Skepticism is a valuable trait in an investor. This doesn’t mean you should always be pessimistic, but you should question the status quo. Skepticism helps you step outside trends of the day and take a more objective view.
I’m not, therefore, surprised that some thoughtful minds have criticized the surging popularity of dividend investing in recent years.
A fresh round of dividend criticism is a good thing. It is important for us to challenge our assumptions.
Dividend doubters
Some vocal dividend skeptics include Larry Swedroe of The BAM Alliance, who has called investor preference for dividends “irrational,” and financial journalist Matt Yglesias, who bluntly called dividends “evil.”
Ouch! As much as we might want to disregard such positions, these commentators and others in their camp make some fair points.
Here are my thoughts on the more popular criticisms of dividends.
1. Shareholders should applaud share buybacks
One argument voiced by the dividend doubters runs as follows: If you’ve invested in a company, you should not mind if it is buying back its shares instead of paying dividends.
Frankly, this is the anti-dividend crowd’s best argument.
In principle, by holding a stock you are implicitly saying you would buy the stock again today. Otherwise, you should sell the stock if you think the price is too high.
As such, you should not be upset with the company also repurchasing the stock at the current price.
To see why this is not a knockout punch to dividends, we need to recognize a few things:
- Investors and capital allocators (managers) typically have different motivations
- Investors are working with only public information; managers possess non-public information
- Investors may reasonably decide to hold on to a slightly overvalued stock
- A buyback made at a discount to a stock’s intrinsic value is a wealth transfer from selling shareholders to ongoing shareholders; the opposite is true if the stock is overvalued
- A dividend has the same wealth transfer effect as a buyback made at fair value – it treats ongoing and selling shareholders equally
Ideally, management teams would follow a fair value discipline with buybacks, but they often have other, less attractive motivations.
These can include supporting earnings per share growth to meet broker estimates, to offset dilution (stock options and so on), or to manage firm leverage. A buyback, then, doesn’t necessarily signal anything about the company’s underlying value.
To be fair, if you suspect the management team is buying back stock primarily for these reasons, you might question why you own the stock in the first place.
Even so, a dividend investor should be perfectly content holding onto what he or she perceives to be a slightly overvalued share in a great company. This is because the odds that you’re right about the share’s fair value are much lower than the odds that you’ve correctly assessed the company’s quality.
I’d wager all of us – and this is certainly true for me – have sold a great dividend-paying company on short-term valuation concerns only to watch the stock (and its dividend) march onto higher gains in the years ahead.
In a perfect situation, we’d sell at a high price, the stock price would quickly correct, and we’d be more than willing to buy it back at a lower price. In practice, we know this isn’t typical. Either our valuation work was wrong, the stock continued to rise anyway, or we failed to seize on the opportunity to buy it back later.
Does this mean that management should follow the same logic and knowingly transfer wealth from ongoing to selling shareholders?
Absolutely not! If they have excess capital on the back of a good year and they feel their stock doesn’t present good value, they could retain the capital or pay a special dividend.
2. Dividends are depriving companies of value-enhancing capital
This statement is only true if you believe management could reinvest the ‘lost’ capital at high-rates of return.
First, it requires the company to have an abundance of high return projects. But mature companies that generate a lot of cash flow may not have enough high return projects available. I believe whatever capital the company can’t reinvest at attractive rates should be returned to shareholders.
Second, this statement requires a belief in management’s capital allocation skill. Fact is if all management teams were strong capital allocators, we wouldn’t see as many restructuring and impairment charges as we do.
Simple statistics would also suggest outstanding capital allocation skill is quite limited:
Statistically, almost nobody is Warren Buffett.
If we think about the capital allocation skill of management teams across the market as a normal distribution (see the illustration above), we can conclude that only 2.5% of them are exceptionally skilled (two standard deviations above the mean). Another 13.5% are good allocators (between one and two deviations above the mean), 34% are fair-to-good, and the remaining 50% are sub-par.
The top 2.5% of management teams should be able to retain all of the company’s free cash flow to reinvest as they see fit. The odds are pretty good that this cohort could do more with the capital than we could.
For example, I’d put Berkshire Hathaway’s Warren Buffett and Charlie Munger in this camp – and as a Berkshire Hathaway shareholder myself, I presently have no issue with the company not paying a dividend for this very reason.
The other 95% of companies should pay varying levels of dividends to shareholders, either because they don’t have enough good reinvestment opportunities or they don’t have a strong investment mentality.
