Last Updated on November 15, 2020 by Oddmund Groette
Introduction and summary:
Dividend stocks have outperformed non-paying stocks, but many non-payers could pay a dividend but chose not to. This article argues there are many reasons for not paying a dividend but rather use a flexible approach to allocate capital. Berkshire Hathaway would not manage a 19% compounded return if they paid an annual dividend. This article provides arguments for why you should not limit yourself to only invest in dividend stocks.
Dividend investing has become increasingly popular as the interest rates keep going down. Risk-free Treasury bonds worldwide yield next to nothing, and income seekers look for dividends to replace the income from the coupons. This has led many dividend investors into high yielding and very risky stock portfolios.
Unfortunately, a dividend is no substitute for a bond, neither is it a proxy for a bond. Many investors thus fool themselves by only investing in dividend stocks believing dividends can replace the coupon from a bond. But equity is inherently riskier than a bond!
We at RationalThinking are not dividend investors. Sure, we own dividend stocks, but not because they pay a dividend, but rather because they are good companies where we expect good long-term total returns. We are investment agnostics.
We argue there are certain drawbacks with dividend investing:
- A rising dividend often attracts coupon clippers – not business owners.
- Coupon clippers treat stocks like bonds.
- Falling marginal rates of return when DRIPing.
- The right shareholders are important to create long-term value, owner-oriented shareholders is often a neglected part of the equation.
- No reasoning behind paying a growing dividend.
- A dividend gets “sticky” – hard to reverse.
- Dividends make the shareholders complacent.
- Dividends are taxable and inflexible.
- Dividends are distributed at book value, but mostly reinvested above book value, thus lower marginal rate of return.
- The alternative story – opportunity costs. Is a rising dividend value-enhancing? What about other options?
- Managements often claim that paying a dividend is doing something for shareholders. It is precisely the opposite. The burden of compounding is handed over to you.
- Are dividend and buybacks really shareholder friendly?
A dividend policy is often reported but seldom do we see explanations justifying the particular course of action. A dividend is just one of five possible allocations for retained earnings, and the focus should be to do this in a value-enhancing way. Allocations done intelligently could be just as value-enhancing as the underlying operations, as explained very well in William Thorndike’s The Outsiders (which gives eight examples of managers that made smart allocations). Thorndike expresses this nicely in his introduction:
Stated simply, two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders…..This inexperience (managers having no education or training in capital allocation) has a direct and significant impact on investor returns. Buffett stressed the potential impact of this skill gap, pointing out that “after ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.
The Outsiders, William Thorndike, page xiii
Thorndike goes on with defining what options management have in where to allocate capital. Roughly speaking, a company has five options in which to spend the retained earnings (in no preferred order):
- Reinvest into the existing business(es) (organic growth).
- Do M&A (diversify).
- Pay back debt.
- Pay a dividend.
- Buy back shares.
Unfortunately, there is no exact science as to what is best. Most of the options are often mutually exclusive: for example, paying a dividend and buying back shares at the same time does not make much sense, in our opinion. Buybacks are efficient at low valuation multiples and/or if the company is trading below intrinsic value, while a dividend makes sense when the stock is trading at high multiples or above intrinsic value. Both allocations assume there is no use for the cash in the business. If the retained earnings can be reinvested into the existing business at acceptable returns, this is always the best option.
- DRIP/dividend investing is inferior to internal compounding
- Why retaining earnings make more sense than distributions
However, there are not that many businesses or management teams that can earn very high returns on retained earnings, especially as they become bigger and reach a more mature state. Because of this, the correct choice is often to return capital back to shareholders. If the return on invested capital (ROIC) is very high, let’s say over 20%, then it makes sense to pay a dividend or buy back shares to avoid a low marginal return on the retained earnings. This means the burden of compounding is transferred back to the shareholders, less friction costs and reinvestment above book values (see more later).
Berkshire Hathaway and its owner-oriented shareholders
It takes lots of time and effort to attract and educate competent shareholder/partners. The last thing we want them to do, is sell.
