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Many dividend income investors are fond of citing the “Bird In Hand” theory when describing their investment philosophy.

Based on the adage that a bird in the hand is worth two in the bush, the “bird-in-hand theory” states that investors prefer the certainty of cash proceeds that derive from dividend payments to the possibility of higher future cash proceeds that derive from capital appreciation via retained earnings.

But this begs a question: Based on the logic of the “bird in hand” theory, why invest in stocks at all? Or even bonds for that matter?

Why part with one’s cash today (the bird in hand) to invest in a stock that promises to pay dividends in the future (the two birds in the bush)?

Isn’t cash in hand today better than dividends in the future?

It is interesting to reflect upon this question.

Investing For The Future

If you ask many income investors why they invest in stocks, they will tell you that they are investing for the future. Specifically, many will say that they are investing in order to obtain an income stream in the future that will enable them to retire comfortably.

But, wait a minute Mr. Bird Catcher! Let’s say you have $500,000 today to invest in your retirement – or that you plan to invest $500,000 into your retirement account over the course of a certain number of years.

Let’s say you expect to live for 10 years after retirement. If your only concern is to have cash to be able to live off of in retirement, why not simply put that money in a safe (bird cage) and take it out after retirement and disburse it to yourself at a rate of $50,000 a year?

Inflation, you may say. Ah, you macro speculator you!

OK. So, why not simply put that money in TIPS where you can guarantee yourself that your $500,000 will at least be worth what it is worth today in terms of purchasing power? Again, why not guarantee your $500K in hand rather than bet on dividends in the bush?

You might say that you are interested in increasing your wealth, not merely preserving it. OK. You could do that in several ways. For example, you could increase your wealth by investing all of your money in growth stocks, sell them at around the time of retirement, put the money in TIPs and live off of that. Or you could invest in dividend stocks, betting that those stocks will increase dividends for whatever number of years at a rate higher than inflation between now and the time of your retirement.

You are already retired are you? Why not put your retirement money in a safe or in TIPS and disburse it to yourself gradually? Why are you speculating on dividends in a bush?

Folks, when you are investing in stocks or bonds you are making highly uncertain bets on the future. You cannot predict dividends or dividend growth 20 years from now any more than you can predict capital appreciation 20 years from now.

You may say that if you are already retired that you need income now. That is incorrect. You need cash now. That cash could come by realizing the market value of the capital you own right now or by receiving dividends.

You might say that you prefer to receive dividends right now rather than draw down your capital. Why? You may say that if you draw down capital you will run out of money. Perhaps. But you could easily run out of money if you invest in stocks. You cannot simply assume that dividends will not be cut and/or that the future value of the stock you invest in will be worth equal to or more than the amount that you originally invested.

Both future dividends and future capital appreciation are birds in a bush – and the further out you project those future dividends or capital drawdowns the more uncertain those future cash payments will be relative to the bird in your hand right now.

Thus, the decision to invest in stocks is a decision to make a highly uncertain bet regarding the availability of cash in the future.

The question is this: Is speculating on future dividends fundamentally any different from speculating on stock price appreciation?

What Drives Stock Price Appreciation? What Drives Dividend Growth?

What drives stock price appreciation over time? Earnings growth.

What drives dividend growth over time? Earnings growth.

Hmm ... Sounds sort of similar.

Is there any difference? Obviously, there is no difference between earnings growth and earnings growth. They are both equally uncertain.

Because earnings growth is fundamentally uncertain, over time, both capital appreciation and dividend growth are fundamentally uncertain. Indeed, over long enough periods of time, their degree of uncertainty is essentially indistinguishable.

Dividend Speculation, Stock Price Speculation

So, is their any difference between projecting dividends and capital appreciation into the future? Yes. Furthermore, I actually think that dividends deserve some level of premium. And in my next article, I will explain why.

The key point I want to drive home in this article is this: The “bird in the bush” metaphor is entirely too glib. There might be a kernel of truth in it, but enough for it to possibly be deceptive to some people.

The fact of the matter is that investors that invest in dividend stocks are letting go of a bird from their hands today in order to chase two in the bush. And they will be chasing those birds in a bush a whole bunch of years in the future – a bush that does not even exist today (think of the bush as the macro and microeconomic environment in which companies will be operating in). Investors should understand these risks fully. There is nothing “in the hand” about dividends or dividend growth in the future.

Please recall that in a recent article I demonstrated that a stock investment that pays a dividend of 5% and grows that dividend at 5% per annum will take an extraordinarily long time to pay an investor enough cash dividends to equal the value of the cash (i.e. the bird) that he is parting with today. Specifically, I showed that assuming an inflation rate of 3.0% per annum it would take 17 years of growing dividends for an investor simply to recoup the real (inflation adjusted) value of his initial investment (the bird in hand). More realistically, assuming that investors demand 10% to part with their cash today in order to make an equity investment (equity cost of capital) it would take 66 years of dividends growing at 5% per annum for an investor to simply recoup the present value of his initial cash investment (the initial bird in hand).

Who can predict dividends or dividend growth 17 years into the future? And the notion that anybody can reliably predict dividends or dividend growth 66 years into the future is almost laughable. That’s true even if you are talking about “Dividend Champions” such Franklin Resources (NYSE:BEN), Family Dollar Stores (NYSE:FDO), Gorman-Rupp Company (NYSEMKT:GRC), Helmerich & Payne (NYSE:HP), Hormel Foods (NYSE:HRL), Illinois Tool Works (NYSE:ITW), McGraw Hill (MHP), Nucor (NYSE:NUE), Stanley Black & Decker (NYSE:SWK) or Washington REIT (NYSE:WRE).

Conclusion

Chasing dividends in a bush 17 or 66 years from now is quite a quest. So, before you decide to part with your hard-earned cash in order to bet on dividend stocks under the premise that the capital value of your investment in the stock market does not matter and that only dividends and dividend growth matters, you might want to ask yourself how good you are at predicting dividends 17 and or 66 years into the future. If you are a little rusty on those skills, you might want to reconsider the dogma that the market value of your stocks in the interim don’t matter. It may matter a great deal. For example, if the dividend is cut or eliminated three years from now and you end up selling the stock, the stock price might end up mattering a great deal.

In this case, you may very well have been better off having drawn down a portion of your capital in hand rather than releasing it into the bush, because tomorrow, when you try to get that capital back (the original bird) you may find that it will be worth considerably less in nominal and/or real (inflation adjusted) terms. In fact, in specific cases, it might make sense to concentrate a bit more on the birds that might be securable in the short term rather than focusing exclusively on the ones that might be available in the more uncertain future.

Source: Is A Bird In Hand Better Than Dividends In The Bush?