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 [1] 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 [2],” and financial journalist Matt Yglesias, who bluntly called dividends “evil [3].”
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 [4] 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 [5].
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 [6], 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 [7] 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 [8] in the UK, or IRAs in the US.
Dividend investors looking across the globe for investment ideas should take note of any tax withholding [9] 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 [10] 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:
[11]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.
[12]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 [13]. For compliance purposes, Todd cannot reply to comments below, though he welcomes any correspondence sent by email [14]. You can read Todd’s expanding collection of dividend articles [1] here on Monevator or check out his book, Keeping Your Dividend Edge [15].