– Mark Leonard, Constellation Software, shareholder letter 2013
Warren Buffett realized early on that attracting the correct shareholders are a very important part of long-term returns, yet usually neglected. The most underrated aspect of Berkshire is how Buffett has managed to attract shareholders that understand long-term value creation and where capital compounds the best: In the hands of the company or in your hands. Buffett has managed to teach the great majority of the shareholders that the best capital allocations are agnostic, opportunistic, value-enhancing and flexible. The shareholders think like owners. Berkshire is not bound by any “strategy”. A strong focus on strategy leaves most people blind to opportunity costs.
Berkshire Hathaway has not paid a dividend for at least the last 55 years. Why should they? One of the reasons it has been such a good investment is that they have NOT paid a dividend. Why would shareholders want a dividend when earnings can be reinvested at high incremental returns? The Berkshire shareholders are smart and have never voted for a dividend.
After the Enron debacle, Buffett was invited to speak at the SEC Roundtable to give his thoughts on how to avoid future Enrons. Buffett’s reply was that he prefers to have the CEOs disciplined by his owners, and not by the courts, according to L. Rittenhouse in Reading Between the Lines. The owners are a powerful group if they know what to look for in the management. Buffett has made the benchmark of what it means to have quality shareholders. Too many shareholders focus on short-term expectations – catalysts – and dividends might disturb management in efficient allocations.
Sell shares to generate “income”:
Dividend “Income” is a complete misnomer. Investors don’t have “income” from dividend-paying stocks. You either have gains in the form of share price appreciation, or you receive distributions of retained earnings in the form of dividends. A dividend is a distribution of capital. Income is something you receive in compensation for providing services or selling products. Investing doesn’t include “income”.
The alternative to a dividend “income” is to sell shares (if you need “income”).
But dividend growth investors don’t want to sell shares to get “income”. They believe this is like sawing off the branch they’re sitting on. But they are wrong. A dividend is the same as a partial liquidation of the company, it’s a transfer of funds from the company to the shareholders, and has the same effect as selling shares. Please read this article for a better understanding of this:
Dividends are distributed at book value, but mostly reinvested above book value
This is a very important point, and I guess not well understood among investors. Dividends are transferred as value for value. It’s simply capital moved from the company’s account (as retained shareholder’s earnings/equity) to your account. But here is the catch: usually a stock trades above book value, and thus any reinvestment is done at a higher multiple, for example, 2x book value.
Ask yourself this:
Why would you accept to receive a dividend, distributed from shareholder’s equity, only to reinvest at a premium to the equity? As Buffett says, you take a beating in doing so. We have explained this in detail in a former article:
In order to create the biggest nest egg you need to understand how to compound your capital efficiently:
Are Dividends rewarding shareholders?
A dividend might be a tactical move, not a strategic one. The appeal of a stock increases with a dividend, for example to institutional shareholders which for many reasons want “income”. A dividend might also serve as a source of “income” for owners who might otherwise demand higher compensation. There is no definite answer fitting all companies. That’s why capital allocations should be flexible.
Dividends seem to be the preferred method of being “rewarded”. But at the end of the day, any investment should boil down to total long-term returns. Whether or not you need cash to pay for living expenses or reinvestment, you need to find the optimal way to make the most off of your capital and withdraw your capital efficiently. I believe dividends often distracts from the real issues: growth and the marginal rate of return (reinvestment return).
Dividend growth investing:
The dividends may fluctuate a bit – sometimes significantly as during the global 2008-2009 crisis – but over the long run they are dependable. Better this – my opinion – than the dividend policy of many American companies of which General Electric (GE) was the poster child in which earnings and dividends go up very predictably every year until the moment of the Big Oops.
-Jim Sloan, contributor on Seeking Alpha
Dividend growth investors love an annual rise in dividends. It’s perfectly understandable, but unfortunately more of an irrational “dividend bias”.
The aim of a dividend growth investor is to have a portfolio of stocks that most likely increase the dividend annually. However, we believe this goal is completely irrational. Why focus on distributions?
