The Market for “Lemons": A Lesson for Dividend Investors - June 2015

Research Affiliates

Description

FUNDAMENTALS Conclusion When purchasing a used car, finding the cherry in the basket of lemons is a challenge. Seemingly identical cars may hide important differences in quality due to their past owners’ driving habits, maintenance practices, and accident history. Finding a cherry takes effort, but that effort is rewarded with many June 2015 miles of worry-free driving acquired at a reasonable price. Likewise, when purchasing high dividend-yielding equities, the challenge is to find high-quality companies at reasonable prices. Simply paying the lowest price for a given dividend is not an optimal strategy.

Some high-yield equities are cherries, cheaply priced equity of high-quality dividend-paying companies. Other high-yield equities are lemons, cheaply priced equity of lowquality companies with unsustainable dividends. Identical dividend yields may hide important differences in the quality of companies arising from financial distress, unsustainability of profits, and poor accounting practices, sometimes even extending to fraud. Endnotes References 1. 2. Akerlof, George A.

1970. “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” The Quarterly Journal of Economics, vol. 84, no.

3 (August):488–500. 3. 4. In our analysis, delisting is due to default. Just as with DCR, ROA is not a magic indicator of profitability. ROE or gross profitability would give similar outcomes. In this simulation we use DCR to identify potentially distressed companies. The results are robust to many other metrics that could be useful to identify distress. Using the DCR filter, the absolute number of delisted companies is zero. It is actually quite rare for companies in the top 1,000 roster by market capitalization to be delisted; for every company that actually defaulted and delisted while in the top 1,000, tens of companies dropped out of the top 1,000 because the market perceived their imminent default, leading to their subsequent delisting.

This result shows that DCR is a great measure to predict default, but in live portfolios can provide no guarantee that the portfolio is immune to default risk. Hirshleifer, David, Kewei Hou, Siew Hong Teoh, and Yinglei Zhang. 2004. “Do Investors Overvalue Firms with Bloated Balance Sheets?” Journal of Accounting and Economics, vol.

38 (December): 297–331. Sloan, Richard G. 1996. “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?” The Accounting Review, vol.

71, no. 3 (July):289–315. Disclosures The material contained in this document is for general information purposes only. It is not intended as an offer or a solicitation for the purchase and/or sale of any security, derivative, commodity, or financial instrument, nor is it advice or a recommendation to enter into any transaction.

Research results relate only to a hypothetical model of past performance (i.e., a simulation) and not to an asset management product. No allowance has been made for trading costs or management fees, which would reduce investment performance. Actual results may differ.

Index returns represent back-tested performance based on rules used in the creation of the index, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are not managed investment products and cannot be invested in directly. This material is based on information that is considered to be reliable, but Research Affiliates™ and its related entities (collectively “Research Affiliates”) make this information available on an “as is” basis without a duty to update, make warranties, express or implied, regarding the accuracy of the information contained herein.

Research Affiliates is not responsible for any errors or omissions or for results obtained from the use of this information. Nothing contained in this material is intended to constitute legal, tax, securities, financial or investment advice, nor an opinion regarding the appropriateness of any investment. The information contained in this material should not be acted upon without obtaining advice from a licensed professional. Research Affiliates, LLC, is an investment adviser registered under the Investment Advisors Act of 1940 with the U.S.

Securities and Exchange Commission (SEC). Our registration as an investment adviser does not imply a certain level of skill or training. Investors should be aware of the risks associated with data sources and quantitative processes used in our investment management process. Errors may exist in data acquired from third party vendors, the construction of model portfolios, and in coding related to the index and portfolio construction process.

While Research Affiliates takes steps to identify data and process errors so as to minimize the potential impact of such errors on index and portfolio performance, we cannot guarantee that such errors will not occur. The trademarks Fundamental Index™, RAFI™, Research Affiliates Equity™ and the Research Affiliates™ trademark and corporate name and all related logos are the exclusive intellectual property of Research Affiliates, LLC and in some cases are registered trademarks in the U.S. and other countries. Various features of the Fundamental Index™ methodology, including an accounting data-based non-capitalization data processing system and method for creating and weighting an index of securities, are protected by various patents, and patent-pending intellectual property of Research Affiliates, LLC.

(See all applicable US Patents, Patent Publications, Patent Pending intellectual property and protected trademarks located at http:/ / www.researchaffiliates.com/Pages/ legal.aspx#d, which are fully incorporated herein.) Any use of these trademarks, logos, patented or patent pending methodologies without the prior written permission of Research Affiliates, LLC, is expressly prohibited. Research Affiliates, LLC, reserves the right to take any and all necessary action to preserve all of its rights, title, and interest in and to these marks, patents or pending patents. The views and opinions expressed are those of the author and not necessarily those of Research Affiliates, LLC. The opinions are subject to change without notice. ©2015 Research Affiliates, LLC.

All rights reserved. 620 Newport Center Drive, Suite 900 | Newport Beach, CA 92660 | + 1 (949) 325 - 8700 | www.researchaffiliates.com Page 5 .