Let’s face it: dividends suck.
The biggest problem with dividends by far is that they are taxed to death. What begins as a $100 dividend ends up being $40-45 in your pockets (maybe). Since you cannot choose whether to receive the dividend or not, you are being “forced” to take a massive tax hit. Of course, one might buy a dividend stock in a tax-shielded account to avoid these headaches, but these accounts come with their own problems (limits on how much you can contribute, restrictions to withdraw, penalties, fees, etc). Only half of your capital gains are taxed - make use of it!
Perhaps I wouldn’t bitch so much about dividends if they actually offered an amount that was interesting. I recently invested in a company that paid a 0.7% dividend per year; why bother? Is there really anyone who cares about receiving that stupid 0.7% payment? The stock varies by more than that every day!
The company had boasted increasing the dividend 10% for each of the past 5 years, a completely meaningless feat. Even if they somehow managed to maintain that rhythm for the next ten years, the company would still offer a niggardly 1.82% dividend yield. Who gives a shit, really? For all the headaches they create, I’d gladly choose to refuse them and would rather enjoy quicker growth!
Paying a dividend is an extremely poor business decision
Remember that dividends are paid after taxes have been paid; if a company earns $0.10 and has to pay a 30% taxes, it has to pay out of $0.07 and not $0.10. And since dividend-holders are taxed - again - it’s just overall a terrible proposition.
To me, a company that pays a dividend is basically saying, “We have ran out of ideas of what to do with our money.” That’s not necessarily a bad idea if a company really makes a lot of money, but there are always better ways for a company to spend that same money, the most obvious option being to buy back shares. Remember: to pay a $1 dividend, a company paying a 33% tax rate would need to earn… $1.50 before taxes!
If your tax rate is 50%, as it is for me, it literally cost the company $1.50 to put $0.50 in your pockets! It’s just insane!
“But F.S., the company would pay taxes anyway!” Not at all: it could reinvest that money into its development or even its marketing for all I care. By choosing of earning profits instead of, let’s say, buying a factory and using amortization as a tax shield, the company is literally burning money!
But dividends must have their pros!
Yes: if you have a tax-exempt entity, I can definitely see an advantage. It can provide the stability of a steady paycheck if that kind of things matters to you, but let me reassure you that you’d make far more from investing in a pure-growth company - and pay less in taxes, too.
Take the following example: Person A invests in company A paying 10% per year. Person B invests in company B which pays 0% per year. Both stocks are valued at $100 today; the stock of company A won’t move while the stock of company B will go up 10% per year.
After ten years, person B will now have a stock valued at $259.36. With a $159.36, half of this will be taxable and assuming a 35% tax rates, he will have realized a total profit of $131.47, or a return of 131.47%.
Person A will not earn anything from a stock price appreciation, but will accumulate $100 in dividends over that period (10 years * $10) less a 35% tax. Assuming those dividends are reinvested in company A - we are ignoring commissions and fees here, another problem about dividend - he will end up with a $103.59 profit, far below than person’s B $131.47.
No, dividend-paying stocks are not more safe
Perhaps the biggest mistake I hear from even so-called “veteran” investors is how a company is safer if it pays a dividend. Nothing could be further from the truth.
The only way a dividend makes your situation less risky is by reducing your “amount at risk” if you keep the dividend. Say you buy a stock is at $100 and it pays a $10 dividend; you no longer have a $100 “value at risk” but rather $90 since you now have $10 in your pockets, i.e. the max loss you could have is $90 instead of $100.
Other than that, dividends do nothing to reduce risk. And even the parable above is misleading: if you invest in stocks, you probably have a fixed amount that you want to be “at risk.” In other words, you do not necessarily want your “amount at risk” to fall from $100 and $90 and such an event might force you to reinvest.
Some people believe that, in hard times, they can rely on dividends to provide a return. This is misleading in so many ways that I wouldn’t know where to start. Say a company is at $50 and pays a $2 dividend per year; if the stocks falls to $20, I doubt the $2 you will receive will be much consolation.
It is also a common misconception that dividend-paying stocks fall less during crisis. Here, we have a serious case of selection-bias: since companies that have been paying dividends for a while are mostly very big companies, of course they are going to fall less during a time of crisis. The dividend has next-to-nothing to do with it: it’s all about the sector, the company itself, its prospects, etc. In other words, paying a dividend for a while does not mean the stock is protected from a precipitous drop (see: Volkwagen, Citigroup, etc.)
Of course, the dividend can be cut any time
Somehow, people look at AT&T, an excellent dividend-paying stock if there is ever such a thing, and just “assume” they will keep getting the dividend forever. They might, but the company might also crash and burn. Just because it pays a dividend doesn’t make it immune to an accounting scandal, a crash or simply becoming obsolete. Plenty of dividend-paying stocks simply “vanished” over time: look at some of the oil giant right now, for now. I doubt the investors of Sea Drill, Glencore or even BP think dividends are as safe as they looked in the first place.
“There’s a common misconception that if a dividend goes up, the stock will go up as well.”
Next on the “terrible misconception” list is how people sometimes look for dividends that have been steadily growing over time and just think, “oh, as long as the dividend keeps growing, the stock will go up.” Start by realizing that if the company hadn’t been paying a dividend, the stock would most likely be much, much higher. Look at Berkshire Hathaway or TSE:FFH for instance. Is it not true to assume that the stock will follow the direction of the dividends; on the contrary, you should assume that the dividend is raised because the stock moved up, i.e. the dividend wouldn’t have been increased if the stock remained low. Of course, there is no guarantee the dividend will keep growing neither; for all you know, they might cut it for no reason tomorrow morning and never talk about it again.
Okay, but what about high-yields?
Are you ready to risk losing 50% of your money pretty much overnight? If so, you might consider investing in a company paying a 15%+ dividend. Sure, the dividend might be maintained, but it’s not without risk: you could very well lose your entire investment.
I’ve invested in companies paying 20%+ dividends that have not only maintained, but actually increased their dividend as time went up. But I was well-aware of the risk and possible losses. And, again, the tax rate is going to slice you in two.
I laugh at people who are attracted by high yields: for the same amount of risk, they could invest in companies whose stock prices would go up two or three times whatever horrible yield they got.
Forget all about dividends, they’re basically a drag, an anchor that you want to avoid at all costs. Even if you want a stable revenue, I would argue investing in non-dividend paying stocks and selling a small portion every month is largely superior. Dividends are a waste of money and another hidden tax on the stupid.
Every rule has an exception and this one is no different. There is one kind of dividend-paying stock you should not only consider investing in, but devote a significant part of your portfolio to. Technically, they don’t pay dividends, but a distribution. Only a part of your distribution is taxable (sometimes at 0%, when it’s considered a “return of capital!) and in many cases, the company pays no taxes at all. This is the case, for example, for REITS. There are also some weird kind of foreign partnership bizarro thing that benefit from some strange loophole and these things are amazing.
But other than that - focus on quality companies and completely ignore the yield it pays.