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.
Outstanding article. I was intrigued by dividend stocks and was beating around that bush for a few weeks now. I felt I was missing something… why do people find dividend stocks appealing… as I was thinking about the very things you laid out…. primarily…
“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.”
Bingo. The small dividend being collected doesn’t lessen the blow if you’re not managing the investment.
Good article. Keep em coming!
Ugh, this article could use some editing and tightening (I wrote it all in one shot at 2AM half-drunk) but everything it says is true.
There is a common misconception that dividends are “good” because they are the only way that you’re “getting money in your pocket” from an investment in a stock. You know how else you can make money from a stock? By selling it for more than you bought it.
Look at SBUX for instance, on which I wrote an article around a week ago. It’s up 400% from just a few years ago - and SBUX was already a giant company by then. Do you think anyone cares about 2-3% per year in dividend (if that) when they could earn a 400%+ return? AND pay half the taxes (or less)? Of course not.
Go for high-growth companies with a material advantage over their competitors that are underpriced: BABA, AAPL, etc. Ignore the dividend.
F.S. you’re correct about dividends by tax disadvantaged, but companies that have raised dividends for 30+ years are safer. They almost ALWAYS have lower beta and off the top of my head, I’d bet they outperform the market. They don’t do well because they pay a dividend, but rather because they’re disciplined companies. Paying a rising dividend every year forces them to remain focused on cash flow.
The stock would overperform even if it didn’t pay a dividend, that was mostly my argument. Plenty of companies have been increasing their dividends steadily for years - before massively crashing. See NYSE:C or NYSE:BAC for instance. Or even GE.
Companies that have raised dividends for 30+ years are less risky because they are big and blue chips, not because they pay a dividend.
Anon above kinda hit on what I was planning on commenting about.
I find companies that have been paying yearly increasing dividends tend to be very disciplined and solid blue chips.
So the fact that a dividend is paid, gives you an idea of the management team you’re dealing with.
Take the Canadian Banks for instance.
The dividends go up for these companies almost every year.
However the percentage yield stays approximately the same every year indicating that the stock has appreciated as well.
I agree with you that the banks would have likely appreciated anyway regardless of if a dividend was paid or not but this just tips you off on what excellent management teams they have.
Plus, there are some people who are very interested in this income stream.
e.g.: I could see a retiree parking a HUGE amount of cash into a bank and just collecting the dividend to supplement their income.
I think, logically, this gives some security as this type of investor would not care as much about the tax implications, and the underlying company gets access to the capital that was invested (i.e.: This is capital that would NOT have been invested if there was no div).
Personally I have a margin account where I am tracking the divs received as they offset the borrowing costs on the loan.
Since I’m able to claim the interest on the loan, that helps to offset the tax paid on the div.
I agree with most of the stuff here, but just some comments:
To me, a company that pays a dividend is basically saying, “We have ran out of ideas of what to do with our money.”
- exactly! That’s one of the main points of dividends. If you as an investor help fund the company, then the company should give money back, if they have no better use of the money.
This leads me to contend another point:
For all the headaches they create, I’d gladly choose to refuse them and would rather enjoy quicker growth!
- This is where we have issues. You DON’T have to invest in dividend paying companies. Often times companies are not the best managers of their money and the investors would prefer dividends being paid instead of all of it being reinvested in the business. Businesses can not be expected to make 100% best use of 100% of their income.
I think your message about “not buying dividend stocks” is extreme - it should really be: do not buy stocks because of their dividend. Many companies give a small dividend - it really should be treated as a secondary reason for purchase, but not a primary reason. I also disagree about the “safety” of dividends, but I think the majority of your qualms with dividend stocks would be avoided if you followed the rephrasing above.
Total return is all that matters. If you have a greater total return, you can buy out the “dividend” portfolio and have cash left over.