It continues to amaze me how many very astute investors inquire about a dividend-only stock portfolio while at the same time misunderstanding the very concept of a dividend, so I’d like to spend the next few minutes debunking some dividend myths. By definition, a dividend is a sum of money paid regularly by a company to its shareholders out of its profits. As a stock owner in a public company, you may be eligible to receive dividends if you own the stock as of the ex-dividend date.
MYTH: Dividends represent an additional return.
Here’s a brief summary of a transaction using a fictitious stock that pays a quarterly dividend of $3/share:
May 3, 2016 Stock closes at $33
May 4, 2016 Ex-dividend date. Stock closes at $30 after the dividend is declared. [In reality the stock would be higher or lower than $30 depending on how the news of the day impacted the stock price.]
If you owned 100 shares, that stock was worth $3,300 as of the close of business on May 3. The company decided that for whatever reason, it was going to return some of its profit to its shareholders. You received $3/share times 100 shares for a total of $300, which you could elect to receive in cash or have reinvested back into the company. Assuming you chose the $300 cash, your 100 shares were worth $3,000 as of May 4. If you reinvested the shares, you now own 110 shares ($300 dividend divided by $30 stock = 10 additional shares) with a total value of $3,300.
May 3, 2016 $3,300 of stock owned
May 4, 2016 (no reinvestment) 100 shares of stock at $3,000 + $300 cash = $3,300
May 4, 2016 (with reinvestment) 110 shares of stock at $3,300
At the end of this transaction, you would have no more or less value than you did prior to the ex-dividend date. Otherwise, if the dividend was “found” money, intelligent investors would simply buy all dividend-paying stocks one day before the ex-dividend date (since that date is announced ahead of time) and then sell all dividend-paying stocks one day later. In fact, a dividend is basically part of your ownership interest being returned to you. As the investor, you then have the option to take the cash and own the same number of shares of the company or reinvest it back into the company and own more shares. Studies have shown that some investors use the $300 dividend as way to control their consumption, as opposed to selling shares and spending from capital. While not rational, this may be necessary for those with a self-control problem such as impulse buying.
In the above example, you would have the same net worth prior to and after the ex-dividend date. However, there is a difference in tax consequences if you held the stock in a taxable account because you would have to pay taxes on the dividend received. Dividends are required to be reported on the federal tax return and possibly on some state tax returns. Even though your net worth appears to be the same before and after the dividend is paid, you actually have less money once you pay the tax. It’s clear to see that you would rather see the company reinvest its profit than pay it out via a dividend. In addition, had you chosen to sell shares to receive cash, you are only paying capital gains taxes, which are typically lower than taxes paid on ordinary income, such as non qualified dividends. Even if you had to sell shares (as opposed to receiving a dividend in cash), you still come out better after-tax.
MYTH: Dividends are a guaranteed return.
A dividend does not represent the total return of a stock; it is just one component. The stock’s price can also change based on earnings and news related to the company.
Company A (no dividend) Stock makes 20%
Company B (with a dividend) Stock loses 10% but pays a 5% dividend for a return of -5%
Which stock makes sense to own in this scenario? Company A, of course. It may feel great that Company B paid you back 5%, but at the end of the day, the total return of the stock, which includes both income and price appreciation, is more important. Besides, why would you choose to avoid a stock growing at 20% per year just because it didn’t pay a dividend? Isn’t the object to get the best return for the least amount of risk?
Company A (no dividend) Stock makes 20%
Company B (with a dividend) Stock makes 15% but pays a 5% dividend for a return of 20%
In the example above, Company B’s stock price did not increase as much as Company A’s stock price because Company B paid out part of its earnings to its shareholders and Company A chose to reinvest its earnings back into the company. An investor could have also sold stock of Company A to accomplish a similar result. One of the possible reasons that investors prefer dividends is that numerous behavioral studies show that investors who sell a stock just prior to a rally feel more regret than those who received a dividend because one act is out of their control (receiving the dividend) while the other is not (selling shares).
