table 5. The summation of dividend y i e l d and c a p i t a l gains y i e l d i s only included for mathematical 43 completeness for from the peculiar viewpoint of an income trustee, i t has been argued i n Chapter 3 that t h i s simple summation may hide relevant information. I t can be seen that the general investment r e s u l t for the higher ranked companies based upon i n i t i a l dividend y i e l d declined i n the second period. Dividend y i e l d declined from 5.7% to 4.1% and c a p i t a l gains y i e l d f e l l from 15.9% to -2.9%. In contrast almost no change occurred i n the y i e l d s associated with the larger group of companies with smaller i n i t i a l dividend y i e l d s . A trustee of an income t r u s t i s l e g i t i m a t e l y interested i n substantial dividend y i e l d s and the y i e l d s associated with the larger i n i t i a l dividend y i e l d s are separately l i s t e d . As there appeared to be a r e l a t i o n s h i p between the i n i t i a l dividend y i e l d s and t h e i r associated dividend y i e l d s t a t i s t i c s , this r e l a t i o n s h i p was explored through simple regression analysis using the model: Average Annual I n i t i a l Dividend error B & H Dividend = a + b Y i e l d + term Y i e l d These regression equations which appear as Table 6 at page 47, were developed to r e l a t e i n a rigorous manner a stock's i n i t i a l dividend y i e l d at the s t a r t of a period and a measure of i t s dividend y i e l d over a 4.5 year period. Over the f i r s t period—from A p r i l 1960 to September, 1964, the v a r i a t i o n i n the, 108 i n i t i a l dividend y i e l d s could explain 42% of the v a r i a t i o n i n t h e i r associated Buy and Hold Dividend Y i e l d s t a t i s t i c s . The p o s i t i v e slope of the regression l i n e 44 L O CD < —• « J 0 ^ a °> _J — • o Q < GO r i-uJ Q u J l -o o in co o (U y a: m & I iii i-CL 111 O h O NO CTN J a: LU O Q <C O e n — > ill <C CL 'JO to 00 O <0 l U z t 0 a o LU >^ O CO Q N. o Lo O v6 J>-O >0 I - 0 S q «? t~ IT) O L r j NO O IT) L O l O to ul ^ *5? -4 O l b ~1 C D < _: >-Q Z E I Q or —i < Q LO N£ to O C O l o o^ ON ro j 3 Q Z -J 2 U uj Q < UJ O N NO CO eve O oo •^6 CN N O O N JS-oo L O J j < UJ :> 2 2 <C z ul O -j < or H UJ •> a <C < O CO Ox Q0 IS N O CM NO Q J ixl u. o NO N O OS uJ z ~ 0 O 1 0 CTN on < ~0 N ^ 0 Nfi IS-vo 1 <M 1 CD ^ to 1 ro CTN ON ro :r ao ^ r ro i * a o or LU CL, ro is o NO Ua • 2: <t a t o O u, o o 2: CO c> 0 ^ ul CO ro Q a z UJ a O Qor < Q £0 J ^ Q * J ^ Ul o N» -ON oj I O o\ C M 2 :> ^: z z <i -4 cvi CO CO o _J o t 0^ 45 indicates that larger i n i t i a l dividend y i e l d s are associated with larger Buy and Hold Dividend Y i e l d s t a t i s t i c s . One d i f f i c u l t y with least-square regression analysis i s i t s extreme s e n s i t i v i t y to a t y p i c a l r e s u l t s . In the f i r s t period the omission of two companies, A t l a n t i c Sugar Refining Co. and Gunnar Mines Ltd., made only a s l i g h t a l t e r a t i o n i n the regression equation. However in the second period, January 1965 to June 1969, the omission of Gunnar Mines which had an i n i t i a l dividend y i e l d of 21.9% and a Buy and Hold Dividend Y i e l d s t a t i s t i c of 1.3%, produced a marked s h i f t in the r e s u l t i n g regression equation based upon 107 companies. Excepting t h i s one company, i t appears that during the second period 55% of the v a r i a t i o n i n the Buy and Hold Dividend Y i e l d s t a t i s t i c can be explained by the v a r i a t i o n i n the i n i t i a l dividend y i e l d s and the slope of regression l i n e i s again p o s i t i v e . I f a trustee of an income t r u s t desires substantial dividend payments over time, then a preference for stocks with large current dividend y i e l d s i s consistent with the p o s i t i v e slope of these regression equations. As each equation's Durbin-Watson s t a t i s t i c i s within the range of i n s i g n i f i c a n t values, from 1.63 to 2.37, i t can be concluded that there i s no s i g n i f i c a n t evidence of s e r i a l c o r r e l a t i o n between pairs of the residual error terms. As the c o e f f i c i e n t s of the regression equations are not stable from period to period, these regression equa-tions cannot be used to predict the Buy and Hold Dividend Y i e l d s t a t i s t i c of a future period based upon the current 46 dividend y i e l d . Using the selected data, the value of the Y intercept was 2.053 in the f i r s t period and 1.08 in the second; the slope of the l i n e changed from .52 to .74. These regression equations are presented s o l e l y to measure the strength of the p o s i t i v e relationship between i n i t i a l dividend y i e l d s and a measure of dividend payments over a 4.5 year period. A separate part of the Fortran program was designed to apply an Administrative Policy to the same 108 companies. As under the Buy and Hold Policy, a thousand d o l l a r s was i n i t i a l l y invested i n each stock, brokerage charges were calculated at a f l a t rate of 1.5%, f r a c t i o n a l shares were not purchased and any cash balance was simply held uninvested. At the end of each quarter, the current annual dividend y i e l d was calculated based upon the sum of dividends received over the past four quarters r e l a t i v e to the market price at the end of that quarter. This current dividend y i e l d was compared with the stock's "sell-low p o i n t , " — a percentage y i e l d defined by the lower bound of the stock's i n i t i a l dividend y i e l d bracket and a "sell-low f a c t o r " as i l l u s t r a t e d below: I n i t i a l Dividend Y i e l d Range of .5% Sell-low point. If"^ current dividend y i e l d f a l l s below thi s point a sale could p o t e n t i a l l y ' occur -i I n i t i a l Annual Dividend Y i e l d of a stock sell-low factor which was experimentally varied from .1% to 2.7% J 0% 47 Table 6 Regression Equations Relating I n i t i a l Dividend Yields to Average Annual Buy and Hold Dividend Y i e l d S t a t i s t i c s Period 1 - A p r i l 1960 to September 1964 108 Companies R 2 D.W. B&H Div Y = 1.94 + . 