Fooled by Dividends

High dividend yields on a number of stocks

There are some enticing dividend yields out there right now as many of stocks have been hammered. Several readers have recently asked me about investing in dividend stocks.

I’m afraid many have misconceptions about the purpose of dividend stocks. So I’d like to share my thoughts.

---

Note: for this article I will ignore tax because it’s jurisdiction-dependent. With that said, corporate tax rates and individual tax rates are an important consideration when evaluating the pros/cons of dividend policy. In some cases, shareholders may be better off if a company simply buys back its shares to reduce float instead of paying a dividend.

When evaluating any asset it is AFTER TAX TOTAL RETURNS that matter. You don’t evaluate a bond on its coupon alone. Same goes for dividends.

Dividends are simply a component of an expected total return. Two companies can have very different dividend policies but similar expected total returns.

From this perspective, a high dividend yield can actually be a red flag that a stock is a value trap. Investors should never be fooled into thinking a company is a good investment because it has a high dividend yield. In other words, something could be fundamentally wrong with the business. In such a case, it’s possible the share price declines further and/or the dividend is cut. So it is imperative to understand the resiliency of the dividend when considering a stock from a total returns view.

This requires an investor to look at how a company is funding its dividend. Is earnings and cash flow sufficient? Or is the company borrowing or issuing shares to fund its dividend? Also, is the company growing its cash flows in order to grow dividends? Or is the company more-or-less in a state of liquidation? If a dividend is expected to remain a component of total returns, it must be resilient.

One must also consider why a company pays a dividend in the first place. In theory, dividends are irrelevant. Imagine you withdrew cash from your bank account and put it in your pocket. You’re not any richer than if you had left the money in your bank account. Dividends are conceptually similar.

However, this doesn’t mean that no companies should pay dividends. It comes down to opportunities. In the example above, it might make sense for you to withdraw excess (i.e. >emergency and liquidity needs) cash from your bank account if you have an investment opportunity with an expected risk-adjusted return greater than the interest rate on your bank account. Same goes for companies. If a company can invest the cash in capital equipment, R&D, etc. and produce a return above its cost of capital there is a strong case for it to retain and deploy cash. This is why a company like NVIDIA pays a infinitesimal dividend while Altria pays a fat dividend.

On the other hand, forcing cash on a company that doesn’t need it could weaken its prospects and expected returns. A company sitting on a cash horde that it doesn’t need will be tempted to do something with it - bloated acquisitions, over-generous executive compensation, expansion into unrelated industries. In all these situations, shareholders would be better off receiving the cash dividend. Dividends force discipline on executives of cash-rich companies in mature industries, ensuring they don’t get cute with cash flow.

There’s also a behavioral aspect to dividends. Similar to clipping coupons on a bond, dividends help shareholders realize an expected return on a predictable, regular basis.

In contrast, a company that doesn’t pay a dividend but has a similar expected return may or may not achieve that return in any given year. Sure, the expected return might materialize over the long-run. But it might not. Or the expected return might change due to unforeseen factors. Dividends are a way of realizing a company’s return as it is generated, and not at some arbitrary unknown point in time.

The predictability of a portion of a stock’s total return makes it easier for individual investors to hold onto during market corrections, helping reduce emotional buy/sell decisions. Dividends ‘pay’ investors to wait out downturns and help mitigate the temptation to sell low. Moreover, many investors - like today - are attracted to the higher yields when share prices decline, putting more money to work when stocks are on sale. Over the long run, this behavior management could help individual investors achieve better long-run returns.

Personally, I’m not really for or against dividends. They have their place and I believe dividends should be paid when it makes sense. But they’re certainly not the be all of investing and should never be the driving factor behind investing in a particular company.