Introduction and summary:
My idea with this article is to show that dividends are simply return of shareholders’ capital (a partial liquidation), exactly the same as selling the equivalent number of shares to create “income”.
Admittedly, selling shares to support consumption feels a little like sawing off the branch I’m sitting on. Strangely enough, why doesn’t it feel the same about a dividend? It seems most dividend investors feel the same as me and are thus reluctant to invest in non-dividend stocks. Why is that? I think it boils down to ignorance of opportunity costs and other biases. Selling a share is perceived as an opportunity cost, whereas a dividend feels like “a free lunch” that has no impact on the alternatives. But a dividend has an opportunity cost, just like selling shares. As a matter of fact, they are both the same.
By selling shares to create “income” you are essentially creating your own dividend. Math shows that receiving a dividend or selling shares give the exact same result – all things being equal. Therefore, there is no reason not to invest in non-payers. Furthermore, there are added advantages of selling shares over dividends: More flexibility, less taxes (depending on personal circumstances), increased investment universe and potentially higher marginal rates of return (will be covered later). In general, it’s much easier to engineer taxes on capital gains compared to dividends.
I have provided a Google Sheet that contains a simulated sequence of stock performance over 50 years, both for a dividend payer and non-payer, including several bear markets. This shows there is no reason to have a bias against selling shares.
Nevertheless, the article is not a case against dividends, but rather an agnostic view on how to create a bigger nest egg for retirement and how to withdraw capital efficiently. Receiving a dividend is often neither the most flexible nor the most efficient, as I conclude in this article.
Are dividends really income?
In my opinion investors are completely mistaken in calling dividends “income”. Why? Because a dividend is simply a withdrawal/distribution of your equity in the business. Equity (book value) is the assets minus the liabilities – also called shareholders’ equity. The equity is simply the assets that the shareholders receive if the company were to be liquidated: liabilities are subtracted from the assets, what is left is sold, and capital is returned back to the owners – the shareholders.
A dividend is paid out from book value/shareholders’ equity, thus reducing the assets of the company. Capital is simply transferred from the company back to the shareholders’ accounts (less taxes). Because of this, the stock drops the same amount as the dividend when it goes ex. dividend. Thus, a dividend is in effect a partial liquidation of the company because it’s a transfer of capital.
By naming it “income” I believe it’s much easier to think of the dividend as a less risky “income” than it really is. A dividend is far from a coupon, but with the prevailing low interest rates investors gravitate toward dividend growth investing. Don’t fool yourself!
The dividend distracts where focus should matter: earnings
When you receive a dividend your net worth is the same as before, even negative if you are in a tax position. Thus, instead of speculating how much you can transfer from your investment account to your cash account, the focus should be on how you can compound most effectively. Personally I have often found myself distracted by the dividend payments and lost focus on the most important things: earnings, growth and multiples.
A company that can redeploy earnings is better than a dividend payer, all things equal, in my opinion. The reason is lower marginal return on the dividend reinvestment, something I will write about in a later article.
A company can return capital back to shareholders either via dividends or buy backs. Both of these can add value to shareholders if done efficiently. Buy backs are effective at prices below intrinsic value, but destroy shareholder value if bought at a premium to intrinsic value. Both methods are initiated by the board of directors and management, and you as a shareholder have very little control over their allocations. You simply have to invest in stocks that have the most competent management where interests are aligned with shareholders. By relying on a dividend you are effectively hiring the board of directors to act as your bank trustees, deciding quarterly how much money you get to spend or reinvest.
It’s worth mentioning that buy backs offer a lot of flexibility compared to a dividend. This is nicely summarized in the annual letters of Credit Acceptance (I recently made an analysis about this company):
As long as the share price is at or below intrinsic value, we prefer share repurchases to dividends for several reasons. First, repurchasing shares below intrinsic value increases the value of the remaining shares. Second, distributing capital to shareholders through a share repurchase gives shareholders the option to defer taxes by electing not to sell any of their holdings. A dividend does not allow shareholders to defer taxes in this manner. Finally, repurchasing shares enables shareholders to increase their ownership, receive cash or do both based on their individual circumstances and view of the value of a Credit Acceptance share. (They do both if the proportion of shares they sell is smaller than the ownership stake they gain through the repurchase.) A dividend does not provide similar flexibility.
Unless you have a tax-deferred account, 100% of the dividend amount is taxable. For me, as a non-resident, this means I receive just 85% of the US sourced dividends. 15% is withheld at source and given to the IRS. This is thus the second taxation of the exact same capital, the first being corporate income taxes.
Dividend stocks can be a useful heuristic
Dividends can be a useful heuristic for selecting stocks because a dividend indicates the business throws off cash and most likely has a consistent cash flow. Empirical evidence proves that dividend stocks have performed better than non-payers (which is logical, non-payers include IPO’s and many new and “unproven” stocks), but it’s not the dividend that makes them outperform, but their business. A lot of good companies could pay a dividend but choose not to, for many reasons. However, be aware that research is not including taxes on the dividend. This means the historical reinvestment returns of the dividends are for most investors overstated. Dividend taxes are a serious headwind, something I will come back to in the next article about marginal rate of return.