5 9 ( I n i t i a l Div Y) + ERROR .42 2.07 (1.87) (.29) (.07) \ti ; 106 Companies B&H Div Y = 2.053 + . 5 2 ( I n i t i a l Div Y) + ERROR .46 2.14 (1.50) (.23) (.05) Period 2 - January 1965 to June 1969 108 Companies B&H Div Y = 2.52 + . 2 2 ( I n i t i a l Div Y) + ERROR .12 1.81 (1.30) (.21) (.06) 107 Companies B&H Div Y = 1.08 + . 7 4 ( I n i t i a l Div Y) + ERROR .55 1.81 (.950) (.21) (.07) Note: The standard error of each variable i s given in brackets beneath i t . 48 I f the current dividend y i e l d i s below the relevant sell-low point and i f the stock's current market p r i c e i s greater than i t s cost, then that stock i s sold at the clos i n g price for that quarter and the net proceeds are immediately reinvested i n another stock which then has the desired current dividend y i e l d . This procedure enables a group of stocks which f a l l within a pa r t i c u l a r i n i t i a l dividend y i e l d range, to be treated uniformly as they a l l have the same sell-low point and t h e i r replacements w i l l a l l be within the same dividend y i e l d range. The requirement that the sale of a stock produce a c a p i t a l gain, i s useful as i t l i m i t s an Administrative p o l i c y to sat i s f a c t o r y holdings. The sell-low factor i s the key concept i n an Admin-i s t r a t i v e P o l i c y as i t i s designed to r e f l e c t a trustee's concern with current dividend y i e l d s . This factor should be set to equal the decline i n current dividend y i e l d that a trustee considers s i g n i f i c a n t . For example, with stocks in the i n i t i a l dividend range of 5.0% to 5.5%, i f a trustee f e l t that they should be sold when the current dividend y i e l d declined below 3.5%, then t h i s would be achieved by setting the sell-low factor at 1.5%. The absolute size of the s e l l -low factor w i l l determine the extent to which an Administrative Policy promotes active trading. With a sell-low factor of .3%, then declines in current dividend y i e l d s of t h i s magni-tude w i l l often occur and an Administrative Policy with t h i s s ell-low factor would produce a pattern of active trading. 49 I f the sell-low factor were set at a large figure, for example 2.7%, then declines i n y i e l d of t h i s magnitude would r a r e l y occur and cannot occur, with stocks y i e l d i n g less than 2.7%. An Administrative P o l i c y necessarily has two a s p e c t s — a p o l i c y that d i r e c t s the sale of c e r t a i n invest-ments, and a p o l i c y that d i r e c t s the proceeds into new investments. The writer's objective was to compare an Administrative P o l i c y keyed to current dividend y i e l d with a Buy and Hold Policy. I t was desirable to f i n d a neutral reinvestment p o l i c y i n order to prevent the e f f e c t of the ' s e l l i n g ' p o l i c y being confounded with the r e s u l t s of the reinvestment p o l i c y . Therefore the reinvestment p o l i c y was designed through reference to only one f a c t o r — t h e current dividend y i e l d . I f a stock was sold, i t s replacement was selected at random from among those stocks which at the end of the quarter had a current dividend y i e l d i n the desired dividend y i e l d range. I f no such stocks were available,-a s e l e c t i o n was made from the next higher range. Three d e f i n i t i o n s of the desired dividend y i e l d range were employed to define in e f f e c t three alternative 'buying' p o l i c i e s . In each case the i n i t i a l dividend y i e l d at the s t a r t of a 4.5 year period defined the i n i t i a l dividend y i e l d range for that stock. For example, an i n i t i a l dividend y i e l d of 4.47% would f a l l into the dividend y i e l d range from 4.0% to 4.49%. One p o l i c y was simply to choose, using a random number generator, another stock whose current > 50 dividend y i e l d was then within the same dividend y i e l d range. Simple variants of t h i s p o l i c y were to s e l e c t investments from the next lower dividend y i e l d range, 3.5% to 3.9% i n the above example and thus to lower the required current dividend y i e l d when reinvesting, or a l t e r n a t i v e l y to s e l e c t investments from the next higher dividend y i e l d range, 4.5% to 4.9% i n the above example and increase the required current dividend y i e l d on a l l new investments. At the end of each 4.5 year period a l l stocks were sold and the sum of discounted dividends was expressed as a y i e l d based upon the i n i t i a l investment of $1,000.00 to produce an administrative annual dividend y i e l d s t a t i s t i c . In a si m i l a r manner an administrative annual c a p i t a l gains y i e l d s t a t i s t i c was generated. At an early stage i n t h i s project an Administrative Po l i c y with a sell-low factor of 1.1% and a "buying" p o l i c y d i r e c t i n g repurchases into the next lower i n i t i a l dividend y i e l d bracket, was applied to a l l 108 companies over the