Many management teams rise through the ranks based on qualities (marketing, sales, operations, and so on) that may be of great value to the business, but this doesn’t necessarily mean they are great investors or capital allocators.
The presence of a progressive dividend policy (a stated goal of increasing or keeping the same level of dividends each year) can serve as a check on empire building by management. Capital rationing may actually be a net positive for some management teams who, being forced to work with less capital, allocate the remaining capital more efficiently than they would have with 100% cash flow retention.
In fact, I once heard it brilliantly argued (regrettably I forget by whom) that companies should distribute all free cash flow as dividends and then convince shareholders to give them the money back when they have an attractive investment opportunity.
It’s not practical, of course, but I agree with the logic.
3. You can create your own dividend by selling shares
It’s true that if you want to generate 4% cash from your investment, you can sell 4% of your shares and create a ‘dividend’. Shareholders are making the quasi-dividend decisions in this scenario, the thinking goes, and so companies are relieved of forming dividend policies.
The first problem with this philosophy is that it doesn’t adequately address the downside of the previous point.
You’re still entrusting management to reinvest all of its capital in value-enhancing projects or buying back its stock at good-to-fair prices. This is far from a sure thing.
Second, this DIY selling route may not be cost-effective for smaller investors.
Let’s say you have £10,000 invested in a share and you want to create a 4% dividend by selling £400 worth of the position each year. Unless your broker fees are less than £4 per trade, this trade would cost more than 1%.
Whilst broker fees are trending lower, there are not many brokers with share trading costs that low.
Finally, one of the attractive features of dividends is that you don’t need to make regular sell decisions (and rack up fresh trading costs with each sale) if you want an income.
The distribution of regular dividends frees investors from having to make unnecessary decisions in the first place.
An investor with a 20 share portfolio who wanted to create semiannual dividends would need to make 40 sale decisions each year. With quarterly dividends, the trades double to 80.
Given the heavy biases and emotions tied to sale decisions, there’s a good chance that you’d mishandle at least a few of those 40 to 80 sales.
4. Investor preference for dividends is illogical
Dividend critics often point to some behavioral biases that can occur with dividend investing.
These include mental accounting (treating income and capital returns differently), regret avoidance, and an inability to defer gratification.
For starters, I cannot think of a single investment strategy that wouldn’t come with a unique set of biases. To be human is to be biased. It is just a fact that we need to recognize and appreciate. The better we acknowledge these biases and consider them before taking actions, the better our outcomes will be over extended periods of time.
Moreover, while mental accounting has its downsides, anything that takes investors’ minds off short-term market price moves and instead focuses them on the prospects of the underlying businesses they own is a net positive.
Let’s say your stock portfolio was down 20% in a given year due mainly to a broader market sell-off rather than any big change in business fundamentals. To an investor focused solely on ‘total return’, this might easily result in panic and poor investment decisions.
If instead that same investor noticed their portfolio was now producing higher dividends than in the prior year – and that the dividend yield on their diminished capital was effectively higher, too – they could reasonably conclude that the underlying businesses are doing just fine. As a result, this investor could have better odds of staying calm in a challenging environment.
Regret avoidance speaks to an investor’s aversion to selling shares to create a dividend because they fear what would happen to the stock after they sold. If they sold 3% or 4% of their shares and the stock subsequently rallied, they would be upset with their decision. On the other hand, if they received a 3% or 4% dividend, they would consider the rally outside of their control.
I have no doubt this is true. As previously discussed though, I think investors likely benefit from not having to make too many decisions. Fewer and better decisions should be the mantra of all long-term investors.
Finally, in my experience speaking with and learning from other dividend investors, I can confidently say that an inability to delay gratification is not a common trait of the group. On the contrary, the hallmark of dividend investing is patience.
5. Dividends are not tax efficient
This depends on in which country you’re investing and where the company you own is based.
Much is written about dividends and taxation from a US perspective, but it’s important to realize that different countries around the world treat both income and capital gains in varying fashions.
The U.S., for example, has a ‘double taxation’ issue when it comes to dividends, whereby profits are taxed at the corporate level and then again at the individual level.
Some other countries, however, provide some tax credits to individuals receiving dividends that reduce or eliminate double taxation.
Further, the investor can mitigate the tax impact of dividends by holding dividend-paying shares in tax-efficient wrappers like ISAs and SIPPs in the UK, or IRAs in the US.
Dividend investors looking across the globe for investment ideas should take note of any tax withholding required by foreign governments. They should consider their country’s tax laws and treaties to determine the right type of account (tax-deferred or not) for their foreign dividend stocks.
