Dividend Irrelevance

Investing and Markets 📈
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I see a lot of focus on dividends among new investors on Freetrade. While dividends are great I wanted to make a thread covering why it makes no sense to focus on dividends when making investment decisions (unless the company’s dividend policy is negatively impacting growth/unsustainable). Hopefully this can be helpful point of reference.

This is referred to as Dividend Irrelevance

There is a Freetrade thread on a video by Ben Felix that very neatly explains this, if you don’t want to read a load of text just watch that video, it explains this.

Why would a company pay a dividend?

If a company has cash that they can’t generate a good return on, they are destroying shareholder value by holding on to it. This is because investors could use that capital to invest elsewhere and expect market returns. This could happen if there are no viable ways for the company to invest in future growth (either internally or through acquisition of other companies)

For this reason sometimes a company chooses to distribute cash to investors. They do this in one of two ways; either issuing a dividend or buying back shares. A dividend moves the cash from the company’s balance sheet into the hands of investors . A share buyback moves the cash from the company’s balance sheet into the value of shares held by investors (by reducing the number of outstanding shares).

It seems obvious, but for clarity: this process does not create money out of thin air, it just moves it. From the investor’s perspective distribution has no immediate impact on value (tax implications aside).

Worked Example
There is an worked example of the impact of dividends on total returns in Buffet’s 2012 letter to shareholders (starting page 19)

Tax

So far it may seem like dividends and buybacks are identical, however they are taxed in different ways which might be relevant to investors. Dividends will be subject to dividend taxes while increases in share value will be subject to capital gains (when sold).

Investors can choose when to sell shares, however they don’t have direct control over a company’s dividend policy and as such this may have sub-optimal tax implications.

This means dividends can have a negative impact on total returns as described in this FT article

Problematic Dividends

Despite their irrelevance some investors do look at dividends as a proxy for earnings / quality. For this reason lots of companies will pay out dividends even when they don’t have excess cash in order to be seen as a consistent dividend payer.

This can be problematic because at a time when the company may already be struggling with reduced earnings if they decide to maintain dividend payments then they have to choose to reduce investment (and consequently future growth) or take on debt to fund the dividend or both.

A firm’s payout ratio gives information about what fraction of the earnings are being paid out, if this is over 100% then the company is paying out more in dividends than it is earning at that time.

Also some companys do become shackled to their dividend policy, paying out dividends even when it doesn’t make sense to do so (no surplus cash) at the expense of future growth, reducing total returns for investors.

Dividend stocks out-performance

Some people point to consistent dividend paying stocks outperforming the market as a reason to pick them. This out-performance is better attributed to value/quality factors (e.g. p/e or stable year on year earnings growth) rather than the market irrationally undervaluing dividend paying stocks.

See more on the 3 (or later 5) factor model.

Here’s a discussion thread on factor investing that I made that could also be relevant

Dividends as a stable income source

Some people suggest the reason to pick a dividend paying stock over a non-dividend payer is that it provides a stable source of income. While this is true to some extent dividend payments do still vary quite a lot and are determined by the company’s policy, this may lead to insufficient or excessive payments for investors.

As selling shares gives the same result as a dividend payment and is entirely at the investors discretion this is a more reliable way of taking income. You get to choose exactly how much to withdraw and when.

This is sometimes referred to as homemade dividends.

Takeaways

  • Don’t choose investments based on their dividend policy unless there are specific tax reasons to do so.
  • Ultimately earnings determine how much cash a company is able to distribute, how they choose to distribute excess cash (dividends / buybacks) is largely irrelevant.
  • Don’t reduce your diversification by excluding non-dividend paying stocks
  • Do your own research. If you care about earnings - look at earnings directly, don’t use dividends as a proxy for profitability
  • Avoid dividend payers if there are tax reasons to do so or if the company’s dividend policy is having a detrimental impact on long term expected returns.
  • Consider looking at dividends if your dividend tax rate is considerably lower than capital gains (as this might help reduce total tax)
  • Don’t be constrained by a company’s dividend policy, if you wouldn’t sell shares then reinvest the dividend. If you wanted a dividend (income) and weren’t paid one - then sell some shares to create it yourself.

Resources (I’ll expand this if I find anything else that helps explain this)

Buffet’s 2012 letter to shareholders, page 19 discusses dividends and why Berkshire doesn’t pay them

The Irrelevance of Dividends - Ben Felix on Youtube

An analysis of dividend-oriented equity strategies - Vanguard

Why Dividend Income Investing is not a good idea for passive income - James Shack on YouTube

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I second this. I am somewhat confused when people talk about “dividend investing strategies”. Surely your strategy should be to invest in a company that is the most likely to have the highest ROI. Existence of dividend payments doesn’t really tell you much about the company itself.

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I love dividend paying companies as an asset, when i buy a dividend company i’m buying it to increase the cashflow for my portfolio’s. Cash can be used to do so many things in a portfolio, it can not only be re-invested in the same stock but also invested into others increasing the diversification of the portfolio, allowing it to grow itself over time. I realize growth stocks do this through selling and collecting the capital gains but its far more uncertain for me, for example during the pandemic many of my growth stocks are down to the extent i no longer wish to sell them as i know they will return to their normal levels in time. So my growth stocks are sat around waiting to increase in value while 80% of my dividend stocks are still paying dividends and those dividends are actively buying up not only themselves but these other cheep companies for me.