period A p r i l 1960 to September 1964. The r e s u l t s appear i n Table 7, page 54, c l a s s i f i e d by i n i t i a l dividend y i e l d ranges. This table indicates that the 67 stocks with i n i t i a l dividend y i e l d s below 4.0% b a s i c a l l y were not affected by an Administra-t i v e P o l i c y . Their average annual dividend y i e l d s t a t i s t i c only declined from 2.9% to 2.8%, while t h e i r average annual c a p i t a l gains y i e l d s t a t i s t i c only increased from 8.7% to 9.0%. In contrast an Administrative Policy had a cl e a r impact on the average y i e l d s of the 41 companies with larger dividend 51 y i e l d s . Their annual dividend y i e l d s t a t i s t i c increased from 5.7% to 6.45% while their annual c a p i t a l gains y i e l d s t a t i s t i c declined from 15.9% to 9.9%. The subdivision by i n i t i a l dividend y i e l d ranges of the 41 higher y i e l d i n g stocks did not appear to be us e f u l . An Administrative Policy increased the dividend y i e l d s t a t i s t i c in 6 out of 7 categories but no consistent pattern could be i d e n t i f i e d . As the writer's object was to i d e n t i f y the average impact of an Administrative Policy, arithmetic averages of individual y i e l d s t a t i s t i c s were employed i n subsequent work. A trustee interested i n substantial dividend income for a l i f e tenant would normally concentrate h i s common stock purchases i n high y i e l d i n g companies, and as an Administrative P o l i c y had been shown to have a minimal impact on lower y i e l d -ing stocks, i t appeared appropriate to apply i t only to higher y i e l d i n g stocks. Consequently i n the f i r s t period an Admin-i s t r a t i v e P o l i c y was applied to the 41 firms with i n i t i a l dividend y i e l d s above 4.0% as of A p r i l 1960. When an Adminis-t r a t i v e P o l i c y was subsequently applied i n a second period, there were only 24 firms with i n i t i a l dividend y i e l d s above 4.0%. To obtain a sample more comparable to that employed in the f i r s t period, an Administrative Policy was applied to the 35 firms with i n i t i a l dividend y i e l d s above 3.5%. In order to understand the impact of various s e l l -low factors on an Administrative Policy, sell-low factors ranging from .3% to 2.7% were applied to the 41 higher y i e l d -ing firms over the f i r s t period, with reinvestments selected from the y i e l d category below that of the i n i t i a l dividend y i e l d ; the r e s u l t s appear on Graph 3, page 53. From t h i s analysis i t appears that the dividend y i e l d and c a p i t a l gains y i e l d s t a t i s t i c s are affected by the sell-low factor and i t therefore i s a relevant variable i n an Administrative P o l i c y . In subsequent work three sell-low factors were employed—.7%, 1.1% and 1.5%, to simplify the analysis and i n the hope that these three could indicate the basic impact of the sell-low factor on an Administrative P o l i c y . These three sell-low factors combined with the three reinvestment p o l i c i e s mentioned e a r l i e r produced 9 alternative operational d e f i n i t i o n s of an Administrative P o l i c y . The random selection of new investments, which was adopted to h i g h l i g h t the e f f e c t s of allowing a decline in current dividend y i e l d s to i n i t i a t e sales, made i t probable that the investment r e s u l t s would vary, p a r t i c u l a r l y with regard to c a p i t a l gains. I t was found that the r e s u l t s of a single a p p l i c a t i o n of a given operational Administrative P o l i c y could not be r e l i a b l y duplicated. To obtain a stable measure, each operational Administrative Policy was applied 20 times to the same data and grand means were calculated from the i n d i v i d u a l average annual dividend and c a p i t a l gains 3 y i e l d s t a t i s t i c s . In t h i s empirical work, to simplify computations, brokerage commissions were calculated at a f l a t rate of 1.5% of the market price, rather than at the graduated rates a c t u a l l y employed by the Canadian stock exchanges during 53 GRAPH 3 ' _ A V E R A G E D I S C O U N T E D ANNUAL. Y[ELDS ? V-/ S T O C K S W I T H I N I T I A L DH / I D I ~ L N D F I E L D S /) B O V E M-.O % , /)PR1L I 9 6 0 T o 5 E . P T . J 9 6 V , R E I N V E S T M E M T /'M T H E L O W E R D I V I D E N D Yieuo RANGE. L ( T »/ T / V E R A G E I3i>-r A N O H O L D C A P I T A L V I E L D 1 5 . 9 ^ J 15% (0 Q -j 14 J Q i ~ 2 o 0 Q / W e f t / ? & e / I D M I M I S T R A T I N E C A P I T A L G A I N ' S r i E L D A j Alio A 5% AVERR&c. / I D M I N I S T R / I T I I / E D I V I D E N D 5~. 85 AVERAGE BUY ANO HOLD D I V I D E N D Y\e.LD 5"7% 5 an =* i 1 1 1 1 1 1 1 1 i 3 9 6 5 .7 /./ ,.3 1.5 1.7 1.9 £ 3 £-7 S E L L - L O W F A C T O R S IN. P e R C E N T 54 u J .J CD cr o a. Ui < z z D Iii CD UJ u. o Z o to a. Z o o 3-ON U-l CD UJ OJ <0 o O N0 ON _1 a. Q O t i l IS-oS Q <3N IN . • O N 1 ^-O N ] S ^ O N <Nf t O N l o \ NO QQ L O i Iri J> in ci N0 O l o ON »ri CN ON us Ci In i n WD SO N O CO ON ( Lo is-l e • CO « 1 O N c i w CM t i s C O 00 > cv <V VO ]S- Lo O N ON Ci v i i CO <vi ON • 1 CN IN. CO O N CO NO ON •< \ Uj <t a 6 U O 0 2 i H UJV. Q i -I O + J CO UJ u z IU oc UJ u. u. en i ^ L U f ° => CD itl o lit UJ u a a IU & £ 1 S U.I < t a £ * 3 CS cr >-CfcT CD 1- _ i r <• a, <A > 2 «C o ^ < v-i >0 u D tti IU D CD CC s h Ui o ti o o Ci. 0 H D Ui <o o lb P Ct «^ •J-c> <C UJ X i U.I H a 2 2 Ul Z \-z Ui a: 0 U. 3 o i -/ N § f»N Q UJ O 0 . r or o d) Ui <t Q J UJ N-5 UJ o -J