I was recently reading an investment book that got me thinking about the concept of deferred dividends. I want to introduce that to all of you here.
For those of you who haven't had the opportunity to read Common stocks for Uncommon Profits by Philip Fisher, I would highly recommend it to you. This book is chock full of intriguing investment concepts that would take me a number of posts to fully articulate and present.
I'll aim to flesh some of these concepts out in the upcoming weeks, but one concept that I want to bring to your attention is the concept of a deferred dividend and why it maybe something that's powerful for younger investors to consider.
First bit of background for all of you. Phillip Fisher is an investment legend to whom Warren Buffett attributes a lot of his success in fact I've read comments from Buffet where he suggests that he's 80% Phil Fisher and 20% Ben Graham.
However the interesting thing about Phil Fisher is that he was primarily interested in growth stocks, and investing in stocks for their growth potential. That meant that he typically went after very early stage businesses that were typically less than 20 billion in market capitalization. Fisher had great in investment success and a really strong track record. It will pay anyone handsomely to take a look at this book irrespective of what your investment style is.
As an investor that has both dividend and growth investments, I found Fishers advice informative and practical. One of the ideas he introduces in his book is the concept of a deferred dividend. The way I think about this is as follows.
Let's say you have identified a high-quality growth stock early on in its growth phase. This business is one that's growing its revenue strongly, it's producing great cash flows and great profitability. It's doing all of this in a way that generates strong returns on equity for its investors.
Given the growth opportunities available to the business, the company chooses to reinvest profits that are generated back into the business to go after untapped growth in its markets to the extent of the businesses can generally able to reinvest these findings at high returns on invested capital it makes sense of this business to continue doing this rather than paying out money back to shareholders.
However eventually what happens is that over time the business generates more surplus capital and cash flow that it can reasonably attempt to reinvest in this business it may have tapped out many of its growth markets it may have reached a steady-state where ongoing capital expenditure hymens minimal and it just has a lot of surplus cash flow this business may then choose to do one of two things.
It may proceed to buy back a lot of its stock and therefore give existing equity owners a greater claim on the earnings of the business or it may choose to pay out this excess cash flow in the form of dividends back to investors. ahead of this business in some cases the company may choose to do both.
What's really happening here is that investors are deferring their claims to immediate dividends and cash returns in the expectation of strong near term and medium-term capital appreciation and a substantial bounty from deferred dividends. See, eventually the strongest growth businesses will pay out cash dividends. its just a question of time. Now for a retiree deferred dividends aren't necessarily an idea that may be appealing.
Retirees obviously have a need for near time cash returns to meet expenses and supplement other forms of income. However for younger investors this raises an interesting question. Is it worth the risk of deferring a dividend in the prospects of achieving significant capital appreciation and a much higher longer-term dividend as opposed to taking a higher cash payment right now?
The answer to this question is going to be dictated largely by her own personal circumstances.
For many of us in the dividend growth investment camp there's a burning desire to achieve financial independence as soon as possible and as early as possible. In that case, there is going to definitely be a tendency to gravitate towards getting a much higher cash payment now.
But such a strong desire to do so exposes you to real risk of chasing these high-yielding slow growth stalwarts that are either only going to be able to raise dividend payments very slowly, or alternatively, have real risks of disruption to their business models because they are more mature companies.
The large telecom companies and the big oil players just two examples of such sectors that come to mind.
With the commoditization of telephony voice and data services through alternative technologies such as Internet-based calling and high-quality Wi-Fi, you have to wonder just how sustainable the business models of Verizon and AT&T are and for how much longer they'll be able to pay out such generous dividends.
You also have to wonder just how sustainable these dividend payments are for big oil. Alternative energy sources have been talked about as a viable threat to their businesses for years. While the efficiency and utility of these and alternative energy sources have never been strong enough to threaten oil producers, it's hard not to think that eventually one day alternative energy will become a reality.
However if you want high-yield and you want immediate cash today these are the kinds of investments and the kinds of businesses that you going to have to deploy substantial amounts of your capital into. I think it's perfectly fine in a balanced portfolio to have some exposure to telecom and to resources and to banking, but if you have significant amounts of your capital tied up in these franchises that are undergoing significant disruption you run real significant long-term risks as far as the viability of your dividend income.
The other thing to keep in mind with high-yielding dividend stocks is that they place a significant tax burden on your income today. Of course dividend income is favorably taxed versus wage income, and qualified dividends make the dividend taxation burden not bad as what it used to be.
However if you don't need the income today, should you pay unnecessary taxes on that income? In my case the $20,000 that I make in dividend income annually sets me back close to $2,500 in incremental taxes.
Don't get me wrong. I'm not complaining about that volume of income or having to pay tax on it.
But the thought has occurred to me more than once that I could probably save paying the $2,500 in annual taxes in return for getting increased capital growth near term and a healthy dividend income stream when I really need it 5 to 10 years down the line.
The counter argument for looking at deferred dividends is that it's always better to have cash in hand now and to grow your passive income if you have a burning desire to achieve achieve financial independence as soon as possible.
With early-stage companies that show real promise and rapid growth, you can never tell if that momentum is likely to be sustained for years to come. Companies go through phases of growth and they test the natural limits of execution at each stage of the growth.
So for example it's relatively difficult to take a $1 billion company and grow that to $10 billion. It's also a different execution challenge to take a company that's capitalized at $10 billion and to grow it into a $50 billion company.
Each defined phase of company size test its ability to put in place processes to manage growth, identify new products and new markets to extend growth and make the right set of new hires to foster growth. So just because something looks promising today there's no guarantee that it will be able to achieve its potential five or 10 years from now.
However if you are fortunate enough to pick those companies that go on to longer-term success and you can identify them while they're still in the growth phase, the dividend bounty that you have to look forward to can be substantial. You don't have to look too far to see examples of these companies.
A few that come to mind include Apple (NASDAQ:AAPL), Starbucks (NASDAQ:SBUX) and MasterCard (NYSE:MA). None of these businesses paid out any meaningful dividend in their early stages of growth. But for investors who were able to identify these businesses early on, they are now reaping substantial dividend payouts that are even more meaningful then would have come from investing that same money into high-yielding companies at a similar point in time. And even better, those same investors would be sitting on huge capital appreciation.
Perhaps the right approach is a combination of both. You can have your high-yielding dividend stocks that provide the foundation for a meaningful and substantial passive income, but you also can find a place for some stocks that could provide you with the promise of substantial deferred dividends where you can shelter a bunch of tax payments and have the potential to see substantial capital growth and enjoy a really large future dividend income stream.
Whatever approach you take I highly recommend Phil Fisher's Common Stocks for Uncommon Profits as an investment resource that's worth reading again and again.
Do you prefer current dividend income or does the prospect of deferred dividends interest you as well?