I would agree with critics that it’s important to be mindful of any tax drag dividends might have on your returns. Many of the studies that show dividends accounting for the majority of long-term shareholder returns assume full dividend reinvestment and don’t take taxes or trading costs.
The smaller the percentage of the dividend you invest back into the share that paid it due to taxes, the less you realize of the share’s ‘total shareholder return’.
Wrapping it up
You’d be hard-pressed to find a successful investor who doesn’t appreciate the value of dividends. There’s also plenty of academic research supporting the role dividends play in long-term returns.
For example, the following graph indicates that higher-yielding shares have outperformed lower-yielders over the long-term:
Over the long-term, higher-yielding shares have delivered higher returns.
Source: Credit Suisse Equity Yearbook 2017
We dividend-minded investors shouldn’t rest easy. Markets, investor preferences, and corporate finance regularly change, and dividend investors must be prepared to address these changes anew with clear eyes.
With time, dividends will fall in and out of favour, but there’s nothing wrong with them in themselves. I believe they remain a long-term investor’s best friend.
Todd Wenning, CFA is an equity analyst based in the United States. Opinions shared here are his own and not those of his employer. A full disclaimer can be found here. For compliance purposes, Todd cannot reply to comments below, though he welcomes any correspondence sent by email. You can read Todd’s expanding collection of dividend articles here on Monevator or check out his book, Keeping Your Dividend Edge.
It is too easy to selects stocks by only one ratio. Swedroe just says that dividend is not a factor. A high dividend strategy would give you exposure to the value factor. The growing dividend strategy would give you exposure to the quality/profitability factor.
@Gregory — Hi. Todd doesn’t engage in factor investing. If you follow the link at the bottom to his other posts you’ll see he is a stock picker with a focus on dividend income.
@TI — Hi. I know he is a stock picker but he mentions Larry. I like “seeing my dividends coming in”.
All good points.
It’s just a shame people are so dogmatic about so many elements of investing. It’s pretty simple: dividends are neither ‘good’ or ‘bad’ – it depends on each individual’s requirements.
They’re useful if you need income. They’re more probable if you prefer a gentler ride, and invest in more defensive stocks.
If you’re into early-stage growth companies, then you’d hope they’d be able to be using the cash generated better than distributing it.
But whatever way you do it isn’t necessarily right for the next person. (This is all so obvious, it’s amazing it even needs to be said).
That’s a nice article Todd. I am not sure why there is so much dividend bashing either. I find people who speak against dividends to be illogical and irrational.
Dividends are more stable than capital gains, and that is evident to anyone who looks at the chart of S&P 500 dividends over the past say 50 years.
In fact, the father of index investing Mr Bogle has stated in a Morningstar interview the following: “Look at the dividend and try to ignore the market. As I’ve often said–nothing like quoting oneself, Christine–the stock market is a giant distraction to the business of indexing, and in particular for the business of retirement investor. It’s the income flow from Social Security, pensions, whatever it might be, and dividend income, and that’s what’s important. It’s amazing how this dividend line [tends to increase over time] and the market [goes up and down over time], but they track each other in the long run.”
I am also puzzled about the homemade dividend thing. If a company pays a dividend, everyone gets the same dividend amount.
If you choose to sell shares, you will get a different price than me. And that would impact the number of shares you have to sell, the number of shares you have left etc. This is simple arithmetic.
Firmly in the dividend camp as I’m now building a portfolio that I intend to live off the natural income and never sell any units.
I don’t even care if it underperforms the global stockmarket as a whole, as there are several key advantages, both practical and psychological. Whatever works for you.
I have spread across a fairly large number of ETFs and investment trusts so if any one fund, or provider, has a flawed methodology it won’t hurt too much.
I do look for a minimum predicted yield of 3%. Close to 4% is better, but anything near or over 5% is likely to be at the expense of much/any capital growth. I have only a couple yielding that high.
P.S. on a related note, when is Greybeard doing the next installment on his drawdown portfolio?
Is right that for some individuals realising capital maybe taxfree while realising a dividend would be taxable.
Obviously depends upon the individual’s tax position and if investments are held in tax-free wrappers etc.
Semi-Passive
Living off the natural yield is likely to maintain your income flow forever but given we have a finite life span, then some flexibility to spend ‘capital’ is not unreasonable…
This was my plan when I ‘retired’ 10 years ago at 49 but I now find that my natural yield has fallen from around 4% to 2% and easily meets my needs , clearly with sufficient capital to last 50+ years if my return merely kept pace with inflation then there is room to spend some capital if I wish.