t-111 III % 55 these periods. Due to the need to adjust market prices for stock s p l i t s i n order to obtain a consistent price record, i t i s d i f f i c u l t to calculate the actual commissions that would have been charged. The only actual prices used in t h i s study were those of June 1969 when the average market price of the 108 companies was $30.69. The Toronto Stock Exchange commission on a purchase or sale of a stock at that price would have been .3867 cents per share or an e f f e c t i v e rate of 1.26%. Thus i n thi s empirical work, i t appears that the e f f e c t of broker's commissions has been overstated. Each of the nine operational d e f i n i t i o n s of an Administrative P o l i c y were applied 20 times over the period A p r i l 1960 to September 1964 to the 41 firms with i n i t i a l dividend y i e l d s greater than 4.0% as of A p r i l 1960, and the grand mean annual dividend y i e l d s t a t i s t i c s and annual c a p i t a l gains y i e l d s t a t i s t i c s are recorded i n Appendix A. In v i s u a l form these r e s u l t s appear on Graph 4, page 57, along with a point representing the investment retsults of a Buy and Hold P o l i c y . Graph 4 portrays the re s u l t s produced by alternative investment p o l i c i e s as represented by the present value of the dividends received and r e a l i z e d c a p i t a l gains or losses, expressedcas an annualized y i e l d based upon the c a p i t a l o r i g i n a l l y invested. Thus while an Administrative Policy concerns i t s e l f with current dividend y i e l d — a r e l a t i v e measure, the res u l t s of thi s p o l i c y are recorded i n an absolute form i n order that comparisons;.with the r e s u l t s of a Buy and Hold Policy can legit i m a t e l y be made. 56 From Graph 4 i t appears that, in t h i s f i r s t period, any Administrative Policy with a de l i b e r a t e l y neutral reinvest-ment p o l i c y had the e f f e c t of increasing the dividend y i e l d s t a t i s t i c while reducing the c a p i t a l gains y i e l d s t a t i s t i c . A broad hypothesis was therefore formed that i n a subsequent time period a l l 9 operational Administrative P o l i c i e s would increase the mean annual dividend y i e l d s t a t i s t i c over that produced by a Buy and Hold P o l i c y . From Graph 4 i t can also be seen that the r e s u l t i n g y i e l d s t a t i s t i c s , associated with the p o l i c y of reinvesting i n a higher y i e l d bracket, symbolized by © , dominate a l t e r n a -t i v e reinvestment strategies represented by and ® when the sell-low factor i s held constant at 1.1% or .7%. When the sell-low factor was 1.5%, no p a r t i c u l a r reinvestment strategy was dominant. I t was therefore proposed as a hypothesis that reinvesting i n the next higher^yield category would tend to dominate alt e r n a t i v e reinvestment strategies. With regard to ' s e l l i n g * p o l i c i e s , i t appears that the results associated with the 1.1% sell-low factor dominates other sell-low factors when a fixed reinvestment p o l i c y of investing in the same or a higher y i e l d bracket i s maintained as symbolized b y ® or © . However the p o l i c y of reinvesting i n the lower y i e l d category, symbolized by#. , did not produce a dominant sell-low factor. A t h i r d hypothesis can therefore be formed that a sell-low factor of 1.1% w i l l tend to dominate alternative ' s e l l i n g ' s t r a t e g i e s . These three hypotheses were the only relevant ones that the writer was able to form based 57 G H / I P H H" GR.AMD M t / I N S o f . P l S C O U N TED ANMUAL DIVIDEND />NO CAPITAL G-^ INS YIELDS A '-jr) F l R t ^ S OVER PeRioo ApR\ L tv. S E P T J A NNi/ « L C A P I T A L . G A ' 13' i o%4 SLP = 1.1% # S L F =r I. I '/„ SLF-- 1.1%.^ . SUFr .7"/.* ^NWi / f lL Div ioeNO .. , K j E L D 5-5% 6% £.S% 7Yo - r e in ves^me «\T i n (i. lower yTelct ca^ i-eg oR r 58 upon the f i r s t period's r e s u l t s ; the 2nd and 3rd hypotheses taken together imply that the combination of a 1.1% s e l l -low factor and a p o l i c y of reinvesting i n the next higher y i e l d category, should dominate a l l other Administrative Pol i c ies. A l l nine operational forms of an Administrative Policy were applied over a second non-overlapping period, January 1965 to June 1969, to 35 firms with i n i t i a l dividend y i e l d s above 3.5% as of January 1965, and the r e s u l t s appear i n Appendix B and i n a v i s u a l form on Graph 5, page 59. i n t h i s second period the impact of an Administrative P o l i c y was reduced as the proportion of firms affected by an Admin-i s t r a t i v e Policy declined. Table 8 Proportion of Firms Affected by an Administrative P o l i c y i n Period l,and Period 2  Period SLF .7% SLF 1.1% SLF 1.5% A p r i l 1960-Sept. 1964 85.3% 75.6% 58.7% Jan. 1965-June 1969 31.4% 20.0% 14.3% From Table 8 i t can be seen that i n both periods as the sell-low factor was increased, the impact of an Administra-t i v e Policy was reduced. However i t i s also clear that i n the second period the dual constraints b u i l t into any Administrative Po l i c y were s a t i s f i e d less frequently. 59 . GRAPH 5" . D I V I D EN D . 3 5 FIRMS Ca.pifx.1 V i e i d 5 ~5Z -zrA ~3%H GRAND OF DI 5 COL/NTEX). AND C / ^ P I T ^ L O ^ I N i Y l E L D S o F OVER PERIOD J/?N. / ?65 to jL/A/f:/969 S U P I. ® SLF '7% I 1 I SLF l.S # 5L.F 1 .5^ S L F U5#' 5LF 5 L F 1 - 1 % + 8u .y-. -H . l4 D I V . V . H.oQ°/a r re 'mvei tmt . i+" in. Jouiev y te.