The Dividend Aristocrats are an exclusive list of companies that have increased their dividend annually at least 25 years in a row. Even more exclusive is the Dividend Kings with a 50-year track record. Quite impressive!
Why not only invest in these stocks? Since 1993 the Dividend Aristocrats have outperformed the S&P 500, even adjusting for the statistical term called survivorship bias. However, there is no data prior to this. Most strategies sooner or later stop working. From the research we have seen, the Dividend Aristocrats’ outperformance can just as likely be the result of low valuation multiples, not the dividend.
Outside the US and the UK, there is less focus on an annual dividend increase. For example, in Scandinavia and the Nordics, the short-term variability of the dividends are huge, while over the long-term rising. We believe this approach makes more sense. This makes the management and board more flexible in terms of capital allocations, and the stocks are less likely to attract coupon clippers:
A growing dividend attracts “coupon clippers” – not business owners
Benjamin Graham wrote in the Intelligent Investor that a growing dividend has the potential of attracting ignorant coupon clippers, not business owners. We believe this is more true now than in the old days due to the falling yields in both Treasuries and corporate debt.
One of the most underrated aspects of Warren Buffett and Berkshire is that he has managed to attract shareholders that both have a very long-term view and act like owners. The same applies to a certain extent to other stocks like for example Markel, Alleghany, White Mountains Insurance (and of course others). All these companies have an advantage over many other companies: It’s much easier to have a rational and flexible capital allocation when shareholders are long-term and do not require a quarterly “coupon”. They simply think like business owners, not coupon clippers.
“Coupon clippers” treat stocks like bonds
Bonds offer a coupon of x% and have a reasonably predictable return, although the value can fluctuate together with market rates and perceived risk. However, bonds are less risky than equity. Thus, “income” streams from dividend stocks will never be as safe as bonds. Even high-quality companies can’t compensate for that.
Inflation is currently running at 2-3%, meaning holding cash is a sure way of losing purchasing power. This has lead to increased interest in dividend investing. We suspect that many investors in reality treat those stocks more like bonds than stocks.
Let’s assume you invest in a stock that increases the dividend 5% annually, and the dividend payout ratio is lower than the earnings per share. You increase both your “income” and principal (assuming constant multiples). You can have the cake and eat it too! Unfortunately, equity is riskier than bonds and many dividend growers need to cut the dividend.
Dividend investors argue that the dividend variability is less than the stock price variability. In 2008/09 dividends from the S&P 500 companies fell about 25% from top to bottom, while the S&P 500 fell almost 50%. However, what many forget, is that the stock prices recovered faster than the dividends.
What would have happened if the financial crisis lasted longer? Most likely we would have seen a much bigger drop in the dividends further down the line.
There are only two ways to make money in the stock market over time: either via growth or via multiple expansion. Obviously, if there are no growth prospects, it’s hard to gain any multiple expansion. Likewise, no growth in earnings per share means no dividend growth unless the company wants to borrow money to pay for the dividend. The sustainability of the dividend is dependant on the earnings and fundamentals. When growth disappears, you are left with a very risky “bond”.
No reasoning behind why a company pay a rising dividend
Dividend policy is often reported to shareholders, but seldom explained. A company will say something like, “Our goal is to pay out 40% to 50% of earnings and to increase dividends at a rate at least equal to the rise in the CPI”. And that’s it – no analysis will be supplied as to why that particular policy is best for the owners of the business. Yet, allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed….. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business…….
– Berkshire shareholder letter of 1984.
Why is a dividend a smart allocation? Rarely is an explanation reported to the owners, and just as likely are the owners happy to receive whatever dividend is thrown at them. Supposedly, returning capital is “shareholder-friendly”. But intelligent capital allocation is usually a bit more complex than that.
In the shareholder letter of 1984 Buffett argues that most managers have a rational approach in allocations on the subsidiary level. If for example Subsidiary A returns 5%, it makes sense to pay a dividend from A and reinvest in subsidiary X, which for example earns 15% on capital. However, at the parent level, this thinking seems to be of less importance.