Selling shares and receiving a dividend are the same:
The most flexible option to create “income” is initiated by you: by selling shares at the prevailing market price. This way you are not dependent on the board of directors. If a company does not pay a dividend and you opt to sell shares, the proceeds minus the cost base are taxable. In many cases this leads to a lower tax burden than receiving a dividend. You can further defer taxes by selling the stock in your portfolio with the lowest capital gains, perhaps even negative appreciation. You can engineer your own tax bill.
This sheet shows that a rational investor should be indifferent to receiving a dividend or selling shares (all things equal). The sheet shows that for a non-dividend stock the number of shares is reduced from 1 000 to 422 after 50 years of selling shares for “income”. Still, the value of the shares has increased from 25 000 to 32 499, not including the sale proceeds. The number for the dividend stock is exactly the same.
If the investor is in a tax position paying 15% on dividends and 30% on capital gains, the investor is better off selling shares because only profits are taxed. Total taxes on dividends in my example is 3 601, but only 2 803 for selling shares, even though the tax rate is the double. However, this might change depending on personal circumstances and how much is gained via capital.
The rational goal should thus be to create high total returns and not focus on the dividend at all. Focus should rather be on the business model, managers’ skills as operators and how they allocate capital. After all, dividends are just withdrawal of profits.
Warren Buffett wrote about this in the annual letter of 2012 on page 18 to 21. Buffett had at the time sold off 4.25% of his ownership every year for the previous seven years (including the GFC in 2008/09) and still managed to increase his wealth. On page 20 in the shareholder letter Buffet concludes:
For the last seven years, I have annually given away about 4.25% of my Berkshire shares. Through this process, my original position of 712,497,000 B-equivalent shares (split-adjusted) has decreased to 528,525,623 shares. Clearly my ownership percentage of the company has significantly decreased. Yet my investment in the business has actually increased…… In other words, I now have far more money working for me at Berkshire even though my ownership of the company has materially decreased…..Over time, I expect this accretion of value to continue – albeit in a decidedly irregular fashion.
On the same four pages Buffett argues about the advantages of selling shares compared to receiving a dividend. I quote his conclusions:
There is an alternative approach, however, that would leave us even happier. Under this scenario, we would leave all earnings in the company and each sell 3.2% of our shares annually. Since the shares would be sold at 125% of book value, this approach would produce the same $40,000 of cash initially, a sum that would grow annually. Call this option the “sell-off” approach….. And, remember, every dollar of net worth attributable to each of us can be sold for $1.25. Therefore, the market value of your remaining shares would be $2,804,425, about 4% greater than the value of your shares if we had followed the dividend approach.
Better sell at multiple to book value than receiving book value
Buffett mentions in the last quote that you you can sell equity for 1.25 times book value. This is yet another advantage of selling shares: almost all stocks trade at a premium to equity/book value. Dividends are paid out from book value, but you can sell shares at for example 2x book value.
Reinvesting/DRIP at above book value gives very poor marginal rates of return. If a company is trading at 2x book value and has 10% return on equity, you reinvest at 4.25%: One dollar in dividend equals just 85 cents after taxes, and 85 cents are reinvested at 2x equity/book value, which equals 4.25% return on equity.
Why receive at book value when you can sell at multiples to book value?
But selling shares impairs future cash flows?
The main argument against selling shares to create “income” is sequence of returns risk. For example, if you needed money in late February 2009 you were forced to sell at much lower prices than one year ago. You receive less and at the same time the shares sold are gone forever. This means they will never have the potential to provide you a cash flow in the future. All these arguments are of course very true.
But investors fail to realize that the same happens when a dividend is paid, as evidenced by the Google Sheet. Why is that? Because a dividend is in effect a partial liquidation: capital is handed back to the shareholders. Let us look at what happens in detail (taxes ignored to simplify):
Let’s say you have a company trading at 100 and paying 2 dollars in dividends. You own 1 000 shares, worth 100 000 USD. Next year the stock drops to 50 dollars. But the company is still firing on all cylinders and decides to increase the dividend to 3 dollars. What happens? At ex.dividend date you get a 3 dollar dividend (3 000 USD) and the stock drops to 47 the very next day to reflect the distribution. You have 3 000 in cash and 47 000 in stock. During the next year the share price increases 100% and ends up at 94 dollars (47 times two). You have 94 000 worth in stock and 3 000 in cash.
What happens if the company pays no dividend and you need to sell shares to create a similar “income”? When the company prefers to not pay a dividend, for whatever reasons, the stock does not go down to 47 as it would with a dividend. Thus, you need to sell 60 shares for 50 dollars to get the similar 3 000 as you would receive with the dividend. You end up having 940 shares: 3 000 in the bank and 47 000 in shares (940 times 50). Next year the stock increases 100% to 100, and you have 94 000 worth of shares and 3 000 in cash, the exact same as with the dividend example.