I would add that some caution in that dividends are very popular in a low return/low interest environment and companies will always aim to provide what investors demand. I have noticed the odd example of a company having a rights issue that is effectively propping up the dividend.
For Canada, at least eight provinces or territories make it possible to receive $51,474 in tax-free eligible dividend income. For most Canadian investors, eligible dividends from Canadian corporations are taxed more favorably than capital gains. At lower levels of income, there is even a “negative” tax rate for dividends (the government pays you), so no wonder dividend investing is popular here, and companies as well pay more in dividends. It is well known that, in aggregate, dividend-payers are better allocators of capital (i.e. they don’t waste cash on stupid projects, and rather return the money to investors).
One problem with the historical superior CAGR of high dividend stocks is that it is gross of taxes, and back in the day they were high, and there was no tax-deferred accounts. Also, the highest yielders tended to be the most risky companies, and thus the higher returns were a pay back for taking more risk (and volatility). Parking dividend stocks now in tax deferred accounts to avoid the taxation forgoes the benefits of step-up basis at death (in US) and the higher total return leads to larger taxes when forced to withdraw (income tax rates can be higher than dividend or cap gains).
Isn’t investing in dividend ETFs somehow related to stock picking? I mean: You choose an ETF which tries to select the best “paying the dividend” shares. Wouldn’t just sticking to the All-World ETF be the best choice for someone, who claims he doesn’t have any edge?
I have in mind VWRL vs VHYL. VHYL has much higher turnover (27% vs 7.4%), much lower “earnings growth rate” (2.8% vs 6.8%) and higher OCF (0.29% vs 0.25%).
Tom – great point on the fact that every individual is different, backed up by the comment by Semipassive is wanting to live mostly off the dividends from their pot as I’m sure other rely on the growth of their fund. I’m very new to this and didn’t even consider the yields when picking my index funds and this may change over time when my needs and understanding differ.
@Kamil — Yes, that is the rational response for those who don’t believe in edge. There is historical evidence for certain factors outperforming (and theories for why that might persist) which as a long-time reader you probably know we’ve discussed many times. 🙂
http://monevator.com/tag/return-premium/
But others certainly agree with your point of view. See this article from Lars, for example:
http://monevator.com/why-invest-in-alternatively-weighted-index-tracker-funds/
I’d point out again though that Todd is a stock picker, not a factor player. (And as he does it partly in pursuit of higher returns, he is claiming edge).
The only really theoretically rational way of valuing shares that makes sense to a simpleton like myself is that of the discounted future returns of income ie dividends.
If there was at no times ever a plan for the company to either liquidate and sell itself and distribute the proceeds or to pay dividends there is no way to give a theoretical value to a company.
Great article as always. I have a passing interest in statistics, so just want to make a quick comment upon the normal distribution in section 2.
A normal distribution would imply that 95% of capital allocators sit within 2 standard deviations of the mean. However, due to the symmetrical nature of the normal distribution, this means that only 2.5% of these allocators lie 2 standard deviations above the mean, while 2.5% lie 2 standard deviations below it.
Thus doubling your reason to suspect non-outstanding capital allocation skills of management teams.
@LondonDB — Thanks for that. Todd can’t response on here (and he’s currently holed up in a fishing village on hols) but we think you’re right and have fixed the slip. Cheers!
I agree there are a number of behavioral reasons for a preference for dividends which makes dividend payers a good fit for many investors. Beware, though, because of their popularity due to low interest rates, valuations are much higher than usual, so expected returns are therefore lower than usual going forward. From a rational point of view, however, there is no reason to prefer dividend payers. They do give you some exposure to the value factor, so if you want this exposure it makes more sense to invest in a value fund or ETF which gives you a stronger exposure to value, and is more diversified, as it includes non dividend payers as well. Otherwise, I’d just invest in total market index funds.
The difference for me is that, as regards dividends, I understand how to get to a realistic analysis of size and sustainability but as regards company valuations I have never met anyone who seriously thinks they can nail them to reality. So virtually all of my equity investments are into dividend payers.
In the case of foreign investing especially emerging and frontier markets the only true reliable information is the dividend yield.
To me ordinary dividends are the stuff of equity investing life. They are at least some form of evidence that a company is making cash profits from continuing operations and giving me some of that along the way. The alternative extreme of looking for gains from pure valuations seems to me like entrusting your wealth to a besuited man with a story.