A dividend gets “sticky”
If you do not have potential high-return investment projects, consider paying dividend. Be aware, however, that dividend decisions can be hard to reverse and that dividends can be tax inefficient.
– The Outsiders, William Thorndike.
When a company starts paying a regular dividend it becomes hard to stop or undo, for several reasons. To cut a dividend is supposedly bad, and a whole business in the investment world spends considerable time and resources to separate which companies can sustain or cut their dividend. Very few dividends are cut unless the company is forced to. Opposite, buybacks can be stopped without any reaction from the market.
Some companies pay a low regular dividend, and pay a special dividend now and then, like for example Costco and WR Berkley. This approach seems much more sensible and leaves room for alternating between dividends and buybacks, whatever makes the most sense at the moment of distribution. Both companies have outperformed the market for decades.
However, in our view, the point with a dividend is to return cash to shareholders that can’t be reinvested at acceptable hurdle rates. If it can be reinvested into the business at good marginal rates of return, it makes no sense to return it back to shareholders (less taxes). However, when a company initiates a regular dividend it gets sticky and has to be paid even though it might be reinvested more efficiently. Mark Leonard, CEO of Constellation Software, sums it up nicely in one of his very readable shareholder letters:
What do they call that type of problem? First world problems? You’d obviously like to be patient and wait for your opportunities, and the issue is, if cash is sitting around doing nothing, it isn’t earning returns for your shareholders, and you could return it to them, and let them invest it. I’ve categorized it previously as the amount of embarrassment that the board is willing to put up with as we sit on cash and people start clamoring for it to be distributed either via dividends or share buybacks. And I think you know my views on most share buybacks. So my preference would be to hang onto the cash. We seem to be ramping our M&A activities, and to some extent, it seems to be paying off. And so rather than returning it to shareholders, I’d rather hang onto it at least for the time being and see if perhaps we can’t deploy it.
A dividend is not necessarily shareholder-friendly
Returning capital to shareholders is considered shareholder-friendly (“rewarding” shareholders). Why? A dividend is only a distribution of retained earnings or paid-in capital. Dividend payment decisions generally don’t create or destroy long-term value, it’s just a transfer of capital, mostly less taxes.
At present Alphabet/Google sits on a huge pile of cash. The pressure is building on the management on what to do with the cash. But why the rush? We own Google and would rather prefer management look for the next YouTube, Waymo or Android instead of paying a regular dividend or do annual buybacks. Finding the next great acquisition or allocation takes time, and it also depends on the earnings multiples and the mood of Mr. Market. We’re happy that Google is building cash, and can only hope they are patient, even though the founders have left the daily operations. We believe investors in Microsoft are happy about the acquisitions done in the last ten years. This seems like a much more wise allocation than “rewarding shareholders”.
Sometimes the best course of action is to wait or do nothing. We never know when Mr. Market gets depressive mood swings. In the long-term, it pays off to be patient.
As a matter of fact, we can say that a dividend does not do much for an investor:
Dividends do nothing for shareholders
Managements often mouth that paying a dividend is doing something for shareholders. It is precisely the opposite. Instead they are saying, “Sorry, we can’t do anything with it; see what you can do. Good luck!
Dividends do nothing for shareholders unless it’s reinvested. When the burden of reinvesting is transferred to the shareholders, it means you have to get off your ass!
Many investors don’t invest in for example Berkshire or Markel because they don’t pay a dividend. Would Berkshire’s shareholders be more wealthy if Berkshire had paid a rising dividend? Of course not! Berkshire could, but shareholders are happy there is no dividend. Not receiving a dividend means that your capital is at work!
Most investors are usually ignorant of what we don’t see or observe, we only value what we see. But every investor has both limited capital and time, and priorities need to be made. At the same time, the board and management must carefully evaluate the best use of capital.
To our knowledge Philip Morris (PM)/Altria (MO) has been the best performing stock over the last century. Both companies, after the split in 2008, happen to pay a juicy dividend. What is not to like? Well, perhaps the performance would have been better if they focused less on the dividend and more on buying back shares? “Unethical” companies have historically been trading at lower multiples than the average of the market, according to US Mutual’s Vice Fund and Marcin Kacperczyk/Harrison Hong research called The Price of Sin: The Effects of Social Norms on Markets (2006).