[Ji co-Fey <£> »~y $ = re. inv-e-sTment" iV +W yield ctAt-flofy 60 From Graph 5 i t can be seen that i n t h i s second period a l l 9 operational d e f i n i t i o n s of an Administrative Po l i c y produced a larger mean annual dividend y i e l d s t a t i s t i c than the Buy and Hold P o l i c y . The broad hypothesis formulated e a r l i e r i s not disproved by t h i s one t r i a l and t h i s w i l l be discussed further i n Chapter 5 as i t i s the basic conclusion to be derived from t h i s empirical investigation into the average e f f e c t s of an Administrative Policy r e l a t i v e to a Buy and Hold P o l i c y . The effe'ct of an Administrative Policy upon c a p i t a l gains i s doubly obscured. In the f i r s t period an Administra-t i v e Policy produced a s i g n i f i c a n t drop i n the c a p i t a l gains y i e l d s t a t i s t i c while i n the second period i t s e f f e c t was to decrease c a p i t a l losses r e l a t i v e to the Buy and Hold P o l i c y . To these c o n f l i c t i n g r e s u l t s must be added the r e a l i z a t i o n that a random reinvestment p o l i c y was d e l i b e r a t e l y adopted to enable the current dividend y i e l d to control both sales and purchases. I t i s at l e a s t possible that a more s o p h i s t i -cated reinvestment p o l i c y employing current dividend y i e l d and a range of other corporate and i n d u s t r i a l factors, would permit an Administrative Policy to maintain an increased dividend y i e l d and yet improve i t s c a p i t a l gains y i e l d . The second hypothesis that a p o l i c y of reinvesting i n the next higher dividend y i e l d bracket would tend to dominate other reinvestment strategies, was contradicted by the second period's r e s u l t s . In t h i s period no one reinvest-ment p o l i c y i s dominant when a sell-low factor i s held 61 constant. The t h i r d hypothesis, that a 1.1% s e l l - l o w factor would tend to dominate other ' s e l l i n g * p o l i c i e s , i s also disproved. In this period there was a tendency for the .7% sell-low factor to dominate other ' s e l l i n g ' p o l i c i e s when the reinvestment p o l i c y i s held constant. I t must be concluded that t h i s simple attempt to define an optimum Administrative Policy based upon i t s r e s u l t s over the period A p r i l 1960 to September 1964, has f a i l e d . 62 Footnotes to Chapter 4 Whether common stocks are a hedge against i n f l a t i o n i s a well-argued question. With regard to an income trust , the relevant fact about the issue may be that i t e x i s t s . With common stocks, a trustee can hope that the r e a l dividend income and the r e a l purchasing power of the corpus w i l l both remain constant; with bonds and mortgages, i t i s clear that the r e a l purchasing power of the corpus must decline. The di s c o n t i n u i t y between the ending of the f i r s t period in Sept. 1964 and the s t a r t of the second period i n Jan. 1965, i s due to the data base that was o r i g i n a l l y a v a i l a b l e . Data was c o l l e c t e d on the cl o s i n g prices and dividends declared during the 41 quarters between A p r i l 1959 and June 1969,. Data on the f i r s t four quarters was employed to calculate the i n i t i a l annual dividend y i e l d s leaving data on 37 quarters available for subsequent analysis. Having decided to employ two equal non-overlapping periods, data on the three months of October, November and December, 1964, was surplus and was not used i n formulating or test i n g hypotheses. To check that 20 t r i a l s was a s u f f i c i e n t number of t r i a l s to produce a stable mean, 60 t r i a l s were made and a T-tes t was conducted to t e s t the hypotheses that the mean of 20 re p e t i t i o n s was not s i g n i f i c a n t l y d i f f e r e n t from that produced by 60 r e p e t i t i o n s . The r e s u l t i n g T p r o b a b i l -i t i e s of .661 and .741 indicate that the hypothesis of i d e n t i c a l means cannot be rejected at the 5% sig n i f i c a n c e The grand means associated with 20 t r i a l s and 60 t r i a l s , based upon a sell-low factor of 1.1% and with reinvestment in the next higher dividend y i e l d bracket were: l e v e l . T r i a l s Grand Mean Dividend Y i e l d Standard S t a t i s t i c Deviation Grand Mean Capi t a l Gains Standard Y i e l d S t a t i s t i c Deviation 20 6.82841 .14812 12.2173 1.45402 60 6.84481 .1407 12.1156 1.1857 63 CHAPTER 5 The Integration of These Empirical Results With F i n a n c i a l  Theory In the empirical work reported i n Chapter 4 , any administrative procedure based on a quarterly monitoring of prices and dividends, produced a larger dividend y i e l d over a 4 .5 year period than a simple buy and hold p o l i c y . That siiihilar r e s u l t s were produced i n a second period i s only s l i g h t support for the proposition that an administrative p o l i c y w i l l increase dividend y i e l d i n other periods. In th i s chapter we seek to r e l a t e these results to some of the American and B r i t i s h l i t e r a t u r e on dividend p o l i c y and the valuation of common shares. I t i s basic to recent f i n a n c i a l theory that share prices are related to expected future dividends and earnings; while studies of dividend payments have indicated that increases i n corporate earnings are not immediately r e f l e c t e d in increased dividend payments. I f share pr i c e s r i s e i n an t i c i p a t i o n of increased corporate earnings while dividend payments l a g behind the increased earnings when they do occur, then there would be a s i g n i f i c a