Dirty Little Secrets About Investing for Dividend Income
Listen, we get it, we know the allure of a passive income and seeing a monthly income stream deposited into our accounts for little to no work. However, before you jump in with both feet and start down that path we want to share with you some dirty little secrets about investing for dividend income at the expense of all other types and styles of investing. Keep one thing in mind while you read this article: A dividend payment is a means by which a company returns investable capital to the investor.
The Income Ain’t Free
Opportunity Cost
Back when the company issued shares for the first time it did so to raise capital so it could invest it in projects and opportunities that would provide great returns for investors. Those projects worked and the company has grown. Now it has great profitability and stable cashflows so it decides to start paying dividends and distributing capital back to investors. It would make better sense to retain some of this money, and invest it into new opportunities and grow. Amazon has historically invested and re-invested in the company and look how they have grown; and look how their shareholders have been rewarded.
Red Flag #1
Watch out if your company pays a dividend but routinely goes to the capital markets to raise money to fund new projects. They should reduce or eliminate the dividend and fund more of the new projects from retained earnings. In the long term everyone is better off as there would be less debt and or more ownership for each stakeholder.
Residual Dividend Policy
Read the dividend policy for the company and find out how they determine their payout ratio. This is the ratio of how much they pay out from retained earnings as a dividend and how much they keep. The best policy is they dividend out the profits only after they have funded new projects. This is known as the residual dividend policy.
The costs of owning shares in a lazy high yielding dividend company are:
- You’re just getting your invested capital back as dividends payouts, and will be taxed if held in a taxable investment account
- Your shares in the company decreases by the dividend amount on the ex-date.
- The company is foregoing growth or acquisition opportunities and resting on its laurels as it sheds investible capital out as dividends
- If you’re just going to reinvest the dividend back into the same company then this was for nothing. The total value of your shares remain the same as before the dividend payout.
You don’t want a company like this in your portfolio. This is another dirty little secret with investing for dividend income: companies are more concerned with maintaining their dividend and less concerned with growth.
Red Flag #2
Watch out if the company payout ratio is above 50% or if they pay the dividend when they haven't generated operating earnings for that quarter. Yes, there can be some bumps along the road but if this continues quarter after quarter get out!
Invest for Dividend Growth Not Yield
This ever increasing dividend will be celebrated by all investors but only when its supported by increasing earnings, a conservative payout ratio and solid ROE. The share price will increase as traders and investors bid the shares up to bring the yield down to what it was before the dividend increase. In fact it may actually go lower as shares are bid higher than before as this kind of performance is handsomely rewarded by investors.
Always pick the dividend grower
People flock to AT&T right now because its yielding just north of 7% yield. But its also paying out 95% of its profit to maintain this dividend. There is no margin of safety if profits dip and there is no room for reinvesting the profits to grow the business further. Their payout ratio is a dirty little secret: it is not stable and they are not reinvesting. Verizon is actually the better investment and could yield more in the coming 5 years because of its policy to retain more earnings. It’s also better at generating a return on that invested equity.
Red Flag #3
Don't get caught in a yield trap by always picking the higher yielding stock. Pick the ones that grow their dividend and show they are able to reinvest a portion of their earnings and generate even more returns for investors. Watch the payout ratio and the ROE as indicators for their ability to reinvest and grow.
You Must Reinvest the Dividend
When you check the annualized performance for a given stock or fund it always assumes the following: no taxes, no commissions, and dividend reinvestment. Honestly, if you don’t need to spend the money then you really should be putting the cash dividend back to work by reinvesting it. As such, don’t think for a second that you get to take that cash payment, spend it, and get the same performance as those that reinvest the money.
This is where my attraction to dividend paying stocks wane and I start wondering what was the point then?
DRIPs
Want to know another dirty secret? Some companies rely on your dividend reinvestment as a source of funding and equity issuance. If you sign up for a DRIP (Dividend Reinvestment Plan) for a particular stock they can, and often do, meet the reinvestment part by issuing you new shares. Is this perpetual stock issuance program (often at a 3-5% discount to market, plus the 2% commission they pay to bank to underwrite the issuance) really in the interest of shareholders? Read more about this sneaky trick here: Do DRIPs drain share values?
Why not truly retain the earnings and use this capital properly instead of churning the money around and having it come back with less? It’s too tempting for companies to start relying on their formal DRIP program as a way to fund capital programs and growth. Much more efficient to kept the money on the corporate balance sheets and deploy the capital in new opportunities.
Red Flag #4
Avoid dividend paying companies that promote their DRIP program and encourage you to sign up for it. Look into the mechanics of the program and see if its truly in your best interest as a shareholder and owner of the company. Are they diluting share ownership? Is this how they issue new shares and fund new programs?
S&P 500 Performance with Dividends
The popular argument for the importance of dividends is the performance of the S&P 500 with and without dividend reinvestment
Can you imagine not reinvesting the dividend? What a horrible return compared to the performance while reinvesting the quarterly cash payout. But nobody asks: “What would the return be if there was no dividend, if instead all of the retained earnings were kept and reinvested?” I would put forward that the returns would be even greater and you’d be north of $2,000,000 in the example above. Why?
- Companies would forced to look for new opportunities to invest and more innovation would occur
- Competition would be stronger and more acquisitions happen
- Less money spent by companies issuing dividends and fancy capital funding programs. Yes there is a transaction cost born by the company for these programs – even paying a dividend payout bears a transaction cost.