Perhaps Altria would perform better if they alternated between dividends and buybacks? Unfortunately, we can’t calculate the alternative with certainty because the world unfolds differently under changing assumptions, but we can make some rough estimations.
By reinvesting the dividend, Altria has returned almost 18% annually in the ten-year period from January 2009 until the end of 2018. Not bad! But this assumes no taxes on the dividend, which means most investors would not manage this return. If Altria instead had focused on buybacks (which is tax-free) and skipped the dividend altogether, we can safely assume total returns would have been 18% (all things being equal).
We, as investors, should think more like Warren Buffett: Through his lens, dividends appear different than they do to most investors. He has a complete rational mindset where he quickly evaluates the opportunity costs. This article has some excellent quotes from Buffett and Munger about this issue, and we end this paragraph by copying one quote:
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.
Dividends are taxed, capital appreciation less taxed, and buybacks Not Taxed
Focus on after-tax returns, and run all transactions by tax counsel.
The Outsider, William Thorndike, page 219.
Unless you have a sheltered or tax-deferred account, you receive the dividend less taxes, which obviously means less to reinvest. This is of course a real headwind when compounding. Opposite, capital appreciation is only taxed when the gains are realized and only taxed on the difference between the cash proceeds from the sale and the cost basis of the shares. You can “engineer” your tax bill by for example selling less appreciated stocks to create “income”.
Buybacks are tax-free, and potentially more powerful if done at opportunistic valuation multiples, and add more flexibility:
Dividends are inflexible
A dividend doesn’t leave you with many choices: you have to accept delivery, whether you want it or not.
Let us summarize the reasons why a buyback is much more flexible than a dividend:
- You are forced to receive a dividend, while a buyback reduces outstanding shares. If a company buys back 3% of the company, your holdings increase by 3%. To pay yourself a “dividend”, simply sell 3% of your holdings. Or, you can do nothing and be happy with increased ownership.
- You can defer taxes, even engineer taxes, via capital gains when you sell shares to get “income”.
- Dividends are paid out from shareholder’s equity, while the sale of shares is usually done at a premium to shareholder’s equity (above book value).
- Dividends are taxed, buybacks are not.
- Whether or not to pay/increase/lower a dividend is up to the Board of Directors. This means the BoD is your “income trustees”. The same goes for buybacks, but the latter offer to defer taxes: Because buybacks are a tax-free distribution it provides shareholders with the option to defer taxes until they chose to sell their shares.
A dividend disciplines the management
A company with a goal of growing the dividend has made a commitment. Dividend investors believe this creates accountability from management. Perhaps it will, but we doubt it.
Some shareholders are happy to receive a dividend to avoid management “wasting” capital. Supposedly a regular and growing dividend limit “empire building”. This statement is repeated endlessly, but we’re not sure it makes any sense. These are more relevant questions to ask:
- If they can “waste” retained earnings, what makes you sure they don’t “waste” for example the working capital?
- Why would you invest in a company in the first place if you fear the management will squander the capital?
- Management is one of the key decisions in any investment, and you need to “hire” only the best people. Does Costco’s regular dividend make Craig Jelinek a disciplined CEO? What does paying a dividend contribute to Costco’s intense focus on customer service? We fail to see the connection.
A dividend makes the shareholder complacent
Perhaps the management makes the shareholders complacent by paying a dividend? Shareholders are happy as long as the quarterly check arrives, and apart from this management can do whatever they want with suboptimal decisions and allocations.
Furthermore, perhaps the dividend track record becomes more of a liability than an asset for the management? If a company has paid a growing dividend for 30 years, it has become “sticky”. Somehow management and investors think it’s more important to keep this track record, instead of allocating resources to for example a promising investment opportunity. Exxon in 2016 comes to mind.
