The only "thing" that drives growth is earnings power. It does not matter if a company decides to return some of the earnings to the shareholders by way of dividends, or decides to reinvest the profits into their own business for future growth.
The dividends are immaterial. Most of us would acknowledge that fact as it applies to the accumulation phase, but the same holds true in the spending or retirement phase as well.
That's not to say that dividends are not a useful measuring stick. In fact a great basket of good dividend payers that grow their dividends over time has historically beat the broad market indexes. To be more specific, dividend growth is a value finder, much like water dowsing. Dividend growth is that divining rod, it finds that value or potential for continued earnings power. So certainly using dividend growth as a style for your equities in the accumulation or spending phase is completely reasonable and should reap wonderful returns if you are a patient and intelligent investor. But in the end the reinvestment or spending of those dividends is completely irrelevant. The dividends are simply a portion of the company's value. You can have that value in dividends or share price for harvesting. The only metric that will determine your success and the ability to perhaps outpace inflation is the value and the earnings power of the company.
It is quite surprising that the debate continues and even Nobel Laureates will write that the only thing that matters is dividends, but of course, they are wrong. How could they get basic math and value so wrong? Dividends largely reflect past and current earnings power (that is, they have enough of profits that they can invest in their own business and return some to their shareholders). Moving forward it's about momentum; enough of the companies that have increased their dividends in the past have created businesses and business models that will allow them to succeed in the future. Pick enough of them, and you might get that market beat because you are investing in a basket of good companies (as Ben Graham liked to write) with earnings power.
This from a Seeking Alpha article from Steve Hassett. You will find the reference links in his article, to the studies. Steve will even go over some of the math for you.
This is wrong in theory and wrong in practice. On the theoretical side, Franco Modigliani and Merton Miller posited in their famous article on the "irrelevance" of dividend policy, that it is the underlying expected earnings and cash flow of companies, not their dividend payouts that determines market values. Dividend policy does not impact valuation.
Dividends have nothing to do with the company's ability to create value or earnings. Of course it's earnings first, dividends second. If you believe that simple fact, then you likely believe that dividends don't really matter.
While it's a little easier for many to accept the fact that the dividends don't matter in the accumulation phase, the argument or fact becomes a little closer to blasphemy in the spending or retirement stage. But the more research and modeling I did on retirement funding it became apparent the dividends don't matter in that spending stage as well. And it certainly runs contrary to my initial opinion and instincts.
Let's use a simple analogy. Joe and Theresa operate their own orange groves. The success of their businesses depends on how many oranges they can produce. Theresa likes to give away 10% of the oranges directly to her shareholders. The shareholders like that because they can see the oranges, and taste them. They can see the fruits of the labour (pardon the pun). Theresa's operation has the potential to produce 2 million oranges a year; some of her trees are a little past their prime.
Joe hardly ever offers the oranges to his shareholders. He has been reinvesting in planting every year and now has the ability to produce 2.5 million oranges a year and he's adding another 200,000 oranges of production a year.
We all know what business we would want to be partners in. The greatest potential to provide earnings and money to spend in future years is present in Joe's business - he has more production (earnings) power. Even if Joe's shareholders demand some cash (oranges) and he sells 500 trees and he still has the ability to produce 2.45 million oranges, with ample production growth, the business is still in great shape. If it has the ability, moving forward, to produce more oranges than Theresa's operation, Joe's operation is a better business to own - even though Theresa has now increased her orange payout to 15%.
But enough about oranges.
I am now in the Warren Buffett camp on retirement planning (that there should be a considerable amount held in stocks), I just disagree on that amount that should be allotted to bonds. As I detailed in this article "The Time Warren Buffett Got It Wrong", a very aggressive allocation to stocks is very important for many in the retirement phase, due to the obvious fact that the best performing asset class is typically our greatest opportunity for long term gains and protection against inflation. Benjamin Graham showed that stocks beat inflation about 80% of the time, so there is no guarantee.
Warren suggested that his estate hold 90% stocks (broad market S&P 500) (NYSEARCA:SPY) and 10% bonds. As research suggested, an all-stock portfolio will provide many, many decades of income with an inflation adjusted 4-4.5% spending rate. In fact an all-stock portfolio would have a 95% success rate in that regard.