- More share buybacks would happen
- Tax efficiencies with the company retaining the money vs. creating a taxable event for shareholders
Always Focus on Total Return
Protect yourself against the free dividends fallacy. The next time you consider a dividend paying stock, make sure you are investing in it to receive the total return, not simply focusing on the dividend payout which may turn out to cost you in the end.
Buybacks Really Are Better
Instead of paying out a dividend to investors the company should retain this money and invest it in new projects or growth opportunities. Easier said than done and once a company reaches a certain size it really gets difficult to find meaningful opportunities. In such cases, instead of resorting to dividends, start implementing a share buyback program.
Such programs let the company to buy back shares from the open market during certain periods. Later the company can either sell the shares back for a profit or it can retire the shares.
The attraction of a share buyback program is it will increase your ownership in the company and therefore give you a larger piece of the profit pie. It increases our earnings per share. This should increase your share price and later when you sell you trigger a more favorable tax event.
Consider the following benefits to share buyback programs:
More Shareholder Value
The most common measure of corporate performance and driver of share prices is earnings per share (EPS). Earnings per share are viewed as a critical measure in determining share prices. It is the portion of a company’s profit allocated to each share. By reducing the number of shares and maintaining the same level of profitability, EPS will increase.
Boost Share Prices
Companies may pursue a buyback program if it believes the company shares are undervalued. Companies choose to repurchase shares and then resell once the price increases to reflect the true value. When earnings per share increases, the market will perceive this positively and share prices will increase after buybacks are announced.
Better Performance
Both dividends and share buybacks are methods to return capital to investors. However in most circumstances the buyback program produces better total returns for shareholders. Consider the following comparisons:
Canadian Stock Buyback vs. Dividend Paying Stocks
Seeking Alpha – Dividends vs Buybacks
Corporate Financial Institute: The dividend vs share buyback debate
But I Need Monthly Cash – And Buybacks Pay Zero Cash
If you’re in the camp that needs monthly or quarterly cash from their investment then why not sell the number of shares required to raise the funds you need. I know there is a bit of a mental barrier to this – but taking the dividend for the same amount has the exact same effect. The dividend comes from the cash account of the corporation and lowered the value of your shares by the same amount.
Red Flag #5
Watch out for investing programs or strategies that focus solely on dividend paying stock; this lacks diversification and favors larger mature organizations that pay hefty dividends. They will likely never provide a total return greater than a diversified portfolio or stocks and bonds that invest in all areas of the economy and favor dividend paying stocks and buyback stocks alike. Dividend paying strategies often suffer home country bias so you will miss out on international markets which can increase returns and lower volatility.
Our Favorite Method
There are many dirty little secrets about investing for dividend income. In light of what we have highlighted in this article, we will always favor total return in all scenarios. Whether for growth or income we always want total return maximized to the fullest extent. We don’t favor dividend paying stocks, but we also don’t shun them either. They are an important integral part of a diversified portfolio and must be included if we are to be truly diversified.
Our favorite method of generating a sustainable income from our portfolio is explained in detail in our article My Favorite Way to Generate High Cash Flow. To summarize our method we set our desired “dividend yield” by dividing our income needs by our capital base and divide this into 12 equal portions. Then we sell some of the assets each month to generate this cash flow. Sell those assets that are furthest up from their target allocation so you can balance the portfolio back to the target allocations.
This really works well within a robo-advisor platform. Our favorite is WealthSimple which is available to both American and Canadian investors alike. Another method to to use a no cost brokerage such as Robinhood which allows you to buy and sell partial shares for no commissions.
If you don’t need the income, don’t take the monthly income stream. Keep everything in the portfolio to compound and grow until you do need an income stream.
Green LIght
Our Recommendation is to invest in a diversified portfolio of low cost index funds which includes all types of stocks. It includes dividend payers along with growth oriented stocks, both big and small and from all over the world. Second, WHEN you need an income, sell a portion of each index to carefully raise the cash needed to meet your needs. A robo-advisor platform can be a great way to execute on all these needs. A no cost brokerage such as Robinhood can also be a great method to execute on this idea.
Buffett Approved
We know our ideas on dividend paying stocks are a bit unconventional. All the rage seems to be about creating a passive income stream and using this as the means to gain financial freedom. In our minds total portfolio performance trumps a given income stream. Even when needed we can still create that monthly income stream all while staying completely diversified. If you haven’t, you need to read My Favorite Way to Generate High Cash Flow.
Our ideas are completely in line with Warren Buffet and Berkshire Hathaway. Why doesn’t Berkshire Hathaway pay a dividend? Because it wants to reinvest in its own business, acquire new businesses, and buy back its own stock when its undervalued. All moves which are in the interest of its shareholders.
In the article: Buffett: You Want a Dividend? Go Make Your Own. Buffet said, “You want a dividend? Make one yourself by selling some of your fondled stock certificates. You get the cash you wanted, and it’s far more efficient than Berkshire paying an actual dividend.”
Lastly Buffett recommends we invest in the S&P 500, allocating 90% of our capital to this index and the other 10% in short term treasuries. If you’ve been following us and our articles you know we also recommend an aggressive index allocation. Cushioned with cash for opportunities and anchored on a touch of gold to keep the governments honest.
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