n t time lag between a r i s e i n a share's price and an increase i n that share's cash dividend. During t h i s i n t e r v a l the current dividend y i e l d would f a l l below i t s i n i t i a l l e v e l , to r i s e only when dividend increases are subsequently made. In an income t r u s t , i f a large 64 dividend y i e l d i s desirable, i t could be a feasible p o l i c y to r e a l i z e c a p i t a l gains when the current dividend y i e l d f a l l s and re-invest to secure the desired y i e l d immediately rather than waiting p a t i e n t l y for larger corporate earnings and ultimately for larger dividends. The success of the Administrative Policy in increasing dividend y i e l d over that of a buy and hold p o l i c y can be r a t i o n a l i z e d i n terms of these two f i n a n c i a l propositions. Lintner (1956) attempted to c r y s t a l l i z e the dividend p o l i c y of corporate executives into an explanatory regression equation which has been a point o:f departure for many sub-sequent studies. In f i e l d studies 28 American corporations were studied and interviewed with a view to determining the factors that entered most a c t i v e l y into each firm's dividend p o l i c y . I t was found that the primary question i n a l l but two cases was whether the e x i s t i n g dividend payment should be changed; the amount of the change was a secondary issue. The practice of making only a p a r t i a l adjustment to any change in earnings i n any one year tended to s t a b i l i z e dividends and provide a consistency in the pattern of dividend changes. A l l companies were found to be reluctant to reduce regular dividend rates once established and were therefore conservative i n r a i s i n g regular rates. Based on data from 1947 to 1953, Lintner estimated that the average propensity to pay dividends was 69% while the short run propensity to change current dividends r e l a t i v e to a change i n earnings was only 21%. 65 Subsequent studies using other data and stressing other variables have l a r g e l y confirmed that the marginal propensity to pay dividends out of increased earnings i s much lower than the long run average propensity to d i s t r i b u t e net p r o f i t s . Darling (1957) reported that the long run average propensity to pay dividends was 37 to 48 per cent, while the short run marginal propensity ranged between 13 and 30 per cent. B r i t t a i n (1966) also found a difference between the average and the marginal propensity to pay dividends. He reported that the average propensity 'LwasS; 63 per cent while the short run marginal propensity to pay dividends was 28 per cent. Despite these variations from study to study, a l l agree that corporations are normally slow to r e f l e c t increased earnings i n t h e i r dividend p o l i c y . F i n a n c i a l theory has yet to produce a t r u l y adequate theory to explain changes i n the market prices of i n d i v i d u a l shares."'" Stock markets could be considered as ongoing auctions in which a fl u c t u a t i n g number of i n d i v i d u a l s and firms p a r t i c i -pate, each motivated by r a t i o n a l or i r r a t i o n a l b e l i e f s , and each exposed to varying amounts of information which i t s e l f may be true or f a l s e . Participants i n the market, whether as brokers or investors often need a t h e o r e t i c a l framework to guide t h e i r thinking. Financial theory, following John B. Williams (1938) has suggested that the value of a share i s the present value of the stream of dividends that i t w i l l generate. As a firm's dividend i s often systematically r e l a t e d to i t s net income, t h i s formulation can be restated i n terms 66 of net income per share. Much of the f i n a n c i a l l i t e r a t u r e dealing with the problems of the cost of c a p i t a l and the optimum dividend rate i s based upon th i s fundamental notion that a share's market price i s a function of anticipated future corporate earnings and the dividends to be declared 2 there from. . Latane and Tuttle (1967) investigated a range of h i s t o r i c a l variables to determine which had the highest c o r r e l a t i o n with stock price changes as expressed as a price r a t i o . They reported for the period 1950-1963, future p r i c e change (P t+1 / P t) i s best correlated with future earnings (E t+1 / P t) and future dividends (D t+1 / P t ) , rather than present or past earnings or dividends. Also the earnings r a t i o generally had a higher simple c o r r e l a t i o n c o e f f i c i e n t than the dividend r a t i o . One r a t i o n a l explanation for a r i s e in the price of a common share i s that investors anticipate larger earnings and dividends i n the future. The work by Latane and Tutt l e i s some empirical evidence that movements i n stock; prices anticipate changes i n earnings. In our empirical work we investigated the discounted dividend y i e l d and c a p i t a l gains y i e l d r e s u l t i n g from either holding, or s e l l i n g a common stock when i t s current dividend y i e l d has f a l l e n , provided i t s sale would r e a l i z e a c a p i t a l gain. As the current dividend y i e l d i s the r a t i o of current annual dividends to the current share p r i c e , a reduction in the dividend or an increase i n the share p r i c e or a combination of both could cause the current dividend 67 y i e l d to f a l l . While i t i s possible that some sales were i n i t i a t e d by reductions i n dividends, inspection of the computer output has indicate that t h i s r a r e