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How many times have you recently read advice that you should own "high-quality, dividend-paying stocks"? Countless times. But almost every argument for dividend-paying stocks is invalid. In fact, the recent inflows into higher-yielding stocks might be a great opportunity for hedge fund managers on the short-side.

Here's why.

Total returns from stocks are defined by a simple equation: the total return on a stock equals the appreciation in the stock price plus the dividends you earn while holding the stock. (For the astute: you also need to compound the dividends.) From this equation, lots of people fallaciously conclude that the higher the dividends a company pays or the market yields, the greater the total return.

But that claim assumes that the two variables in the equation - stock price appreciation and dividends - are independent. But they're not. When a company earns profits, it can:

  • pay them as dividends
  • buy back stock
  • re-invest in its business.

Buying back stock and investing in its business should fuel future stock price appreciation. Paying dividends doesn't.

I'm staggered that so many smart people make this error. Their claims are reformulations of the fallacy above, and include:

"Much of the market's historical return comes from dividends, but now the dividend yield is low. So expect lower returns, and pick dividend paying stocks."

"The market is range-bound. So if you own dividend paying stocks, at least you'll get paid while stocks go nowhere."

It gets worse. We now have the tax argument: "Since the tax cuts, dividend paying stocks are even more attractive". Yes, dividend paying stocks are more attractive when dividends are taxed at a 15% Federal rate than at 35%, 37% or even higher. But the tax treatment of dividends still makes them unattractive.

Look at it this way. Let's say you plan to hold an S&P 500 index fund for 30 years until retirement, re-investing the dividends along the way. Now, the companies in the index have a choice: they can use their profits to buy back stock or pay dividends. (Let's assume for the moment that they can't find profitable businesses to invest their profits in.) If they pay dividends, you'll get hit with 15% Federal tax plus State and Local taxes. I live in New York, so my aggregate tax rate is about 22%. So if the companies pay me dividends, I'll re-invest them in the S&P 500 index minus 22% tax. What if the companies buy back stock instead? No taxes are paid, and the money ends up contributing to a rise in the S&P 500 index, by lowering the share count and thus boosting stock prices (assuming P/E ratios stay constant). Sure, when I eventually sell my index fund I'll pay 15% Federal long term capital gains plus State and Local, but meanwhile I pay nothing, and my money compounds. And for long term investors, that compounding makes a lot of difference.

Bottom line: dividends are less tax-efficient than stock buy-backs.

So given the total lack of theoretical justification for dividend paying stocks, why is everybody advocating them now?

A few reasons:

Stock options. Abuse of stock options has been a problem, particularly with tech companies. Dividends are incompatible with stock options. Dividend payments reduce stock price appreciation and therefore transfer value to current holders of the stock, not those who have an option to buy the stock. (That's why Microsoft first reformed its options plan before it decided on its one-time and ongoing dividend payments.) So some people argue that dividend-paying companies are less likely to destroy shareholder value through stock-option abuse.

Bad management. It only makes sense to re-invest profits in a business if the rate of return is higher than investors could get if the profits were paid to them as dividends. Over the last few years, we've seen some momentously bad investment decisions by companies. So some people conclude that pressuring companies to pay dividends prevents bad investment decisions.

Accounting safety. We all know that many companies lied about profitability during the last few years. Many people argue that if companies were forced to pay out cash as dividends, they wouldn't have been able to lie. Cash is King, right?

Lack of growth opportunities. If we are now in a lower growth environment (perhaps due to the twin deficits, global aging, the deflationary impact of China...), then companies shouldn't be re-investing in their businesses because their return on investment will be low. Better to pay out the profits as dividends?

Are these arguments convincing? I don't buy them. New rules have forced the expensing of stock options, so no need to rely on dividends for that. Bad management? Just buy stocks of well-managed companies, and give the managers maximum flexibility to generate profits. (Would you want Warren Buffet to pay dividends???) Accounting safety? There's no direct relationship between dividends and real profits. Dishonest companies can raise lots of money (Enron, Woldcom) and pay dividends from the cash on their balance sheets. And if you think that growth opportunities are lacking and earnings won't grow, buy bonds instead of stocks. They're less risky and your "dividend" is assured.

In fact, the recent dividend fad may be a great opportunity for savvy hedge fund managers:

  • Dividend paying stocks may well be overpriced. I'm currently short SBC, because I think voice over IP will destroy the RBOC's revenues over the next three years, they wont be able to build out fiber networks in time, and even if they did the revenue from the "TV, local plus long-distance and Internet access" bundle is in free-fall. SBC pays a relatively high dividend yield, and I'm hoping that dividend hungry investors have pushed its price up. As the business suffers, I expect the dividend will eventually be cut. Do I mind paying the dividend in the meantime? Not if I end up covering the stock for substantially less than I sold it at.
  • Options become more attractive. Instead of shorting the market indexes, it's looking more attractive to buy long-term put options. Why? Because as more and more companies jump on the fallacious dividend-paying bandwagon, more of the indices' return will be in the form of dividends rather than the movement in stock prices. So better to own a put option than be short the index and pay the dividends as they are raised.

Full disclosure: at the time of writing I'm short SBC and own LEAP puts on various other dividend paying telecom stocks and market index ETFs.

Source: Why Dividend Paying Stocks Are a Mistake