This is a very short article based on two much longer articles:
- Don’t be fooled by your dividend bias – sel shares to create “income”
- Dividend investing: Don’t be fooled by your dividend bias – marginal rate of return/incremental return
On the 30th of April 2020 Royal Dutch Shell cut their dividend 67% (I have a tiny position in the stock – 0.05% of my portfolio). As expected the comments on Seeking Alpha is full of anger and resentment over the smart decision, in my opinion, to cut the dividend. To cut is of course smart because the wise thing to do now is to protect the business and cashflows, not to hand out distributions to shareholders. Unfortunately, Shell has attracted a lot of dividend investors who often look at the equity as a proxy for a bond, which obviously it isn’t.
My experience as a former quasi-dividend investor has led me to the conclusion that a strategy based upon dividend stocks is a foolish one. Richard Feynman once said that the first principle is that you must not fool yourself and you are the easiest person to fool. I believe dividend investors too often fool themselves because they have it backwards: They focus on the distribution of profits, not how to make profits. They are what Benjamin Graham would call coupon clippers. In The Intelligent Investor Benjamin Graham made this fantastic comment:
…..a steady rising dividend has the potential of attracting “ignorant coupon clippers, not business owners.
You can read many more quotes from this book here:
Let’s look at some of the downsides of dividend investing:
Low bond yields make people take greater risk
Dividend investing has become immensely popular since the GFC in 2008/09 together with the growth in the FIRE-movement. If you search at Google Trends you will find a gradual rise in the search activity for both terms. Those who retire early obviously need cash and capital to live on, either from “income” or sales of capital assets. With fixed income generating less than satisfactory returns, it means retirees need to take on greater risk to generate those needed returns.
If risk-free government bonds yielded 5% while inflation is running at 5% or lower, I think it’s safe to assume many investors would own bonds instead of equities. But after 2008, when interest rates dropped significantly, many have shifted from bonds to equities in the search of “yields”. But a bond is a much safer “income” than equity. They who tell you otherwise and point to Coca-Cola or Unilever, do not fully understand the risks.
This means they lean on dividend stocks to provide the income stream they rely on. This is a foolish strategy because:
A dividend is not “income”
In my opinion dividend 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! You can just as well sell share to generate that “income”:
Sell shares to create “income”
Selling shares to create “income” is exactly the same as receiving a dividend. I have explained this in details in a previous article.
Many companies could pay a dividend – but chose not
Selecting investments from a pool of dividend paying stocks can be a useful heuristic. After all, dividend stocks have outperformed non-payers for over a hundred years, at least before considering taxes on dividends. As such, it makes sense to look among the dividend stocks. But why limit yourself? Many great companies could pay a dividend but chose not to: Berkshire, Markel, Facebook and Google to name the most successful. It’s because Berkshire does not pay a dividend it has been such a fantastic investment (by reinvesting retained earnings at high rates of marginal returns).
The focus on “income” distracts
If you have “income” and dividend in the back of your head, your analysis is biased from the start. I call this the dividend bias – a behavioral bias just like all the other biases.
Poor marginal rate of return – incremental return
What is perhaps the biggest drawback with dividend investing is poor marginal returns – incremental return. You might have to pay taxes on the dividend – a huge drag. Perhaps worse is you reinvest at multiples to book values. Dividends are paid out from book value, but you can sell shares at for example 2x book value.
Reinvesting/DRIP at multiples to book obviously 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 (assuming withholding taxes of 15%), and 85 cents are reinvested at 2x equity/book value, which equals 4.25% return on equity.
I’m already working on much longer article about marginal rate of return which will be finished later.
So what should be the main focus?
Conclusion: Growth and valuation should be focus
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.