I’m increasingly focused on dividends beyond all else. In some funds / ETFs I’ve been creaming off the top and reallocating but am still sat with capital gains of +20% in some cases.
I could easily lose this should there be a drop, so I’ve been wondering about selling some, then buying again at the same price in order to increase the overall dividend via an increased number of units held, so Dollar cost averaging upwards in a way.
I’m not sure if this contradicts the orthodoxies of investing or not. I’ve never seen this type of thing discussed across the different forums I read.
@Gregory, do I detect a hint of xenophobia? Why do you restrict your comments to “In the case of foreign investing”? In the UK we are not exactly short of accounting scandals (Tesco).
In any case, I disagree that the only true reliable information is the dividend yield (I assume you mean dividends paid, rather than yield which varies with share price). Another example of verifiable factual information are the details of outstanding debt in the form of listed corporate bonds.
Historical dividend information is not a reliable source of future dividend payments either (Tesco again).
@Simon, so does that mean that you would not want to take advantage of non-dividend paying growth shares, as Apple was for many years?
I am a purely passive investor these days, but see nothing wrong with dividend investing for those wanting to put in the effort. The danger I see is in focusing on historical dividend record and current yield to the exclusion of all else, such as the debt (amount, structure and cost of), whether the current dividend yield is sustainable/covered by earnings, historical and expected earnings/dividend growth rate, etc. There are lost of things the Analyst will be looking at in addition to a company’s historical dividend record and current yield.
@Lee, you could do this, but you are taking a number of risks:
– At the moment you will likely be earning less on cash than on your return from dividends
– You may not see, or miss the right time to buy back in. If the market climbs upwards after you sell, with little sign it will come back to below your sell price, how long would you hold out from re-investing?
– You might get lucky a few times, but it is highly questionable whether the strategy is sustainable. The equity markets intrinsically offer higher returns than cash due to the higher risks, so the longer you are in cash, the lower your likely future returns will be.
– Trading in and out will add to the costs of your investment due to bid/ask spreads and fees.
Having said that, there are mechanical trend following strategies that some people use and claim to have worked in the past to enhance returns and/or reduce risk. These will give you more discipline in when to buy and sell, devoid of emotion, which I think is a better approach to market timing.
I just annually rebalance between equities and bonds/cash (if necessary), which is another mechanical strategy.
I found the article accurate, if not compelling (I do not chase dividends and this hasn’t swayed my opinion).
But the wrapping up graph seems out of place to the balanced prose. While true that high yielding stocks have outperformed low and no yielders, there is no consensus that this evidences causality. In fact, most evidence attributes the difference to exposure, albeit polluted exposure, and possibly unintended exposure, to the value factor. they note that exposure to that factor is more easily sought through other non dividend strategies.
So for me, the article would have been stronger without the graph – up go the BS antennae.
@TT — Well, your intuition is correct in that I suggested to Todd we add the graph after the piece was submitted, so it wasn’t in his original vision. And you’re correct that dividends as a return factor has been seen as possibly just another weaker (compared to price to book, say) expression of value. However I disagree the graph is without merit in this context. When you discuss divided-focused investing with both active stock pickers and passive investors, they will typically say something along the lines of “it’s all a slight of hand, you’ll just get lower returns from capital as the expense of getting a higher yield over the long-term”. Which was also predicted as you probably know by financial theory — but it hasn’t happened historically. So I think it’s worth including the data as it heads off that criticism. Personally I’m not wildly convinced causality is explained definitively for any of the risk premiums; to me it just seems a matter of which stories sound convincing. The future is unknown. 🙂
@Naeclue — I think @Gregory is on-record on the site as being a European (non-English native speaker) so ironically perhaps just slightly clumsy phrasing on his behalf. 🙂
Everyone has a right to their own opinion:) “The inherent ambiguities in calculating earnings support the case for paying close attention to dividends. If a firm pays a dividend, you know what you are getting. It is much harder to fake a dividend payment than it is to misrepresent an earnings statement.”
Siegel, Jeremy J. The Future for Investors: Why the Tried and the True Triumphs Over the Bold and the New
As an investor, i would much rather a company paid a smaller dividend than paid a larger one and asked me for more cash next year. It’s just a lot more comvenient and suits my passive investing style. Interested to know if anyone agrees with me?
For me personally the dividend yield is the only thing that matters. And actually I am handling dividend paying stocks similar to bonds. Off course there are fundamental differences, but if company pays dividend and my investment decision is based only on dividend concept, then whatever the price is on the stock market, I want that the company continues to pay at least same amount of dividends than before. Btw, you have really great content!