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 (T), Banco Santander (STD), and SK Telecom (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 (MO), Total (TOT), and Exelon (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 (BDX), Sigma-Aldrich (SIAL), and Ecolab (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 (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.
