Dividends are everywhere these days. Numerous blogs cover dividend stocks and it is hard to open The Report on Business these days without running into one (if not more) columns on investing in dividend paying stocks. And judging by the number of new investors interested in dividends on the Canadian Money Forum, one would think that dividends are all there is to investing in stocks. Nothing could be further from the truth.

Investors should not lose sight of the fact that dividends are just one form of returning profits to owners. Businesses that generate profits can employ capital in other ways. Management can reinvest profits and grow the business — provided, of course, that reinvested profits generate a higher rate of return than owners can manage on their own. Management can also buy back the company’s shares, so that each remaining share can then earn a higher proportion of future profits. Though investors are not directly receiving their share when profits are reinvested or shares purchased for cancellation, they are indirectly receiving the same value through appreciation in the value of shares they hold.

Take Berkshire Hathaway (BRK-A) which has famously not paid a dime in dividends and until recently has never had a repurchase program. Long time BRK shareholders are unlikely to be crying that their holding is not paying a dividend. Neither do shareholders of Apple Inc. (AAPL) whose earnings have exploded due to the popularity of iPods, iPhones and iPads. Investing in stocks by just looking at current and past dividends is a mistake. What matters in investing is the profits that a business will generate in the future, not the dividends it paid shareholders in the past. If dividends were all there is to investing in stocks, AIG, Freddie Mac, Fannie Mae and Bear Stearns wouldn’t have gone bust and nobody would own shares of Berkshire Hathaway or Apple Inc.

This article has 26 comments

  1. This is true, but it’s also important to recognize that the vast majority of share buybacks are of no net benefit to shareholders… they’re just a way of offsetting dilution due to insider compensation. It’s been a number of years since I last looked into what percentage of Dow companies with buyback programs were actually doing *net* buybacks at the time; it was very low. Thus, although dividends are less efficient, I’d prefer them.

    On the other hand, it looks like the Buyback Achievers index has outperformed various dividend-oriented indexes over the last couple of years, so it may be that companies are becoming less shareholder-hostile.

  2. Further to Viscount’s comment, buying stocks when you’re anticipating management to perform share buy backs is just as impossible as trying to buy take over targets. Sure, you make money hand over fist when your stock is taken out by acquisition, but making an investment solely on that basis is gambling, not investing.

    There is no sure thing in investing, but a distribution yield is getting paid while you wait for something good to happen with the stock and I generally prefer that over a non-yielding stock. In my own experience, my core portfolio is about 80% dividend payers and I “dabble” with non-dividend payers in my last 20%, but my “gambling” portfolio is a mix of stocks and commodities. But I recognize that my dividend payers are my boring “bread and butter” stocks, whereas I’m gambling with the other 20% in commodities / juniors / venture capital.

    My evidence is that on any given trading day, you can find stocks with P/E ratios from the low single digits to the triple digits. So, as far as I’m concerned, there is no direct correlation between company earnings and its stock price.

  3. CC, well said. Although we all love owning a solid company with a great track record of increasing dividends (and sp), the emphais you note on dividend stocks is directly correlated to the low level of interest rates and investors striving to achieve returns above 1 or 2%. Thus, care must be taken to ensure the company is not going stale by not re-investing their profits and the dividend return is not offset by a future decrease in sp.

  4. You are a brave man, CC. Brace for impact.

  5. Dividend paying stocks make sense to me. Since most investors don’t even calculate their portfolio returns, dividends give them tangible ‘evidence’ that they are getting something out of their investments.

    I wonder how many comments will tout dividend paying stocks as superior?

  6. I love dividend stocks, and completely agree that there is much more to investing than simply holding dividend payers.

    Having noticed an increase in media coverage of dividend payers, I have to wonder why. Is media only covering it b/c of low interest rates and people are seeking higher returns, is it demographics as baby boomers are starting to seek yield in retirement, or is it simply the tech fad of the next decade, in the eyes of the media?

  7. I hope this debate doesn’t de-generate into a mud slinging debate between dividend zealots and index zealots. Both approaches have merit, depending on the time committment available to the investor, and whether sthe portfolio in question is inside of a registered account.

  8. @Viscount: I agree that buybacks aren’t always better either. Like you say, often times, managers are simply offsetting dilution of stock and option grants. That’s not necessarily a bad thing but companies have tended to do buybacks regardless of the stock price. Further more, management has an incentive to allocate capital to buybacks because it makes their vested options more valuable.

    Tech companies used to be the worst offenders when it comes to options and buybacks. I haven’t looked at the numbers but my sense is that many tech companies seem to have cleaned up their acts. They make less option grants these days preferring restricted stock instead. A cursory glance at INTC, MSFT, CSCO all show decreasing share counts.

    @Phil: There are plenty of fish in the pond even if one restricts the universe of stocks to those that pay a dividend. But many investors, especially ones new to investing, seem to be picking a stock just because it pays a dividend without any further analysis. I think it’s a mistake.

    @Blunt Bean Counter: I agree that the growing interest in dividends is directly a result of low interest rates. But dividend payers are stocks too. They are also volatile and investors switching from bonds to stocks just to earn a better yield should realize that doing so entails more risk.

    @Canadian Couch Potato: I think newbie investors are blinded by dividends are taking on more equity risk than they would otherwise. Some investors may not like that opinion but I don’t care!

    @Sampson: Fair enough. As long as investors realize they are investing in stocks and hence can expect volatility, stay disciplined, are well diversified and keep their costs low, investing solely in dividends will be a very good choice. I worry that many investors are focusing on dividends and forgetting the main rules of investing.

