Dividend growth investing has grown in popularity. It almost seems magical. Coca-Cola, for example, has raised its dividend every year for the past 53 years. Here is a dividend machine that keeps paying you more and more, year after year. Who can not love that?
Well, I will mince no words here. Cash dividends are terrible. They force you to share your wealth with the IRS, diminishing your after-tax net return, which is what counts. Cash dividends are toxic to your financial well-being.
In a previous article, I laid out five key reasons why stocks with lower dividend yields make better long term investments. Please take a moment to review those reasons now. In this article, I will go one step further to argue why the long-term investor should strongly consider investing in companies that generate lots of cash flows from operations, but choose not to pay out cash dividends.
The overarching reality is simple: Gross returns in the financial markets minus the costs of financial intermediation equal the net returns actually delivered to investors. Although truly staggering amounts of investment literature have been devoted to the widely understood EMH (the efficient market hypothesis), precious little has been devoted to what I call the CMH (the cost matters hypothesis). To explain the dire odds that investors face in their quest to beat the market, however, we don't need the EMH; we need only the CMH. No matter how efficient or inefficient markets may be, the returns earned by investors as a group must fall short of the market returns by precisely the amount of the aggregate costs they incur. It is the central fact of investing.
- John C. Bogle, The Relentless Rules of Humble Arithmetic, Financial Analysts Journal; November/December 2005
Within a taxable account, qualified dividends from stocks are currently taxed at 15%-23.8%, for those at or above 25% ordinary income tax bracket (single filers with income above $37,650 and married joint filers with income above $75,300 as of 2016). Non-qualified dividends, such as those from REITs, are taxed even higher as ordinary income. Assuming a 15% tax on dividends, you are effectively paying a 0.45% expense ratio on a portfolio yielding 3% dividends. Starting with a $1M portfolio at 10% annual growth, cash dividends will cost you $2,019,206 lost to taxes over 30 years! And that is assuming the currently very favorable tax rates on qualified dividends do not go up in the future.
(Note that the above discussion applies only to taxable accounts, which should be heavy in stocks if you are a good saver and make more than $23,500 a year, the contribution limit of 401k and IRA combined in 2016.)
Cash dividend payouts are fixed by the management. If you buy a share of Coca-Cola, you have no choice on how much dividend you receive on your stock, or when you receive it. It is a forced periodic distribution from your portfolio. If you are in the wealth accumulation stage and don't need the dividend income, you may reinvest the dividend, but still have to pay taxes on it anyway. The IRS wins!
You would have been better off if Coca-Cola reinvested those cash dividends for you instead, via share repurchase, leading to appreciation of the share prices, without a 15% loss to taxes. You won't have to pay taxes on those gains, until you decide to sell later on your own terms, and may not even have to owe taxes at all if you can offset with capital losses from other holdings.
Cash dividends not only limits your flexibility as an investor, but also the flexibility of the company. This especially holds true for dividend growth stocks. A company that has been paying consistently higher dividends every year for decades has a strong incentive not to break that trend. Investors hate dividend cuts and will surely pour out their wrath upon the stock price of any company that dares break its pristine dividend growth record. However, company earnings are subject to the ups and downs of the business cycle, and it is to the chagrin of their investors when companies over-leverage themselves, just to try to maintain a dividend record. The dramatic fall from grace during 2008 of Citigroup, once a dividend growth darling, should serve as a cautionary tale.
Cash flows from operations may be used in several ways: reinvest back into the business, acquire new businesses to complement the current business, pay down debt, buy back its own stock, or pay it out as dividend. A regular cash dividend payment means less cash is available to reinvest in the business for future growth or to improve its balance sheet as needed. The burden of maintaining a consistent dividend payment is similar to that of interest payments on debt, and worse, due to the high cost of equity. Companies with return on equity above 15% can typically reinvest its cash to earn similar high rates. Dividend payout hurts growth prospects. This formula shows why:
Sustainable Growth rate (SGR) = Plowback Rate x ROE = (1- Payout Ratio) x ROE.
