Why I Prefer Dividend Paying Stocks 13 comments
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Companies can be categorized in all sorts of ways, like small caps, consumer discretionary, industrials, etc. Two general categories are dividend paying companies and non-dividend paying companies. During the course of this bear market, I've been thinking about their advantages and disadvantages, and about stocks in general.
Although it is a rather plain fact, I don't think most of us usually regard shares of stock as basically pieces of paper that provide documentation of our rights as owners of a business (it's slightly more complicated, of course, but this simplification should do).
When individual investors buy shares of stock of businesses that we cannot afford to buy controlling interests in (I mean companies listed on the major exchanges, and I don't mean small businesses like the corner store), we buy pieces of paper that we hope we can sell to someone else at a later time for a higher price. This is true of both categories of companies, but less so with dividend payers.
With dividend payers, you get a cash deposit into your brokerage account or a check in the mail one, two, four, or more times a year. To a certain extent, owning shares of a major stock exchange listed dividend paying company is close to owning a large or full stake in a small business. You get paid regularly for your ownership stake. While having all the same rights that come with owning a non-dividend paying company, owning shares of a dividend paying company gives us cash on a regular basis that we can use to buy other stuff.
With non-dividend paying major stock exchange listed companies, we buy only with the plan to sell our stake to someone else for a higher price at a later date. It struck me recently that with these types of stocks, we're not really getting anything "real" for our trouble. That is, we have to sell them to derive any benefits from them. Yes, we can go to shareholder meetings, contact management, etc, but most of us, by ourselves, can't really affect the course the business takes.
And even if we manage to affect the course of the company's business, short of making it pay dividends or hiring us, we don't really get anything in return until we sell. Owning shares of a non-dividend paying company is like owning a painting, except we can derive aesthetic enjoyment from the painting before we sell it. If you want financial benefits, you cannot own a non-dividend paying stock forever.
Suppose I bought shares of Berkshire Hathaway (BRK.A) when Warren Buffett did, and, like him, I never sell a single one. Assuming I have no descendants and don't care about the government or charity, I'd be better off had I never bought them. Unlike a deed to a house, a non-dividend paying stock certificate doesn't amount to anything until you sell it. You can live in a house, on the other hand.
There are market booms and busts. Share prices for both dividend and non-dividend paying companies fall during market busts. Suppose company A is a solid dividend payer that will last and grow for another thousand years. Suppose company B is a solid non-dividend paying company that will last and grow for another thousand years. What advantage would you have in owning company B your entire life? Your paper net worth would be high, but without selling you wouldn't be able to do anything with that potential money (yes, you can sell calls on your shares or use them as collateral, but I consider this a part of selling because that's what these transactions can lead to).
Suppose there's a major crisis and the stock markets are closed for an extended period. You will find it exceedingly difficult to sell your shares (and likely for a much lower price) if you suddenly need the money (you'd have to find a buyer, and then either transfer your stock certificates to him or enter into a contract to do so at a later date). Company A, on the other hand, will continue sending you checks. At such a time, I'd bet potential buyers would be more interested in company A than B.
Though seemingly likelier now, an extended market closure isn't that probable. But a market bust would still hurt company B owners more than A owners. Investors typically look to the future to decide how much to pay for a company's stock. They're usually willing to pay more than the company's book value. Two common measures are share price multiples on earnings and discounted future cash flow. During good times, investors are willing to pay more for earnings and cash flows. In bad times they're often very stingy. A company can double its earnings while its stock price and share counts stay the same. The P/E ratios (forward and trailing) just contract (in this example by 50%). A company can keep increasing its earnings while potential buyers, pessimistic about the future, can be willing to pay less and less. With company B this probably means that you have to wait for investors to get more optimistic before you want to sell. With company A, it means the dividend payments you receive will probably be higher.
The stock market is to a large extent a Ponzi scheme. Future buyers have to pay more than past buyers for participation to be worthwhile. In a certain sense, it can't be sustainable. As we saw with the housing bubble, it took more and more money for homeowners to get the same percentage return (and down payments as a percentage of purchasing price kept going lower and lower). For example, buying an asset for $2,000 and selling it for $4,000 requires finding a buyer willing to pay $2,000 extra for one to get a 100% return. That buyer has to find someone, call him C, willing to pay $4,000 extra for him to get a 100% return. C has to find someone willing to pay him $8,000 extra for him to get a 100% return.
It doesn't take long before some future buyer, call him Z, can't find anyone willing to pay him double what he paid. Z and, more likely than not, prior owners, have to settle for lower percentage returns. For example, let's say some buyer, F, paid $400,000 for the asset. Whereas C doubled his money when he found a buyer willing to pay $8,000 extra than C paid, if F finds a buyer willing to pay $8,000 extra, he'll only make a 2% return. F has to find someone willing to pay $40,000 extra just to get a 10% return.
Eventually, the potential returns are so low and potential losses are so high that there are no willing buyers. No asset can forever increase in value.
This makes dividend paying stocks worthier investments. While like any other asset these stocks can't go up forever, they pay you regularly. Their earnings don't have to increase indefinitely, they only have to remain stable.
What I'm taking away from all this is that non-dividend paying large cap stocks are worse investments than large cap dividend payers and small cap non-dividend payers. Small cap dividend payers are probably the best lifetime stock investments. When buying non-dividend paying companies, we take a gamble on future buyers' willingness to pay more than we do. When we buy dividend payers, we make the same gamble, but we also take into account how much we will be paid in the meantime. If a stock will pay me $x a quarter for the rest of my life, what do I care if future buyers are willing to pay less for the stock than I did (as long as $x does not decrease substantially due to inflation)?