We believe it’s safe to assume the shareholders of Berkshire and Markel are different from those in dividend-paying stocks. Dividend stocks risk having complacent shareholders that mainly care about their dividends, “coupon-clippers as Benjamin Graham called them, while Berkshire and Markel want owners that truly understand their business and the principle of capital allocation and compounding. Management that promotes a rise in the dividend could be a sign focus is wrong?
Dividends make management less flexible
I know a lot of people have very strong and definite plans that they’ve worked out on all kinds of things, but we’re subject to a tremendous number of outside influences and the vast majority of them cannot be predicted. So my idea is to stay flexible. …My only plan is to keep coming to work…I like to steer the boat each day rather than plan ahead way into the future.
– Henry Singleton in The Outsiders by William Thorndike, page 53
Making a “promise” to pay 50% of earnings as dividends certainly do not make the allocations flexible. In the shareholder letter of 1984 Buffett argues that management should choose whichever course that makes sense, retained or distributed, although he mentions a consistent dividend is understandable. However, it’s just a very few companies in the stock universe that has a business model and economics that can sustain a steadily growing dividend.
Buffett ends his discussion about dividends in the 2012 letter like this:
We will stick with this policy as long as we believe our assumptions about the book-value buildup and the market-price premium seem reasonable. If the prospects for either factor change materially for the worse, we will reexamine our actions.
Management makes suboptimal decisions to continue raising the dividend
Sometimes it makes sense to pay a dividend, and sometimes it does not. For example, back in 2016 after the sudden fall in the price of oil, the dividend of Exxon Mobile was questioned. Countless articles on for example Seeking Alpha centered around if Exxon could maintain their dividend aristocrat status. The dramatic fall in the price of oil forced Exxon to practically borrow money to pay the dividend because the dividend payout ratio was above 100%, which of course is pretty absurd. S&P downgraded Exxon from AAA to AA- in April 2016, partly because of the dividend:
“We believe Exxon Mobil’s credit measures will be weak for our expectations for a ‘AAA’ rating due, in part, to low commodity prices, high reinvestment requirements, and large dividend payments.”
When companies borrow to pay dividends, do they have a vision on how to best build their companies? This is yet another example of how sticky a dividend becomes, and is more of a liability than an asset. Even today, in 2020, we can read analysts arguing about how to make sure Exxon pay a growing dividend:
To continue to grow the dividend, it makes sense to wring out non-core costs and strip that outspend down a little bit.
The success behind the eight managers in The Outsiders is mainly due to their clear evaluations of alternative costs. We believe dividend investors have a lot to learn from reading Thorndike’s book.
The reasons behind the success of Warren Buffett and the other successful allocators are their common sense, rational decisions, ability to change, and the removal of errors. Their only focus is the best total returns, they don’t have a particular investment strategy. They are investment agnostics and have no preferences toward any investment as long as it makes sense considering the alternatives. This article has provided many arguments for reasons why not to become solely a dividend growth investor. The focus should be to find investment opportunities that offer good long-term returns.
Where do we find the best allocators? We believe a useful heuristic is investing alongside managers that have real skin in the game. History indicates skin in the game creates market-beating returns. This gives you better odds of being aligned with managers thinking and acting like owners. This is important because smart allocations are not that complicated, but the managers need to think independently and be patient. Management can only be patient if shareholders are rational, long-term, and having an understanding of what it means to be “rewarded” in the long run.
William Thorndike gets the last word with this quote from page 217:
This outsider approach, whether in a local business or a large corporate boardroom, doesn’t seem that complicated; so why don’t more people follow it? The answer is that it’s harder than it looks. It’s not easy to diverge from your peers, to ignore the institutional imperative, and in many ways the business world is like a high school cafeteria clouded by peer pressure. Particularly during times of crisis, the natural instinctive reaction is to engange in what behaviorists call social proof and do what your peers are doing. In today’s world of social media, instant messaging, and cacophonous cable shows, it’s increasingly hard to cut through the noise, to step back and engange Kahneman’s system 2, which is whewre a tool that’s been much in the news lately can come in handy.