Imagine two companies A and B, each with 20% ROE. Company A pays out 50% of its earnings, while Company B retains all its earnings. Applying this equation, we see that Company A will have an SGR of only 10%, half that of Company B. Over the long term, the difference between these two companies will widen tremendously due to compounding effect. The ability of retain its earnings for growth confers the cash dividend-free company a durable competitive advantage.
Share buyback is much more flexible than cash dividends as a form of returning profits to shareholders. Rather than a self-imposed fixed periodic payment, the company may choose to buy back more shares when it has little use for the cash, and fewer shares when more attractive investment opportunities arise or it needs to improve its balance sheet.
Okay, enough for theory. Let's examine some real life case studies.
Case Study 1:
Genuine Parts and AutoZone are both in the automotive business. Genuine Parts is a dividend aristocrat and has been paying consistently higher dividends for 59 years. AutoZone never paid a dividend. Over the past 20 years, AutoZone has significantly outperformed Genuine Parts.
On a price appreciation basis over the past 20 years (showed by graph above), AutoZone 2213%, while Genuine Parts returned only 231%. Even including dividends, Genuine Parts' total return was only 558%, or about a quarter of AutoZone's.
Case Study 2:
Pfizer and Biogen are both in the biopharmaceutical business. Pfizer used to be a venerable dividend aristocrat, until it got demoted from the list in 2009 after cutting its dividend. Biogen never paid a dividend. Over the past 20 years, Biogen has significantly outperformed Pfizer.
On a price appreciation basis over the past 20 years (showed by graph above), Biogen returned 9948%, while Pfizer returned only 201%. Even including dividends, Pfizer's total return was only 439%, or about 5% of Biogen's.
Case Study 3:
Wal-Mart and Dollar Tree are both in the discount store business. Wal-Mart is dividend aristocrat and has been paying consistently higher dividends for 41 years. Dollar Tree never paid a dividend. Over the past 20 years, Dollar Tree has significantly outperformed Wal-Mart.
On a price appreciation basis over the past 20 years (showed by graph above), Dollar Tree returned 2929%, while Wal-Mart returned only 476%. Even including dividends, Wal-Mart's total return was only 708%, or about a quarter that of Dollar Tree's.
There are many more examples than we have space to cover here. Cash dividends are not created from thin air. Any cash dispersed as dividend is less available for reinvestment and growth. It's that simple. I'm sure there are exceptions where the dividend stock outperforms its no-dividend counterpart, but such are the exceptions to the rule. Ceteris paribus, no-dividend stocks will outperform dividend stocks over the long run.
Investors must be cautious and bear in mind, however, that the vast majority of stocks paying no dividends are speculative stocks that do not generate consistent positive free cash flows to afford dividends. It behooves investors to steer clear from these stocks and leave them to the realm of speculators. Investors should focus on stocks that generate plenty of free cash flow and could pay dividends, but choose not to.
The table below shows a list of 17 stocks that should fit the bill.
|Ticker||Company||Price||P/E||Return on |
As of 5 July 2016. Silent dividend (%) is the average annual % shrinkage in shares outstanding over the past five years. Source: Google Finance; Morningstar.
These stocks have consistently earned positive cash flows from operations and high ROE (not meaningful for AutoZone, which has negative book value). All of them have embraced share repurchase as a form of shareholder return. AutoZone, for example, has shrunk its shares outstanding by an astonishing 8.2% annually for the past five years. Think of that as a tax free 8.2% silent dividend yield. Use this list as a starting point for your own due diligence.
Also, note that investing in silent dividend stocks does not mean you are confined to growth stocks only. Some of these stocks (such as Global Sources, Fossil, Discovery and Biogen above) have P/E lower than the S&P 500 and would qualify as value stocks.
What if you need income today? You're still better off buying silent dividend stocks and selling appreciated shares as needed, rather than get a 3% dividend, lose 0.45% to Uncle Sam, and end up with only 2.55% for yourself.
Warren Buffett's Berkshire Hathaway made generations of investors very rich by paying no dividends. (Unfortunately, Warren Buffett's years on earth are numbered, and he also admits that his company has grown too large and won't have the same growth it enjoyed in prior years.) A diversified basket of silent dividend stocks, such as those above (or you can invest in the motif here), can do the same for you today.
Disclosure: I am/we are long AZO,WMT,BIIB,KO,FOSL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.