Dividends don’t matter. An intense focus on dividends can hurt you financially.
If I heard this statement 7 years ago, I would be angry. I loved dividends. I did not invest in a company unless it paid a dividend.
But, my love for dividends resulted in more losses than gains. I fell into yield traps, I assumed a dividend meant a company was “safe”, and I thought re-invested dividends provided higher returns (relative to a lower dividend-yielding stock).
After 4 years, I learned that individual stock selection was a colossal waste of my time. It’s very hard to beat the market.
Therefore, I moved into index dividend ETFs. I still thought dividend-yielding stocks provided higher returns relative to the market (they do, but not for the reason you think).
Fast forward to today.
No longer do I care about dividends. They don’t matter. Now I maximize risk-adjusted returns with low-cost stock index funds.
My aim is for you to walk away from this post a better investor.
Table of Contents
1. The Yield Trap: A Higher Dividend is Better
High dividend yields can be attractive. But this is troublesome if the company cannot sustain the dividend.
Consider a company that has a dividend payout that is larger than its earnings. What do you think will happen?
The dividend will likely be cut, and the share price will drop. This is a yield trap.
The yield trap burned me in 2015 and 2016. The company I owned kept cutting its dividend. Eventually, the dividend went to zero. Today it is no longer listed as a stock.
An 8% yield looks nice on the surface. But you may ask, “why is the yield so high”?
It is often because the stock price is suppressed. A stock’s price represents expected future earnings plus the company’s book value.
Investors are not confident in future earnings, which are the fuel for dividends. Therefore, the future dividend is uncertain.
For a dividend to be sustainable, the company must be able to cover the dividend with its earnings.
Yield Trap Example
Do you see what is happening here?
The dividend is higher than earnings for 4 years in a row. Retained earnings are negative, meaning the company is eating itself rather than growing. As expected, equity (assets-liabilities) per share is declining each year.
I am leaving out some complexities, such as Distributable Cash Flow, which can give information that earnings may not capture.
When earnings cannot cover the dividend, the company will need to sell assets, eat into its cash reserve, or take on debt to maintain the dividend.
Yield traps look nice on the surface. But your investment can get dragged down by a series of dividend cuts while the stock price plummets.
Understanding the underlying financials is essential to determine if a high dividend is sustainable.
2. Dividend Stocks Provide Higher Returns
Dividend-yielding companies, as a group, have experienced higher returns relative to the market.
You may ask, “Jake, how is this a misconception!?”
I would say “Dividends are not the reason for the excess returns of these stocks!”
Instead, stocks that pay high dividends tend to have low price-to-earnings (P/E) ratios and low price-to-book (P/B) ratios. Stocks with low P/E and P/B ratios are called value stocks.
And evidence shows that value stocks provide higher returns than the broad market. This is because value stocks are riskier than growth stocks.
The excess returns from value stocks are labelled the value premium. It is a well-known factor in the Fama And French 3-factor model. The value premium is proven by historical data in multiple various global markets.
In summary, it is true that dividend stocks have provided higher returns. But the higher returns come from the value premium, not the dividends.
Maybe value stocks are suited to your risk profile. If so, there are better ways than chasing dividends to target the value premium.
3. Dividend Stocks Are Safer
Dividend stocks, as a group, are not safer than the market. The opposite is true. Here is why.
As I discussed above, dividend stocks have value characteristics. These stocks, as a group, have lower P/E ratios and lower P/B ratios.
Value stocks are riskier than the general market. Therefore, dividend stocks are riskier than the market.
Think about why the stock price is low for these companies. Investors have low growth and low confidence in future growth and they see uncertain future earnings. Such companies get hit harder in recessions.
Even big companies can fail. I had a small position in General Electric back in 2015. “The company has been around for 130 years, what could go wrong”.
GE’s historical performance did not persist. The biggest companies don’t always remain the most prominent companies.
None of the top 10 largest US companies from 1973 are in the top 10 today. Even in the last 23 years, Microsoft is the only company remaining in the top 10 stocks. Disruptors take over, as displayed by the vast churn in top 10 US stocks.
4. Dividends Are The Only Way To Share In Earnings
Dividends are not the only way to share in the earnings produced by a business.
Consider what happens when a company pays out a cash dividend. The company pushes earnings out to shareholders. Cash is leaving the company.
When a company pays out a dividend, the company is worth less by an amount equal to the dividend.
Now consider what happens when a company holds onto its earnings instead of paying them out as a dividend.
Maybe the company uses earnings to buy new buildings. Perhaps they build a new factory to enhance future earnings.
You may wonder, how does the investor see benefit from earnings that are retained in the company?
With all this new stuff, the company is worth more. It has a higher book value. The investor sees this via an increase in share price.
The share price increase won’t be as obvious as a cash dividend, due to the background noise of market volatility.
But this should not matter to a good long-term investor (I hope this is you).
With exception of tax differences, it doesn’t matter whether earnings are realized via share price growth or dividends. A strong understanding of where stock returns come from makes this intuitive.
Dividends don’t matter.
Share Buybacks
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Since 1997, more earnings have been returned via share buybacks than dividends in the US (source).
What is a share buyback?
Instead of dishing out cash to shareholders, the company “buys back” its shares.
This reduces the shares outstanding, resulting in a company of the same size, with fewer shares.
Basic math states that the price per share goes up. Each share now represents a larger fraction of the company.
You (the investor) see the returned earnings in the form of a capital gain.
5. Dividend Income Is Superior To Selling Off Shares For Income
Living off dividends is no different from selling off shares for income.
This is illustrated by the above examples of share buybacks and retained earnings. Investors see the earnings, regardless of the company’s dividend policy.
In reality, when you sell off shares, you may pay a commission fee to your brokerage. Taxes on investment income are another factor to consider.
When taxes are factored in, capital gains taxes are often more efficient than investment income taxes on dividends.
In addition, dividends are taxed in the year they are paid. Therefore, reinvested dividends impose a “tax drag”, while capital gains compound tax-free.
Conclusion
It feels good to see cash dividends hit your account. Due to mental accounting, people treat dividend money differently than money from selling shares. Dividends feel like free money.
But dividends are just a reflection of how a company decides to use its earnings. You will see the return regardless. It may be a dividend, or it may be a capital gain.
I hope this reframes the way you look at investing. If anything, I hope it helps you avoid the dreaded yield trap.
To avoid dividend drama, I implore you to research the dirt simple investing method of total market index funds.
Jake out.
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