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In my previous article, Less is More: Why I Prefer Low Yield Stocks, I gave five reasons why low yield stocks tend to make better long term investments than high yield stocks. This article goes into more detail explaining the effect of taxes.

Imagine four types of companies: A, B, C, and D, all four of which generate 10 percent total return annually, about the same as historical stock market returns.

The A type company is a fully mature company that has no more reinvestment needs, so it pays out all its earnings each year, for a 10 percent dividend yield, and zero growth. AT&T (NYSE:T), Banco Santander (STD), and SK Telecom (NYSE:SKM) are approximate examples of A type companies.

The B type company is a high dividend payer with a 6 percent yield, reinvest the other 40 percent of earnings, and grows at 4 percent a year. Altria (NYSE:MO), Total (NYSE:TOT), and Exelon (NYSE:EXC) are approximate examples of B type companies.

The C type company is a low dividend payer with a 2 percent yield, reinvest the other 80 percent of earnings, and grows at 8 percent a year. Becton Dickinson (NYSE:BDX), Sigma-Aldrich (NASDAQ:SIAL), and Ecolab (NYSE:ECL) are approximate examples of C type companies.

The D type company does not pay dividend and reinvest all earnings, and grows at the full 10 percent a year. Berkshire Hathaway (NYSE:BRK.A) is an approximate example of a D type company.

It would appear that all four types of company would have the same long term total return, i.e., 10 percent a year. But the reality is that, thanks to taxes, long term returns are higher for investors in low yield stocks. Let us assume 15 percent tax on dividend (which is historically low, given that the top bracket was up to 90 percent in the past), and all dividends are reinvested, after paying the 15 percent tax. For simplicity, suppose a share of stock sells for $100 initially for all four types of stocks. Let us compare the final account value for investors in each of the four types of stocks after 30 years.

Investment Results for A Type Company

Year Stock Price Beginning Balance Dividend After tax Dividend Shares Bought Total Shares End Balance
1 100 100 10 8.5 0.085 1.085 108.5
2 100 108.5 10.85 9.2225 0.092225 1.177225 117.7225
3 100 117.7225 11.77225 10.0064125 0.100064125 1.277289125 127.728913
4 100 127.7289125 12.77289 10.85695756 0.108569576 1.385858701 138.58587
5 100 138.5858701 13.85859 11.77979896 0.11779799 1.50365669 150.365669
6 100 150.365669 15.03657 12.78108187 0.127810819 1.631467509 163.146751
7 100 163.1467509 16.31468 13.86747383 0.138674738 1.770142247 177.014225
8 100 177.0142247 17.70142 15.0462091 0.150462091 1.920604338 192.060434
9 100 192.0604338 19.20604 16.32513687 0.163251369 2.083855707 208.385571
10 100 208.3855707 20.83856 17.71277351 0.177127735 2.260983442 226.098344
11 100 226.0983442 22.60983 19.21835926 0.192183593 2.453167034 245.316703
12 100 245.3167034 24.53167 20.85191979 0.208519198 2.661686232 266.168623
13 100 266.1686232 26.61686 22.62433298 0.22624333 2.887929562 288.792956
14 100 288.7929562 28.8793 24.54740128 0.245474013 3.133403575 313.340357
15 100 313.3403575 31.33404 26.63393039 0.266339304 3.399742879 339.974288
16 100 339.9742879 33.99743 28.89781447 0.288978145 3.688721024 368.872102
17 100 368.8721024 36.88721 31.3541287 0.313541287 4.002262311 400.226231
18 100 400.2262311 40.02262 34.01922964 0.340192296 4.342454607 434.245461
19 100 434.2454607 43.42455 36.91086416 0.369108642 4.711563249 471.156325
20 100 471.1563249 47.11563 40.04828761 0.400482876 5.112046125 511.204612
21 100 511.2046125 51.12046 43.45239206 0.434523921 5.546570045 554.657005
22 100 554.6570045 55.4657 47.14584538 0.471458454 6.018028499 601.80285
23 100 601.8028499 60.18028 51.15324224 0.511532422 6.529560921 652.956092
24 100 652.9560921 65.29561 55.50126783 0.555012678 7.0845736 708.45736
25 100 708.45736 70.84574 60.2188756 0.602188756 7.686762356 768.676236
26 100 768.6762356 76.86762 65.33748002 0.6533748 8.340137156 834.013716
27 100 834.0137156 83.40137 70.89116583 0.708911658 9.049048814 904.904881
28 100 904.9048814 90.49049 76.91691492 0.769169149 9.818217964 981.821796
29 100 981.8217964 98.18218 83.45485269 0.834548527 10.65276649 1065.27665
30 100 1065.276649 106.5277 90.54851517 0.905485152 11.55825164 1155.82516