l y occurred. The requirement that a l l sales r e a l i z e a c a p i t a l gain prevented many dividend reductions from t r i g g e r i n g sales. I t i s there-fore probable that most of the sale signals produced by an administrative p o l i c y were i n i t i a t e d by r i s i n g stock p r i c e s . An administrative p o l i c y may have produced a larger dividend income than a buy and hold p o l i c y because i t refused to hold a stock during the i n t e r v a l between the stock market's a n t i c i -pation of increased earnings (which raised i t s p r i c e and reduced i t s current dividend y i e l d ) and the time when the improved earnings were r e a l i z e d and f u l l y r e f l e c t e d i n aug-mented dividend payments. The random s e l e c t i o n of a stock for reinvestment based s o l e l y on current dividend y i e l d i s not recommended as a proper investment p o l i c y for a trustee; however i n t h i s study i t had a methodological advantage. While i t would be att r a c t i v e to se l e c t shares for purchase based on a ranking system using current dividend y i e l d and another variable such as a f i v e year growth rate i n earnings, the results would then be a combination of the ' s e l l i n g ' p o l i c y founded on current y i e l d and a 'buying' p o l i c y based on y i e l d and another v a r i -able. The ef f e c t s of one p o l i c y would be confounded with the other. The a r b i t r a r y technique employed i n t h i s thesis enables the p o l i c y of maintaining a minimum dividend y i e l d on p r o f i t -able stocks to be viewed i n i s o l a t i o n . 68 Some other assumptions and li m i t a t i o n s inherent i n our research design should be noted. Our data base, of 108 companies were pre-screened to ensure complete data on prices and dividend payments. The r i s k of d e l i s t i n g or bankruptcy were e f f e c t i v e l y removed. This a r t i f i c i a l f i n a n c i a l environ-ment, however, should not have a material e f f e c t on the v a l i d i t y of inter n a l comparisons though i t prevents meaningful external comparisons. The computer program which produced the dividend y i e l d and c a p i t a l gains y i e l d s t a t i s t i c s , did not calculate them net of Canadian income tax. Very few empirical studies attempt to present t h e i r r e s u l t s i n such a form as the tax status of investors and the applicable tax rates can vary widely. As a c a p i t a l gains tax was not l e v i e d i n Canada during the period 1959-1969, our re s u l t s which do not make any provision for taxes on r e a l i z e d c a p i t a l gains, have the virt u e of h i s t o r i c a l consistency. However i t should be pointed out that under Canada's present c a p i t a l gains tax, an Administrative Policy which involves the r e a l i z a t i o n of c a p i t a l gains, w i l l expose the trus t to income tax l i a b i l i t i e s . Under Section 104 (2) of the Income Tax Act, a t r u s t i s taxed as a separate tax payer with regard to any income received by i t and not paid to a beneficiary. Sections 40 (1), 38 and 3 (b) provide that one h a l f of net r e a l i z e d c a p i t a l gains constitute taxable income. As a t r u s t i s normally not obliged or permitted to pay c a p i t a l gains to a beneficiary, any taxes on r e a l i z e d c a p i t a l gains 69 must be paid out of the corpus. I f a t r u s t sold an asset for $10,000 with $5,000 being c a p i t a l gains, then the tr u s t ' s taxable income would be $2,500 and Federal and Pro v i n c i a l 3 taxes would be approximately $550. The sum available for permanent reinvestment would be only $9,450. Neglecting transaction costs, i f the asset had previously yielded 3% per annum and the proceeds were;-reinvested to y i e l d 4%-per annum, without a c a p i t a l gains tax the annual income would have r i s e n from $300 to $400 but with a c a p i t a l gains tax i t would only r i s e to $378. A c a p i t a l gains tax probably reduces the a b i l i t y of any Administrative P o l i c y to increase dividend income. The extent of the reduction could best be determined by a r e p l i c a t i o n of t h i s study using market data generated since 1972. Our res u l t s could s t i l l be of relevance to trustees who attempt to balance c a p i t a l gains with c a p i t a l losses and so keep the trust's tax l i a b i l i t y to a minimum, or to trustees of charitable t r u s t s or endowments whose income i s not subject to income tax . 4 70 Footnotes to Chapter 5 1. Michael Keenan (1970) reviewed the general r e s u l t s of attempts to develop models of share price valuation based on h i s t o r i c accounting and f i n a n c i a l data. He concluded that the a r t i f i c i a l i t y of the data and the r e s t r i c t i o n s inherent i n the regression methodology used, explain the i n a b i l i t y of any of the models to develop stable estimates of the magnitude and sign of the various parameters. 2. Many of the major a r t i c l e s on the cost of c a p i t a l and the relevance of dividends are based on an equation that re l a t e s share prices to future earnings. Reference may be made to a r t i c l e s by Modigliani and M i l l e r (1958) and 1961), Myron J . Gordon (1962), and J . Lintner (1962) and (1964). 3. Assuming that $2,500 constitutes a l l the income of the t r u s t not paid to b e n e f i c i a r i e s then under Section 117 (4) (d) of the Income Tax Act, the Federal Tax would be $425 i n 1975 and P r o v i n c i a l tax levied as 30.5% of the Federal Tax, would be $129.62. Total Federal and Pro v i n c i a l Taxes a r i s i n g out of the Trust's r e a l i z a t i o n of a net c a p i t a l gain of $5,000 would be $554.62. 