Our biases distort rational decisions
Most investors have biases which lead to suboptimal allocations and thus less total returns: confirmation bias, anchoring, a rigid mindset, not willing to have an open mind or inflexible for other ideas (to name a few). I believe the reasons behind the success of Warren Buffett and Charlie Munger are their common sense, rational decisions, ability to change and the removal of errors. Both have the remarkably ability to change their minds when they realize they are wrong, and they have the personality to overcome the biases that haunt most investors, including me. Their only focus is to look for best total returns. They don’t have any biases toward any particular investments or capital allocations, as long as they are within their circle of competence and the allocations make sense. They don’t walk into the office in the morning to just focus on one type of asset or strategy. Both gentlemen realized early in their investing careers that the easiest way to obtain above market returns is to work at their mental biases. They have numerous times argued the case for focusing on your behavior. I’ve never heard them arguing the wonders of dividends. Instead, they are touting the power of compounding. You can compound returns, but just as well can you compound knowledge.
Our biases make it difficult to sell shares, while at the same time receiving a dividend feels so smart. Admittedly, I feel the same. That’s partially why I wrote this article. My aim is to become a better investor and by addressing my biases I hopefully gain a better understanding of my investment decisions.
The Endowment Effect
Dan Ariely writes about the Endowment Effect in Predictably Irrational: we value our belongings more than other people do. We fall in love with what we have, not things we don’t have. Furthermore, we focus on what we might lose when selling or giving away things. The longer you have owned something, the more difficult it is to depart with it. This applies just as well to abstract things like politics, philosophy, sports etc. My opinion is that we can add investments to this. If you have owned Philip Morris for 40 years, and this stock has of course served you very well, it’s hard to sell it. You get attached to it. You fell in love with it and no way you are going to sell. At the same time, when you receive a dividend, it feels like you are not losing anything.
Lumpy rewards vs. even distributions
There is another type of satisfaction provided by the option seller. It is the steady return and the steady feeling of reward – what psychologists call flow. It is very pleasant to go to work in the morning with the expectation of being up some small money.
I believe this quote from Taleb sums up pretty well the feeling of receiving a dividend (exchange dividends for options). If you rely on selling shares you most likely do it less often than quarterly, you need physical effort to do it and you need to make a decision. This comes at a disadvantage compared to doing nothing to receive a dividend. Taleb has later said that the three most addictive things in life are drugs, carbohydrates and a monthly paycheck. Again, exchange the paycheck with dividends.
If you make 500 000 in year one and nothing in the following nine, you will most likely be a lot unhappier compared to receiving 50 000 evenly in all ten years. Behavioral experiments suggest our happiness depends far more on the number of positive feelings than on the amount when they hit. This means any payment is much more important than the size of it. In order to have a pleasant life most people should thus spread these payments evenly. (Even worse is if you make 500 000 in year one and give back 400 000 over the next nine years. It most likely feels better to receive nothing because you have nine miserable years.)
Most stocks pay a quarterly dividend, a few even monthly, and thus selling shares for example once a year comes at a psychological disadvantage for most of us.
Alternatives and opportunity costs
Many great companies could pay a dividend but choose not to: Berkshire, Markel and Facebook come to mind. Berkshire has not paid a dividend since 1967, simply because the capital does more good retained and reinvested than distributed. Thus, a dividend always has an alternative use that should be considered. Would buy backs be better? Perhaps it’s better to pay back debt? In 2016 Exxon stuck to its rising dividend, and rating agencies cut their rating partly because of the enormous dividend payments. Was this in the best long-term interest of the shareholders?
Philip Morris pays a dividend and has presumably been the greatest stock ever. But perhaps shareholder returns would have been better if they had a flexible approach and alternated between buy backs and dividends? It’s difficult to see the cost or gains of alternatives because they are not observable. This is what Nassim Nicholas Taleb calls the alternative history in Fooled by Randomness. We can all see the dividends hitting the account, but we don’t see the alternative use.
Likewise, an investor should always strive to increase the opportunity cost. This “cost” is the difference between the best use of your capital compared to second, third, fourth use etc. Charlie Munger has said that Berkshire and Costco are his opportunity cost, at the right price. This makes sense: why invest in your 15th best investment idea, if you can invest in the best? When you marry it’s presumably because it makes you happy and it’s a good fit. Most people have no problem with this reasoning. But the same reasoning should be applied on your capital, and your bar should be put as high as possible, ie. to create a high opportunity cost.
Charlie and I don’t know our cost of capital. It’s taught in business schools, but we’re skeptical. We just look to do the most intelligent thing we can with the capital that we have. We measure everything against our alternatives. I’ve never seen a cost of capital calculation that made sense to me. Have you Charlie?
– Warren Buffett
I believe a rational investor should evaluate an investment based on estimated total returns and opportunity costs, and not pick an investment based on a dividend. Whether or not you need cash to pay for living expenses or reinvestments, you need to find the optimal way to make the most off of your capital.
My numbers show there are other options to withdraw equity than just via dividends. I think it makes sense to have an open mind on how to create the best investment results, as long as you understand what you are doing, without focusing on the dividend. Each investor must set up their strategy that best fits their knowledge and needs, and my point with this article is to open up some other methods to reach your goals efficiently. It’s easy to get “trapped” by the dividend bias.
I think being agnostic and non-biased is a great way to increase both returns and knowledge!