Investors also seem to think that a company that pays a dividend is a safer company and that this dividend is guaranteed. Dividend-paying companies are typically more mature and don’t have the need for excess cash, whereas growth companies need a lot of capital and are constantly reinvesting back into the business. Just because a company pays a dividend today does not mean they will pay a dividend next quarter. That dividend can be cut or even eliminated if the business struggles. In 2015, 394 companies trimmed dividends, a 38% increase over 2014 according to S&P Dow Jones Indices.
MYTH: The higher the dividend yield, the more attractive the stock.
We see too many investors fixated on the dividend yield, which is the dividend divided by the stock price. For example, an investor picks up their statement and sees that he or she owns a stock with a 5% dividend yield and a value of $10/share ($0.50 dividend divided by $10 = a dividend yield of 5%). The investor feels good about getting a nice return, especially when the bank is paying less than 1%. The investor picks up next month’s statement and sees that the same stock now shows as having a 10% dividend yield. What can be better than that? The investor should probably scroll over to the stock price:
Dividend of $0.50/share
Dividend yield of 10%
Stock price = $5/share ($5 price X 10% dividend yield = a dividend of $0.50/share)
So, while the investor is feeling better because his or her dividend yield is going up, in reality he or she lost $5/share and should be feeling worse.
An alternative approach to the dividend-only philosophy
Looking back a few decades, it was easy to find bonds paying double digits and stocks yielding attractive dividends, which could help supplement someone’s income. However, those days are long past with secure 10-year U.S. government bonds paying 1.8% as of this writing and the current S&P 500 dividend yield standing at 2.08%. Clients who go reaching for yield often end up buying risky, long-term bonds and stocks of companies they don’t want to own simply to get the dividend. All too often they are pushed into high-yield bonds (aka junk bonds) that are susceptible to large losses if interest rates rise (as the Fed seems inclined to pursue such a policy) or the economy suffers. Time after time, we see clients who own an equity portfolio primarily consisting of real estate and oil pipeline stocks, which do pay high dividends, but have seen large portfolio losses in times of volatility.
We believe that clients need cash flow, not income, so we divide a portfolio into two buckets. Each client who needs cash flow has an amount equal to their twelve-month cash needs set aside in an interest-bearing savings account and the balance of their investments can be used to purchase a diversified, prudent portfolio consisting of multiple asset classes, regardless of whether each individual investment pays out income. It allows us to own high quality bonds to preserve principal, dividend and non-dividend paying stocks both in the U.S. and abroad, as well as other asset classes like real estate, commodities, and alternative funds. Due to the fact that the client has a large cash balance, we don’t need to arbitrarily avoid solid investment ideas simply because they don’t provide annual income. The goal is to achieve maximum total return made up of interest, dividends, and capital appreciation.
While there is some opportunity cost of the cash reserve account not earning market returns, the cash reserve account serves a few purposes. One, from a psychological standpoint, it allows clients to sleep well at night when the market goes through a rough patch because they know they have enough cash to cover their core living expenses for a long time. Two, it gives our firm the opportunity to decide when to refill their cash reserves based on how the market is performing. If things are going well, we can refill cash sooner by selling stocks at a “high point.” If the market is not doing well, we can sell bonds, which presumably have maintained their value, so that we can hold on to the stocks and await their rebound. The worst mistake is to be forced to sell investments at the wrong time, with the market down, because then you lose the opportunity to recover your loss. This strategy has worked very well for many of our clients, especially during the 2007-2009 Great Recession.
The bottom line is that investors need to understand how a dividend works and that there are alternative strategies that we believe accomplish a similar goal, but are more prudent. While dividends may be used as a self-control device or to avoid regret, they are not free, guaranteed money.
Feel free to contact Brett Horowitz with any questions by phone 305.448.8882 ext. 216 or email: BHorowitz@ek-ff.com