The A type company pays out 10 percent dividend a year. Because all its earnings are paid out, the company has zero growth and its stock price remains $100 per share for 30 years. After buying one share of stock for $100, the investor reinvest all after-tax dividends for 30 years. By the end of 30 years, the investor in A type company would have 11.558252 shares and a final account value of $1155.83, which is a 1056 percent gain over 30 years, or 8.5 percent a year.

Investment Results for B Type Company

Year Stock Price Beginning Balance Dividend After tax Dividend Shares Bought Total Shares End Balance
1 100 100 6 5.1 0.051 1.051 105.1
2 104 105.1 6.306 5.3601 0.051539423 1.102539423 114.6641
3 108.16 114.6641 6.879846 5.8478691 0.054066837 1.15660626 125.0985331
4 112.4864 125.0985331 7.505911986 6.380025188 0.056718192 1.213324452 136.4824996
5 116.98586 136.4824996 8.188949977 6.96060748 0.059499564 1.272824016 148.9024071
6 121.66529 148.9024071 8.934144425 7.594022761 0.062417332 1.335241348 162.4525261
7 126.5319 162.4525261 9.747151567 8.285078832 0.065478181 1.400719529 177.235706
8 131.59318 177.235706 10.63414236 9.039021006 0.068689131 1.46940866 193.3641552
9 136.85691 193.3641552 11.60184931 9.861571917 0.07205754 1.5414662 210.9602934
10 142.33118 210.9602934 12.6576176 10.75897496 0.075591131 1.617057331 230.1576801
11 148.02443 230.1576801 13.8094608 11.73804168 0.079298004 1.696355335 251.102029
12 153.94541 251.102029 15.06612174 12.80620348 0.083186656 1.779541991 273.9523136
13 160.10322 273.9523136 16.43713882 13.97156799 0.087266001 1.866807992 298.8819741
14 166.50735 298.8819741 17.93291845 15.24298068 0.091545392 1.958353384 326.0802338
15 173.16764 326.0802338 19.56481403 16.63009192 0.096034637 2.054388021 355.753535
16 180.09435 355.753535 21.3452121 18.14343029 0.100744028 2.155132049 388.1271067
17 187.29812 388.1271067 23.2876264 19.79448244 0.10568436 2.260816409 423.4466734
18 194.79005 423.4466734 25.40680041 21.59578035 0.110866959 2.371683368 461.9803207
19 202.58165 461.9803207 27.71881924 23.56099636 0.116303704 2.487987071 504.0205299
20 210.68492 504.0205299 30.24123179 25.70504703 0.122007058 2.60999413 549.8863981
21 219.11231 549.8863981 32.99318389 28.0442063 0.127990097 2.737984226 599.9260604
22 227.87681 599.9260604 35.99556362 30.59622908 0.134266534 2.872250761 654.5193319
23 236.99188 654.5193319 39.27115991 33.38048592 0.140850758 3.013101519 714.0805911
24 246.47155 714.0805911 42.84483546 36.41811014 0.147757863 3.160859382 779.0619248
25 256.33042 779.0619248 46.74371549 39.73215817 0.155003681 3.315863063 849.95656
26 266.58363 849.95656 50.9973936 43.34778456 0.162604823 3.478467886 927.302607
27 277.24698 927.302607 55.63815642 47.29243296 0.170578714 3.6490466 1011.687144
28 288.33686 1011.687144 60.70122865 51.59604435 0.178943631 3.827990231 1103.750674
29 299.87033 1103.750674 66.22504046 56.29128439 0.187718752 4.015708983 1204.191986
30 311.86515 1204.191986 72.25151914 61.41379127 0.196924191 4.212633174 1313.773456

The B type company pays out 6 percent dividend a year. The stock price appreciates at 4 percent a year, for a 10 percent total return. After buying one share of stock for $100, the investor reinvest all after-tax dividends for 30 years. By the end of 30 years, the investor in B type company would have 4.212633 shares and a final account value of $1313.77, which is a 1214 percent gain over 30 years, or 9 percent a year.