When i sell shares it does the same thing, it puts profits into my fund, but selling shares is an active decision, it dilutes my holdings in the company. Where as the dividend stock simply keeps paying dividends and increasing those dividends.

I do love growth companies i just find they behave differently as an asset to dividend companies, and an asset that behaves differently in my opinion warrants strategies based around it.

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I know selling shares is an active decision to create income, but issuing dividends is also a decision, the only difference is that someone else made it for you.

All else equal getting a dividend in a down market is the same as selling shares, even though psychologically it feels quite different.

I realise that companies behave differently and that growing companies (especially ones with small earnings) will behave very differently to mature companies with consistent earnings and so different strategies are appropriate.

Want I’m trying to explain is that we shouldn’t conflate dividends with these factors, it’s not the dividend that makes them behave in this way, it’s the underlying fundamentals (largely earnings).

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I am not sure how you can equate selling shares at a loss to receiving a dividend?

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I see them as acting differently especially in the pandemic due to continuing to give me returns in the way i expect that i could then use during the pandemic. The share price of these dividend companies behaved similarly to the capital growth companies, they fell which made them inflexible when it came to selling shares.

The dividend allowed them to continue to give me returns during this hard time, these returns were re-invested into not only themselves but other cheep companies that also went down during this time. I cannot sell a lot of capital growth companies while they are down during the pandemic, but dividend companies continue to function and produce the same returns that i purchased them for.

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Erm I’m not really sure how else to explain it beyond the above.

If you think of all your investments as mini bank accounts (balance sheets) all of which grow at some expected rate based on the fundamentals of their business.

Some of these bank accounts pay you money occasionally, reducing the size of your holding and thus and your future returns.

Others never pay you anything and you have to chose when to make withdrawals from them. Withdrawing money from them reduces the size of your holding and thus your future returns.

I guess in the simplest terms think where is the capital for the dividend is coming from, it’s not created from nothing, in fact you (as a shareholder) are the one paying it! :hushed: Thinking about it in that way hopefully makes it more intuitive that it’s the same as selling.

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If I as an individual rely on my income to fund my lifestyle I will invest in the best companies I can. However, these companies values can collapse due to market turmoil even those the cash flow of the company is not materially impacted.

If that were to occur I would be forced to sell shares in good companies at a loss to fund my lifestyle. However, with dividends even if the share price collapses you can still realise the cash flow in a sustainable manner.

The way you explained it by equating a balance sheet to a bank account is not really accurate because a balance sheet can remain solid but a share price can collapse.

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You can do the same thing by selling shares. I’m not suggesting anyone should do so, for the long term investor it makes sense to buy during a downturn (provided they are able to do so) but if you want income it’s still available.

I realise I simplified it a lot, I was just trying to find another way to explain it. I don’t pretend to be able to communicate it as clearly as Buffet.

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Then someone is selling those shares at a loss which makes no sense?

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I’m not saying it makes sense, I’m just saying it’s the same a getting a dividend. Really total return is what we should all care about.

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How does selling shares at a loss to create income help produce sold total returns?

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This is incorrect, if the share price collapses your dividend also collapse. Let’s say you had 10% dividend on $100 investment and it tanked to $70, you will now get $7.

This is exactly the same with non-dividend stocks, except they will start higher because they are not paying dividends. So your $100 would be $110 assuming same level of growth, then it will tank to $77 after collapse and $70 after you sell 10% to sustain your lifestyle.

So exactly the same thing. Except your ROI for average value company is probably higher.

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It does not follow that a share price collapse leads to a dividend collapse? No company pays out a dividend as a percentage of the share price but as a specific dollar amount so it is independent of any short-term move in the share price.

If a company can continue to make the dividend payments it will even in a down market.

In your second example if I bought the $100 for $90 then I sell 10% at $77 I am losing $2 to realise an income of $7 which is a nonsense thing to do.

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It all related to earnings though. Unless the market is behaving completely irrationally the price will be at least somewhat related to the future expected earnings of the company (with some discount applied).

These future earnings are also what determine the sustainability of future distributions (either through dividends or buybacks). It would be very unusual for the price to drop significantly unless there was some perceived risk to future earning potential.

As you said in your post, the dividend payments themselves are irrelevant, it’s the company’s ability to pay them that matters (i.e. their earnings).

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Ye, this is pretty much what I meant. You would take a hit sooner or later. In fact stock tanking 30% might mean you are not getting any dividends at all.

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Isn’t it just as simple as to understanding that the share price decreases by the dividend amount? Therefore it does not matter if you choose to sell shares at a loss or the company does it for you as a dividend.

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BHP shares fell massively during the March chaos but if anything its cashflow and earnings are likely to be higher than ever.

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Absolutely when buying a company for added income its important not to chase yield but to look at its ability to grow its cash flows and its future growth and sustainability.

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Yeah perhaps this is a better way to express it.

To expand this, during a down market the % decrease in price will be larger than at a peak. E.g. a ÂŁ2 dividend will have a bigger relative impact on share price at ÂŁ40 than it does at ÂŁ50.

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