    @Cal: I too think low yields are the reason for the interest in dividends. These days bonds are yielding something like 2%. In comparison a 4% dividend yield looks very good. The problem, of course, is that switching from bonds to stocks means taking on equity risk. It is only when stocks decline in value that investors suddenly realize that it is total returns, not dividend yields that matter.

  9. CC Why do you think that newbies have too much equity risk with dividend-payers; do you believe that they are not balancing their equities with FI investments?

  10. An investor can always manufacture a dividend by selling a small portion of their shares (if you take transaction costs out of the picture). This is true unless you are invested in a stock like Berkshire Hathaway with a sky high price and minimal liquidity. Warren Buffet is right that stock splits do nothing to increase shareholder value, but they do make some things, like selling small portions of your investment, much easier.

  11. CC- this kind of post is why your site is excellent. Calm reasoning and rationale when people are getting carried away.

    The only thing I will add about dividends (maybe it was already said – i only skimmed comments) is that they are easier for investors to hold and this behavioural advantage is worth at least something.

    Where people go really wrong is they look at dividends and not with any inquiry as to payout ratio. Investors in Yellow PAges or Yellow Media have recently learned this the hard way and this alone could be worth a post to drive the point home.

    In any event – great post CC – you are the man

  12. @Dr. Dale: If an investor is replacing bonds with dividend payers just because yields are higher, they should realize they are taking on more equity risk. I’m not convinced they are thinking through the implications.

    @Robillard: I agree. Fortunately, BRK is a special case. The only other stock I can think of that has an explicit policy of not splitting is GOOG but it has a long way to go before we run into liquidity problems.

    @Rob: I would agree that holding dividend payers in a downturn may make it a little bit easier. But I wonder if investors even notice the dividend when compared to volatility. RY, for instance, has a 52-week range of $44-$61. Compared to that the annual dividend is just $2.16. In the long-term those toonies will make a big difference but do investors keep that in mind when watching the stock drop in price?

  13. “Dr. Dale Rathgeber says:
    September 28, 2011 at 10:17 am
    I hope this debate doesn’t de-generate into a mud slinging debate between dividend zealots and index zealots.”

    Indexing zealots? I resemble that remark! :) But even though I’m an indexer, philosophically, I want companies to be paying me dividends to invest in them. Just in case the capital gains thing doesn’t work out, I want a steady trickle of those toonies CC talks about being deposited into my investment account!

  14. Good points CC; I think it’s important for investors to realize that dividend paying stocks should not be the only types of investments to consider while employing an investment strategy. Diversification is key, and there are more than just dividend stocks that can return cash to the investor.

    Offloading bonds in exchange for dividend-paying stocks simply for the sake of yield can add risk to the investor indeed, and I echo your thoughts in terms of the importance in taking heed of these suggestions.

  15. Pingback: Becoming An Index Investor: The Strategy | The Wealthy Canadian

  16. Pingback: My Own Advisor » Weekend Reading – Dividend Growth Index edition » My Own Advisor

  17. Fair points CC, but for me, dividend-paying stocks are the only stocks to invest in. They are a sure fire sign that a company is making money and I get rewarded as a shareholder accordingly. The Canadian dividend tax credit is even a bigger reason. Over time, dividends don’t lie – either a company can afford to pay dividends or they can’t.

    Just like another commenter said, there is no sure thing in investing, but getting income and rising income over time while you wait for some capital appreciation is a pretty great thing. Dividend-investing and index investing both have their benefits; that’s why I employ both.

    • @My Own Advisor: I have no quibbles when an investor restricts their stock picking universe to dividend payers. Hopefully, they understand that they are invested in stocks and as such can expect returns and experience risk similar to a bunch of stocks.

      Surely, you realize that just because a company is paying a dividend is no guarantee it is earning a profit in it’s business. In the right market conditions, a business can keep issuing shares and using the proceeds to make dividend payments. A number of income trusts did exactly that. Moreover, a business may have earned profits and paid dividends in the past but there is no guarantee that the nice state of affairs will continue in the future. As I pointed out in the post, Bear Stearns kept paying a dividend right until it got acquired for $10. There are other examples. Two were in the news recently. Yellow Media and Eastman Kodak. EK was a Dow component for crying out loud. Look where it is now.

  18. CC, who needs recent examples.

    Look at every single bank in the US. They kept paying dividends, but had you bought before 09, your current YOC would be less than 1-2%.

    Don’t like banks? How about GE? Dividend aristocrat in the past. You would think a company that had 25 years of consistent and growing dividends could both maintain and continue to grow them.

    They can go in a split second.

  19. Pingback: Best of Blogs – tough times | Retire Happy Blog

  20. Pingback: What’s New Around The Blogosphere: September 30th, 2011 | Boomer & Echo

  21. Pingback: he Wealthy Canadians Carnival # 4: Rainy Day Edition | The Wealthy Canadian

  22. Pingback: My Own Advisor » My online conversation with Barry, the dividend-investor millionaire » My Own Advisor

  23. Pingback: Bargain Hunting: 5 Stocks I'm Buying & Watching | The Wealthy Canadian

  24. Pingback: My Own Advisor » September 2011 Dividend Income Update » My Own Advisor

  25. Pingback: September 2011 Dividend Income Update - My Own Advisor | My Own Advisor

Leave a comment

Your email address will not be published. Required fields are marked *

*

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>