Last Updated on March 6, 2021 by Oddmund Groette
Investing in dividends has gained quite some momentum with increasing popularity as the interest rate goes down. Dividends have become replacements for coupons for many investors. The process has left several dividend investors chasing high yields and risky stock portfolios.
Thus, be careful if you are a dividend investor. You shouldn’t only buy dividend stocks. The main aim should be the total return. Many dividend investors find themselves chasing high yield, not the total return.
It comes as a surprise to many that Berkshire Hathaway has not had any dividend for the past 55 years. They have learned to attract shareholders who understand the benefits of long term value creation and where compounding is the best option. In their case, the investors think like the owners and understand the flexibility and increasing value, the best course for capital allocation.
There are many cases where investors excessively focus on dividend-paying stocks. while yes it’s true that dividends are a great source of income but there are many misconceptions, potential risks, and significant errors along the way. Following are some of the reasons why investing in dividend stock may not be a great idea.
Any investor taking on to selecting their own stocks is in itself a risk that is not necessarily compensated. And the major problem that comes with overly focusing on stocks that make dividend payouts is that it quite often heads towards investing in individual stocks. Diversification, however, is the easy way out of this risk.
But even though diversifying eases your way into eliminating risks, you won’t be paid for it. Moreover, holding five or ten stocks in your portfolio is basically taking on a lot of single stock risk. Buying a low-cost, highly diversified index fund is an easy way into diversifying and avoiding unsystematic risk, ie. risk that is related to stock picking and not having a diversified portfolio.
Choosing stocks by yourself can also manage risks in the situation. It has been quite clear that even with millions of dollars worth of resources at hand, a professional can’t possibly choose stocks good enough to depend on top index funds over the long haul even after paying the cost of the process, especially on an after-tax basis. If an investor has a certain value of their time and the professionals have a low possibility of doing the job, an individual investor should be very restrained about giving it a shot.
Overlooking total return
One of the widely faced issues, when an investor focuses excessively on dividends, yields, or income out of an investment, is that they often fail to acknowledge the most crucial component – Total Return. The entire take on focusing on dividend yield and which stock is paying high dividends leaves the significance of long term return or total return out.
For instance, let’s imagine two stocks, the first one has a yield of say 10%, and the second has a yield of 0%. The question arises, which one would you choose to invest in. Even though the general rule that follows among young investors is to follow high yield, the answer to the above question is simply none based on just the dividend yield factor. There is basically not enough information to justify your decision.
Chasing a high yield is not as beneficial as the attractive numbers that follow this trend. While a high dividend yield may provide a hefty dividend payout, it fits nowhere in your planning for long term return or expanding your earnings. Paying attractive dividends is a sign of a company’s lack of motivation towards their future plans and investment for growth and potentially increasing returns. This makes the investor lose focus on their total return.
Moreover, a high yield of low valued stock and a low yield of high-value stock can reap the same dividend payout, but obviously, it might as well be wiser to go with a high-value stock once you have systematically gone through your checklist before investing in a stock.
One of the most blatant forms of misconception often conceived by many dividend-oriented investors is that they end up considering dividends as bond-like entities for periodic income. Even though one of the positive aspects of dividends is a potential lack of volatility but still there are plenty of fluctuations. Moreover, it is important to understand that companies that are known for being strong dividend payers have also ended up bankrupt plenty of times.
No matter how many pros are attached to dividend stocks, they are stocks at the end of the day. More importantly, dividends are simply distributions from a company’s end, motivated out of goodwill and appreciation for the trust. And yes, at times to maintain a healthy track record for dividend payments, like we currently see in Exxon Mobil.
The question is of obligation. Where dividend payments are not made compulsory to be paid to the shareholders, bonds are legally bound to be paid. Bonds can very well be called fixed income as compared to dividends. Because you never know when a company makes the decision to invest their profits into retained earnings – funds that are kept aside, used for further expanding the growth and potential earnings in the future.
Dividend distributions are not exactly as much of a sweet deal as an investor may come to think of, even though many qualified dividends are considerably taxed at a lower tax rate than the general income. This is one of the crucial reasons behind the fact that Warren Buffett’s Berkshire Hathaway has not paid a single dividend for decades.
Probably the biggest advantage of a situation where dividends are not distributed is that it gives investors the power to decide when to pay taxes on their share of the company’s earnings. An investor can even choose to declare their own dividend at a moment by simply selling their part of the shares. However, in a year when there is no income needed, nothing needs to be taken and hence no tax needs to be paid.
Moreover, it’s better to focus on after-tax returns and have all the transactions go through tax counsel. Generally, if you don’t have a tax-deferred account there is a high chance that you receive the dividend less which costs you reinvesting and ends up creating a problem with compounding.
This is a thumb rule for the company that if they do not have any plans for a potentially high return investment project, then it’s better to consider paying dividends. Given that we have already established that taxes can be inefficient in the above point, it can become quite hard to reverse dividend decisions.
Cutting a dividend in simple terms is supposedly considered bad and the entire business in the world of investment contributes a lot of their time and resources to figure out which companies can maintain or slash their dividends. However, It is actually quite common for companies to stop paying dividends, once they start paying them regularly for reasons like maintaining a regular dividend-paying track record and several other reasons. For example, 26 of the original 59 Dividend Aristocrats in 2007 were no longer included in the list in 2016. The GFC in 2008/09 is the main culprit for this, but it shows the dangers of survivorship bias in most analyses: We only measure the winners, not the losers.
Practically speaking, there are not many cases where dividends are cut unless the company is pressured into doing so. In fact, there is a practice followed famously by companies like Costco and WR Berkley. It’s called a special dividend where a company intends to pay a low but regular dividend and in addition, pay a special dividend every once in a while. This take seems to be a better and sensible approach that also leaves scope for switching between buybacks and dividends, or whatever seems to be making the most sense at the time of distribution. Both companies Costco and WR Berkley using this method have been known to be outperforming the market for decades.
Is there a possibility that by paying regular dividends, the management is actually making the shareholders complacent? It is quite obvious for shareholders to feel satisfied as long as they are receiving their timely checks. But apart from that management becomes free to do anything they want with poor decisions and allocations.
Moreover, there is also a possibility that maintaining a regular track of dividend payment can become more of a liability than a treasured asset for the company’s management. It is quite common to find an extensively long record of growing dividends, for instance, 30 years, to become ‘sticky’. But sadly, it has become quite a pattern for some company’s management and investors to believe that maintaining a regular dividend-paying track record is more important than finding a promising opportunity for the company to reinvest the funds in.
The conclusive line to keep in mind is that being an investor is about focusing on the total return. Dividends are not income, they are distributions and highly risky. Even though the figures seem attractive, they often mess with long-term growth and higher returns in the future. Every penny that a company is paying in dividends is a penny they are not investing in their own company. This takes away the trusted and assured ways of expanding one’s income like compounding. Investing in the company’s future and growth increases the value of the stock as well as expands your returns. That’s exactly why high yield should not be chased as they do not reflect well on a company’s plan for growth in future returns.
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Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.