Are Dividends Overrated? 4 Lessons for Dividend Investors

October 28, 2014

Are you retired or nearing retirement? Do you invest in dividend yielding stocks? Do you treat these dividends as “income”?

There is a famous saying “A bird in the hand is worth two in the bush.” Most people think that dividends are more important than capital gains, but will a company paying a dividend give you higher returns over than one that doesn’t?

 

The Total Return Equation

One important concept in investing is being aware of the components of total return.

Total return =   Dividends + Capital Appreciation – Taxes – Transaction costs 

Notice that dividends are only one part of the equation. From 1926-2012, dividends have only accounted for less than half of total returns.

Dividends-Comprise-Almost-Half-Annualized-Total-Return_Figure3

Not all investments appreciate in value and create a capital gain. If your investment incurs a capital loss greater than the dividend, you have actually lost money.

If your investment has not appreciated, your total return may be slightly positive, but may not be enough to offset inflation.

Both of these scenarios illustrate that a focus on dividends alone is not enough.

 

Total Return Equation: Case Study and Implications

Here is the dividend information on one of the most recognized companies in the world:

Price: $34.50

Dividend: $1.84 per share

Dividend Yield : 5.2%

(Note: For confidentiality purposes, I will leave this company unnamed.)

In today’s interest environment, a lot of people would love to have an investment that pays 5.2%. There is only one problem. Dividends are not eternal. At any time, the company can choose to reduce, or even eliminate their dividend. If the company is not profitable enough to cover the dividend, the company has only one choice in order to prolong paying a high dividend rate, and that is to borrow money. They can’t borrow forever. Eventually, they have to face the music by either reducing the dividend, or eliminating it entirely.

You can argue that you have found a growing company with a high dividend. Ask yourself, if the company really has good growth prospects, and is paying a high dividend, “Why isn’t everyone joining the bandwagon?” Especially at a time where 30-year US treasuries are yielding below 3.3%.

Simplicity is a double-edged sword. A simple idea can be really profound if it came from years of mastery, or a foolish one if it came from just a few minutes of thought. There are reasons why a stock is yielding 50% or more than the 30-year US treasury. Your job is to know all of those reasons. If you can’t justify your investment thesis after performing a thorough analysis, you are better off avoiding the investment.

A lot of retirees are currently faced with a difficult interest rate environment. In their quest to stretch for yield/interest, avoid the potential downside of fixed income investments, and preserve purchasing power from inflation, they uncomfortably step outside of their circle of competence into the realm of individual stock investments.

When someone steps outside his or her circle of competence, there is a high risk of incurring a permanent loss of capital. So for those of you who have bought high dividend paying stocks, with the primary objective of generating income for your retirement, please consult with a competent and trustworthy adviser.

 

Opportunity Costs

Opportunity cost is defined as the loss of potential gain from other alternatives, when one alternative is chosen.

Every investment must not only be considered by itself, but should also be compared to every other investment opportunity.

If your investment passes the first test of being a good investment, you also have to consider other investments that could potentially provide you with a higher return. Over a long-term horizon such as 30 years, a 1% difference in return is astronomical.

 

Opportunity Costs: Case Study and Implications

You have a choice between 2 investment opportunities to hold for 30 years. Investment A has a high dividend yield, but low expected capital gains. Investment B has a much lower dividend yield, but has higher expected capital gains. Which is the better investment?

It all depends on the difference between the dividends and capital gains of both investments.

For example (note: dividend yield, capital appreciation, taxes and transaction costs are all hypothetical and reflected as an average over a 30 year holding period. Dividends are also assumed to be reinvested.):

Investment A: Dividend (5.2%) + Capital Appreciation (1%) – Taxes (0.93%) – Transaction Costs (0.01%)

Investment A Total Return = 5.26% per year

 

$100,000 invested in A after 30 years = $465,000

Investment B: Dividend (1.0%) + Capital Appreciation (7%) – Taxes (1.2%) – Transaction Costs (0.01%)

Investment B Total Return = 6.79% per year

 

$100,000 invested in B after 30 years = $717,000

The example shows a huge difference between investment A and investment B after a 30-year investment period, even with only a 1.5% difference in returns. Which investment do you prefer, A or B?

In the real world, we have a significantly larger number of investment options. Although the example above illustrates only 2 investment options, the general idea can still be applied.

Warren Buffett says:

 

4 Lessons for Dividend Investors:

  1. Dividend policy is one of the many factors you must consider before investing in a company, but please do not ignore or give less weight to all the other factors.
  2. Perform extra due diligence on very high dividend yielding stocks. There is a reason why it is high.
  3. Choose the investment that you think will provide you the highest total return possible (adjusted for risk), not the investment that will provide you with the highest dividend yield.
  4. Be aware of your opportunity costs.

If you know someone who is stretching for yield in their retirement investments, or using dividends as a primary factor in their investment approach, please share this article with them. Help them realize that focusing on dividends alone may not the best way to achieve their financial objectives.

I would love to hear your comments and questions.

 

Disclaimers/Scope of Blog Post:

  • Intangible costs as part of total return is outside the scope of this blog post.
  • Forecasting an investment’s forward risk adjusted rate of return is outside the scope of this blog post.
  • Rising dividends can be an indication of a company’s long-term prosperity. A dividend growth approach to investing has produced very good historical results. These frames of reference are excluded to emphasize two points:
    • Perform extra due diligence on very high dividend yielding stocks.
    • Expand your focus from dividend yield to total risk-adjusted returns, and be aware of your opportunity costs.
  • I hope to provide a general retirement strategy for the unusually low interest rate environment today in a future blog post. This future blog post will include lessons from the 2012 Berkshire Hathaway annual letter, where Warren Buffett talks about selling instead of dividends to provide for your “income” needs.
  • This blog post is meant for illustrative purposes, and may not be suitable for your particular circumstances. Please consult with a competent financial advisor before taking any investment actions. If you would like to explore this investment concept in greater detail, you can contact Earl Yaokasin, CFA of Wealtharch Investment Services at earl@mywealtharch.com or call 626-888-2314.

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