Investment Results for C Type Company

Year Stock Price Beginning Balance Dividend After tax Dividend Shares Bought Total Shares End Balance
1 100 100 2 1.7 0.017 1.017 101.7
2 108 101.7 2.034 1.7289 0.016008333 1.033008333 111.5649
3 116.64 111.5649 2.231298 1.8966033 0.016260316 1.04926865 122.3866953
4 125.9712 122.3866953 2.447733906 2.08057382 0.016516266 1.065784915 134.2582047
5 136.048896 134.2582047 2.685164095 2.282389481 0.016776244 1.08256116 147.2812506
6 146.9328077 147.2812506 2.945625012 2.50378126 0.017040315 1.099601474 161.5675319
7 158.6874323 161.5675319 3.231350638 2.746648043 0.017308542 1.116910016 177.2395825
8 171.3824269 177.2395825 3.54479165 3.013072903 0.017580991 1.134491007 194.431822
9 185.093021 194.431822 3.88863644 3.305340974 0.017857729 1.152348736 213.2917087
10 199.9004627 213.2917087 4.265834175 3.625959049 0.018138823 1.170487558 233.9810045
11 215.8924997 233.9810045 4.67962009 3.977677076 0.018424341 1.188911899 256.6771619
12 233.1638997 256.6771619 5.133543239 4.363511753 0.018714354 1.207626253 281.5748466
13 251.8170117 281.5748466 5.631496933 4.786772393 0.019008932 1.226635185 308.8876068
14 271.9623726 308.8876068 6.177752135 5.251089315 0.019308146 1.245943332 338.8497046
15 293.7193624 338.8497046 6.776994092 5.760444979 0.019612071 1.265555403 371.718126
16 317.2169114 371.718126 7.434362519 6.319208141 0.019920779 1.285476182 407.7747842
17 342.5942643 407.7747842 8.155495684 6.932171331 0.020234347 1.305710529 447.3289383
18 370.0018055 447.3289383 8.946578765 7.60459195 0.020552851 1.32626338 490.7198453
19 399.6019499 490.7198453 9.814396905 8.342237369 0.020876368 1.347139748 538.3196703
20 431.5701059 538.3196703 10.76639341 9.151434394 0.021204978 1.368344726 590.5366783
21 466.0957144 590.5366783 11.81073357 10.03912353 0.02153876 1.389883485 647.8187361
22 503.3833715 647.8187361 12.95637472 11.01291851 0.021877796 1.411761281 710.6571535
23 543.6540413 710.6571535 14.21314307 12.08117161 0.022222168 1.433983449 779.5908973
24 587.1463646 779.5908973 15.59181795 13.25304525 0.022571962 1.456555411 855.2112144
25 634.1180737 855.2112144 17.10422429 14.53859064 0.022927261 1.479482672 938.1667022
26 684.8475196 938.1667022 18.76333404 15.94883394 0.023288153 1.502770825 1029.168872
27 739.6353212 1029.168872 20.58337745 17.49587083 0.023654726 1.526425551 1128.998253
28 798.8061469 1128.998253 22.57996506 19.1929703 0.024027069 1.55045262 1238.511083
29 862.7106386 1238.511083 24.77022167 21.05468842 0.024405273 1.574857893 1358.646659
30 931.7274897 1358.646659 27.17293317 23.09699319 0.02478943 1.599647323 1490.435384

The C type company pays out 2 percent dividend a year. The stock price appreciates at 8 percent a year, for a 10 percent total return. After buying one share of stock for $100, the investor reinvest all after-tax dividends for 30 years. By the end of 30 years, the investor in C type company would have 1.599647 shares and a final account value of $1490.44, which is a 1390 percent gain over 30 years, or 9.4 percent a year.