A retiree who was invested completely in the S&P 500 and began his or her retirement in 2004 would have been able to draw down 4% annually with a 2% inflation adjustment and would have seen a $1 million dollar portfolio also increase in value to $1.28 million. That investor is using the dividends and selling shares of his index ETF. Even from a very unfortunate 2008 start date that retiree would have his inflation adjusted income and the portfolio would have increased in value from an initial $1 million. Given that, it becomes obvious that one can use dividends and sell shares and fund retirement. The metric that matters is the earnings power of the companies that you hold, or the earnings power of the total market if you hold the index.
Larry Swedroe has demonstrated this fact with his simple portfolio models that use the greatest risk-adjusted growth potential for the stock component - small cap value stocks. Between 1927 and 2010, small-cap value stocks outearned the S&P 500 by roughly four percentage points annually.
On dividends or not Larry explains...
There is no difference in expected returns between two stocks with the same P/E, P/B, etc and one pays dividends and one does not.
Using the small cap as the stock component Mr. Swedroe creates models that deliver the returns of the broad market with portfolios that hold just 32% equities and the rest in safe bonds. That creates the returns with much lower volatility. That is certainly what an investor would be seeking in any stage, accumulation or retirement. In retirement that investor gaining the market average (let's just say) of near 8 to 10% annual returns would be just fine living off of the bond income, dividends and harvesting shares or units. There is growth that is typically well above inflation.
That investor is protected by the growth potential of the equity assets. That growth can come from various equity sectors or styles of investing.
When an investor holds a very high concentration of stocks, the glitch can be a very, very poor or unfortunate start date for retirement. Start your retirement just prior to two or three years of stock market declines and that can spell trouble for your portfolio value, and retirement standards. The all stock portfolio would have been crushed with a year 2000 start date. There is the need to protect the equities against years of decline with cash and bonds. As I demonstrated in the Buffett article, even starting retirement in the year 2000 with 2 years of cash and a balanced portfolio of 60% SPY and 40% Treasuries would have provided the inflation adjusted income and a 2013 year end portfolio value above the year 2000 start value.
The portion redeemed from equities was a combination of the S&P 500 dividends and harvesting of shares, tapping into that total return. Again, it would not matter if the investor was paid by 3% dividends and 6% capital appreciation (harvesting of shares) or 5% dividends and 4% capital appreciation - if the earnings growth of the equity holdings is equal.
When we hold $1 million worth of companies, we hold $1 million worth of earnings power. If a high yield dividend portfolio stands at $1 million, and a lower yielding equity portfolio stands at $1 million, and the both have the same earnings power, they will provide equal growth and potential protection from inflation. It does not matter if an investor had recently harvested $40,000 of shares from the lower yield portfolio taking the value from $1,000,040 down to that $1 million.
It also does not matter if that inflation protection comes from that increasing dividend stream or by an increasing stock price supported by earnings growth; because the dividends and the share price are both funded by that same earnings growth.
I understand the lure and emotional attachment to dividends and income. It certainly feels good to "get paid". It feels like a pay cheque because it's real money (taken out of a company). But we should also realize that there is no need to chase yield in retirement, even though that is a stage that we are typically advised to bulk up on yield from stocks and bonds.
Is a typical dividend growth investor in any danger because dividends don't matter? No, not at all. We know that dividend growth if tailored for total return can deliver a market beat with respect to total return. The dividends are a comfort zone. They make investors feel safe because it's something to watch instead of the share price. But of course during a real correction, most investors will feel little comfort from the dividend stream, and as we witnessed in 2007-2009 dividends can get cut, reduced or eliminated at an incredible pace. Dividend investors should not have a false sense of complacency.
In this article "Cutting My Dividends By 35%, Improving My Dividend Growth Portfolio", I applied the above investing truth to my dividend portfolio. I will also carry that through to the retirement funding stage resisting the lure of yield. I know that we will be "better off" holding the better performing (total return) equity asset indexes or ETFs in the spending stage.
But I have to admit, resisting the lure of that easy-to-see and watch dividend stream will not be an easy task.
Happy investing, and be careful out there.
Disclosure: The author is long SPY, VIG, EWC, EFA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Dale Roberts is an investment funds associate at Tangerine Bank (formerly ING Direct). Dale's commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.