4. Under Section 149 (1) (h) of the Income Tax Act, no tax i s payable on the income of a t r u s t , a l l the property of which i s held absolutely i n t r u s t e x c l u s i v e l y for charitable purposes. 71 BIBLIOGRAPHY Ascher, L.W., Dollar Averaging i n Theory and Practice, Financial Analysts Journal, September 1970, p. 51. Blume and Friend, A New Look At The Capital Asset P r i c i n g Model, Journal of Finance, March 1973, p. 19. B r i t t a i n , J.A., Corporate Dividend Policy, The Brookings I n s t i t u t e , 1966. Campbell, D.T. and Stanley, J.C., Experimental and Quasi- Experimental Designs for Research, Rand McNally and Co., Chicago, 1966. Clendenin, J.C., Dividend Growth As a Determinant of Common Stock Values, Trusts and Estimates Magazine, February 1957. Reprinted i n Elements of Investments, Wu and Zukor, Holt Rinehart and Winston, 1965. Cox, Dr., Planning of Experiments, John Wiley and Sons Inc., 1958. Dince, R.R., Another View of Formula Planning, Journal of Finance, 1964, p. 678. Darling, P.G., The Influence of Expectations and L i q u i d i t y on Dividend Policy, Journal of P o l i t i c a l Economy, June 1957, p. 209. Elton , E.J. and Gruber, M.J., Marginal Stockholder Tax Rates and the Cl i e n t e l e Effect,, Review of Economics and  S t a t i s t i c s , February 1970, p. 68. Evans, J.L., Analysis of P o r t f o l i o Maintenance Strategies, Journal of Finance, June 1970, p. 561. Evans, J.L. and Archer, S.H., D i v e r s i f i c a t i o n and the Reduc-t i o n of Dispersion: An Empirical Analysis, Journal of Finance, December 1968, p.761 Fisher, I., The Theory of Interest, New York, Macmillan, 1930. Fisher, £. and Laurie, J.H., Rates of Return on Investments i n Common Stocks, Journal of Business, January 1964, p. 1. Fama, E.F. and MacBeth, J.D., Risk, Return and Equilibrium, Empirical Tests, Journal of P o l i t i c a l Economy, May/June 1973, p. 607. Fama, E.F., Risk, Return and Equilibrium, Some C l a r i f y i n g Comments, Journal of Finance, March 1968, p. 29. 72 Glower, J.W., Tables of Applied Mathematics i n Finance Insurance and S t a t i s t i c s , Ann Arbor, Michigan, George Wahr, 1930. Gordon, M.J., Optimal Investment and Financing Policy, Journal of Finance, May 1963, p. 264. Keenan, M., Models of Equity Valuation, Journal of Finance, 1970, p. 243. Lintner, J., D i s t r i b u t i o n of Incomes of Corporations Among Dividends, Retained Earnings and Taxes, American Economic  Review, May 1956, p. 97. Litzenberger, R.H., Joy, M.O. and Jones, CP., Ordinal Predic-tions and the Selection of Common Stocks, Journal of  f i n a n c i a l and Quantitative Analysis, September 1971, MacDonald, J.C. and Baron, D.C., Risk and Return on Short Positions i n Common Stocks, Journal of Finance, March 1973, p. 97. Markowitz, H.M., P o r t f o l i o Selection, Cowles Foundation, 1959. Meiselman, D., Bond Yields and the Price Level, Banking and  Monetary Studies, Dean Carson Editor, Homewood, 111., Irwin, 1963, p. 112. McEnally, R.W., Risk-premium Curves for D i f f e r e n t Classes of Long-term Securities, 1950-1966. Comment. Journal of  Finance, September, 1972, p. 933. M i l l e r , M.H. and Modigliani, F., Dividend Policy, Growth and the Valuation of Shares, Journal of Business, October 1961, p. 411. Richardson, L.K., Do High Risks Lead to High Returns? Financial Analysts Journal, March/April 1970, p. 88. Sargent, T.J., Interest Rates i n the Long Run, Journal of  Money, Credit and Banking, February 1973, p. 385. Sharpe, W.F., Capital Asset Pri c e s : A Theory of Market Equilibrium Under Conditions of Risk, Journal of Finance, September 1964, p. 425. Sheard and H u l l , Canadian Forms of W i l l s , 3rd E d i t i o n , Carswell, 1970. Soldofsky, R.M. and M i l l e r , R.L., Risk-premium Curves for Diff e r e n t Classes of Long-term Se c u r i t i e s , Journal of  Finance, June 1969, p. 429. 73 Soldofsky, R.M. and M i l l e r , R.L., Reply, Journal of Finance, September 1972, p. 943. VanHorne, J . C . and McDonald, J.G., Dividend Po l i c y and New Equity Financing, Journal of Finance, May 1971, p. 507. 74 Appendix A Grand Means and Standard Deviations Produced By 20 T r i a l s  of Each Operational Administrative Policy, With the  Discounted Annual Average Dividend Yields and Cap i t a l Gains Yields Obtained From 41 Companies Over the Period A p r i l 1960 to September 1964 SLF .7% Standard Dev REPURCHASES IN LOWER YIELD BUYING POLICIES REPURCHASES IN. SAME YIELD REPURCHASES IN HIGHER YIELD DIV Y CAP Y DIV Y CAP Y DIV Y CAP Y 6.36 .18 9.14 1.64 6.53 .16 9.01 1.54 6.69 .17 11.28 1.59 SLF 1.1% 6.34 9.34 Standard Dev .17 1.12 6.59 11.65 .17 2.09 6.82 12.21 .15 1.45 SLF 1.5% Standard Dev 6.25 12.24 .15 1.05 6.28 10.88 .14 1.30 6.38 10.35 .12 1.23 75 Appendix B Grand Means and Standard Deviations Produced By 20 T r i a l s  of Each Operation Administrative Policy, With the  Discounted Annual Average Dividend Yields and Capital  Gains Yields Obtained From 35 Companies Over the Period January 1965 to June 1969 BUYING POLICIES SLF .7% Standard Dev SLF 1.1% Standard Dev SLF 1.5% Standard Dev REPURCHASES IN LOWER YIELD DIV Y CAP Y 4.37 -1.53 .12 1.56 4.29 -2.35 .09 1.25 4.22 -1.56 .03 .83 REPURCHASES IN SAME YIELD DIV Y CAP Y 4.44 -1.05 .15 1.88 4.29 -2.53 .11 1.43 4.28 -1.20 .09 1.75 REPURCHASES IN HIGHER YIELD  DIV Y CAP Y 4.51 -2.29 .14 1.23 4.28 -1.20 .09 1.75 4.29 -1.72 .05 1.44 

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