Investment Results for D Type Company

Year Stock Price Beginning Balance Dividend After tax Dividend Shares Bought Total Shares End Balance
1 100 100 0 0 0 1 100
2 110 100 0 0 0 1 110
3 121 110 0 0 0 1 121
4 133.1 121 0 0 0 1 133.1
5 146.41 133.1 0 0 0 1 146.41
6 161.051 146.41 0 0 0 1 161.051
7 177.1561 161.051 0 0 0 1 177.1561
8 194.87171 177.1561 0 0 0 1 194.87171
9 214.358881 194.87171 0 0 0 1 214.358881
10 235.7947691 214.358881 0 0 0 1 235.7947691
11 259.374246 235.7947691 0 0 0 1 259.374246
12 285.3116706 259.374246 0 0 0 1 285.3116706
13 313.8428377 285.3116706 0 0 0 1 313.8428377
14 345.2271214 313.8428377 0 0 0 1 345.2271214
15 379.7498336 345.2271214 0 0 0 1 379.7498336
16 417.7248169 379.7498336 0 0 0 1 417.7248169
17 459.4972986 417.7248169 0 0 0 1 459.4972986
18 505.4470285 459.4972986 0 0 0 1 505.4470285
19 555.9917313 505.4470285 0 0 0 1 555.9917313
20 611.5909045 555.9917313 0 0 0 1 611.5909045
21 672.7499949 611.5909045 0 0 0 1 672.7499949
22 740.0249944 672.7499949 0 0 0 1 740.0249944
23 814.0274939 740.0249944 0 0 0 1 814.0274939
24 895.4302433 814.0274939 0 0 0 1 895.4302433
25 984.9732676 895.4302433 0 0 0 1 984.9732676
26 1083.470594 984.9732676 0 0 0 1 1083.470594
27 1191.817654 1083.470594 0 0 0 1 1191.817654
28 1310.999419 1191.817654 0 0 0 1 1310.999419
29 1442.099361 1310.999419 0 0 0 1 1442.099361
30 1586.309297 1442.099361 0 0 0 1 1586.309297

The D type company pays no dividends. The stock price appreciates at the full 10 percent a year. After buying one share of stock for $100, the investor simply holds the one share of stock for 30 years. By the end of 30 years, the investor in D type company would have 1 share and a final account value of $1586.31, which is a 1486 percent gain over 30 years, or 9.7 percent a year.

As we can see, because of taxes on dividends, even at a rate of 15 percent, the investor in A Type company loses out on 430 percent of possible gain he would have had if he had invested in D Type company that reinvested all earnings. His final account value would have been 37 percent higher, which is significant. If the dividend tax had been 30 percent instead (as taxes are likely to go up in the future), the investor in A Type company would have only $761.23 final account value after 30 years, which is less than half of what he could have had in D Type company.

While this analysis suggests that non-dividend paying stocks, or D Type stocks, would make ideal investments, that would only be true if we live in a perfect world and can find great companies paying no dividends and capable of growing earnings indefinitely through successful reinvestment within the business. In reality, D Type stocks are rare to find, if they exist at all. Most stocks that do not pay dividends are suspect. I may be old-fashioned, but I am a believer that companies exist to pay dividends, and only cash dividends are irrefutable proof that a company has real earnings. In general, I would strongly advise against investing in companies that pay no dividends.

Although some might argue that Berkshire Hathaway fits into the description of a D type stock, I think the company probably has reached its zenith. It has become so big and diversified, that it is essentially the stock market. In addition, Warren Buffett, the greatest investor in our generation, has become old and is increasingly likely to make major investment mistakes that detract value, such as those in US Air, General Re, Conoco Phillips, Goldman Sachs, and Bank of America. In Kenneth Fisher's words (he said this about his father in the introduction to Philip Fisher's book, Common Stocks and Uncommon Profits, but I think Buffett is no exception):

There are no great octogenarian investors.

The real life comparison, in my opinion, is between the B Type company (high yield stocks) and the C Type company (low yield stocks). By accepting a lower current yield, the investor in low yield stocks is temporarily forgoing income now to allow the company to grow through the years, and reap bigger rewards later. The out-performance of low yield stocks over high yield stocks increases with time, and, because the dividend grows at a faster pace, the absolute amount of dividends actually catches up and become even bigger than those from high yield stocks after many years. So investors in low yielding stocks are not only more likely to benefit from greater price appreciation, but also from bigger dividend checks after many years.

Conclusion

Taxes significantly detract value from dividends for long term investors. Even with a currently low 15 percent tax on dividends, total long term returns are significantly lower for high yield stocks compared with low yield stocks, even if they have the same total annual return (dividend + stock price appreciation). In real life, the difference in returns is likely even greater, for other reasons I mentioned in my previous article. In this regard, long term investors are well advised to build a core stock holdings of low yield stocks, such as Sigma-Aldrich, Becton-Dickinson, and Ecolab, that have low payout ratio and a solid track record of increasing dividends and strong growth over many years.

Disclosure: I am long BDX, T, TOT, EXC, SKM, STD.

Source: How Taxes Diminish Long-Term Returns For Investors In High Yield Stocks