Depending on how we distinguish investing from gambling, I think the latter approach is more worthy of being called investing than the former.
These are just some random thoughts I've had recently. There are probably a few errors in my thinking below, but I still consider it worth thinking about and posting. A previous post on the subject can be found here.
Disclosure: I don't have any positions in any securities mentioned above. It would be nice, though, to own a good number of BRK.A shares. Although if this were the case, I'd have already exchanged them for cash.
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This article has 13 comments:
If I invested money in a local company I am going to expect to get something in return. Now it may take a while for that company to generate a profit, but once that company becomes successful, I'm going to expect to get some payout from my investment.
I would not want to own part of a company knowing that they are never going to give me any cut of the profits. Why would anyone want to own a company that doesn't give them anything in return? Why would anyone want to buy that from me?
But obviously, since it appears most stocks pay very little or nothing in dividends, most people don't share the same view as I do.
But wait, less than 3% annual gains? History suggests that the long-run returns are much higher! What gives? The rest of your gains represent nothing but the increase in the money supply, which is currently running anywhere from 2% to 40% per year depending on your preferred metrics. In fact, the money supply usually grows much faster than real GDP, meaning that the majority of nominal capital appreciation in stocks is not real. But you'll be taxed on it anyway, which further reduces your real return. In reality, long-term indexers in taxable accounts are unlikely to achieve any significant real return. Those in untaxable accounts may do slightly better but given the massive increases in the money supply it would take only small changes in measurements or assumptions to make the difference between a real gain of 2% and a real loss of 3%.
That's why dividends are so important. They represent the vast majority of all real returns on stocks. Over the past 10 years, that's been true in nominal terms, but it's always true in real terms. But, one might ask, what do you do with dividends? The most obvious answer is to reinvest them, as most traditional advisors recommend. And, indeed, this can be a good way to compound your gains. But it's very sensitive to market conditions; reinvest a 4% dividend at the wrong time and your long-term real return on it will be negative for 50 years. I would suggest this only when you believe that the stock is very attractively valued. Much better is to siphon off dividend payments and store them in the form of gold. The real return on gold is zero, but you've already received your return. Putting it aside in this fashion builds a risk-free pool of past gains that can either be saved for retirement or invested at the right time.
if the company takes what they would otherwise pay in dividend and reinvests it in the company, which then grows sales or makes it more productive etc, in the end increasing earnings significantly, then someone would definitely want to pay you more for your stock.
said differently, if the company can take the money they'd otherwise pay as a dividend, and invest it for a better return than you could with the dividend itself, you'd rather have the company do that. Your share of a company that can do that will be worth more than the dividend plus the share of a company that can't/won't.
and total return is why we're all here.
Mr Author, I'm amazed that you really feel that way. Perhaps this is just stream of thought and you'll come back and edit that line?
Buying companies that create value is what this is all about. Companies that take good ideas, develop them into products that consumers will pay for to raise their standard of living. Creating value. Houses don't do that. Houses only go up with the price of inflation, much like BearFund's gold.
BearFund, you have no interest in compound returns? Interest on interest?
Why not just take all of your investable income from working and buy gold? Why bother with the middle step of taking some risk in a dividend paying stock?
First you are interested in taking a little risk and earning a dividend, then immediately after you have it you want no more risk and you put it into a "risk-free" pool of gold b/c you never know when a good time to invest the dividend is.... oh wait, then you say it could be invested at the "right time".... ? Going to fill us in on when that is? You're talking out of both sides - which do you mean?
I'll counter and say you are taking too much concentrated risk in dividend paying stocks -- you're subject to excessive risk that companies that forgo investing in their businesses in order to pay dividends are at a competitive disadvantage to companies that don't. Those companies can build cash and invest and/or make acquisitions at opportune times... also subject to risk that tax laws change... further, dividend chasing portfolios often are concentrated in just a few sectors... I could go on...
The thought that the company cannot prosper because it is paying a dividend is nuts. There is no guarantee that a companies shares will go up because there is no dividend payed. lol You can bet that the CEO's salary will.
All that matters is who can get a better return on that money -- you or the company. If you crave a dividend, you are saying that you can get a better return on that money than can the company. That may well be true in some cases - there are plenty of poorly run companies with no prospects of internal return - but it's not a truth to live by.
If the company can get a better return by internally reinvesting it, then it's clear you'd rather get no dividend and have the company do that. Your stock of that company will be worth more than the dividend + stock of a company that can't.
As for when the "right time" might be? Market close on Monday was one of those "right times" for taking a chunk of gold out of the cellar and exchanging it for solid stocks that will pay 4-10% dividends for decades to come. Which is exactly what I did. No doubt there will be more, perhaps even better, such opportunities. You don't have to buy at the exact bottom to make money, you just have to buy when the current and future yield is high enough to be worth the risk. Because of the mega-boom in US stocks over the past 25 years, that mostly means the only time you will be compensated for the risk is after deep waterfall plunges. Even the best companies are overvalued 95% of the time now. That is why I rarely believe in automatic dividend reinvestment. And of course when prices really get out of hand I just sell.
Permabears use this persistent overvaluation as an excuse to do as you suggest, take no risk, and sit on gold and nothing else forever. That's fine if you have a source of income sufficient to meet your lifetime objectives without any returns. I'm not in that happy position, so I must take some risk. I try to take it wisely, which is to say when I'm likely to be paid for it. This is one of the rare times I think that just might happen.
FWIW, AAPL, last time they re-invested their cash in the company, they spent billions building a retail store network.... that is/was a much better return than one could reasonably expect an investor to get with a dividend payout. (though the value is not priced in to the current stock price, the value is there and it is/will be paying incredible returns...)
www.chicagogsb.edu/fac...