What if I told you that dividends are not all they are cracked up to be?
That doesn’t mean they are necessarily bad. However, receiving a dividend is like taking money from your bank account and holding it in cash. Your financial situation hasn’t necessarily changed; you are just holding part of your money in a different form. The true measure of a good investment should be the total return instead of the dividend stream it pays. This can be a touchy subject for people, so I apologize in advance.
Where Do Dividends Come From?
When a company pays a dividend, the price of its stock declines by the amount of the dividend. They refill the coffers by continuing whatever line of business they are in and hopefully turning a profit. Using the bank account analogy, your bank account hopefully has an upward trajectory from contributions from your paychecks. Whether you hold that money in the bank or dollar bills is up to you, but it doesn't change the amount of money you have. Warren Buffett’s company, Berkshire Hathaway, has paid one solitary dividend in its history – a $0.10/share payout in 1967. Buffett is so opposed to paying dividends that he quipped, “I must have been in the bathroom when that decision was made.”
Are Dividend Paying Companies Better?
People love dividends because they represent tangible value from their investments. However, it's easy to lose sight of the big picture by focusing on dividends, not the total return. Total return is comprised of price appreciation plus income (dividends). Companies that pay dividends systematically force their investors to recognize one side of that equation while the market determines the other. To illustrate my point, AT&T has routinely paid between 6-8% of its share price in dividends since the beginning of 2016. The total return over that period has been a rounding error above 0%. Compare that to non-dividend-paying Berkshire Hathaway with a total return of over 150% over that same period. Which would you rather have?
The Risk of Focusing On Dividends
Dividends are nice because they get paid by companies who (usually) have enough cash lying around to distribute to their shareholders. Beware the siren song of a high dividend yield, though! Payouts are not guaranteed, and companies might choose to suspend dividend payments, which usually causes a double whammy of a loss of income plus a drop in stock price. Residents of the Capital Region need look no further than General Electric from 2017 to 2018, when they cut their dividend from $0.24 to $0.01 per share. The share price responded by dropping over 65%.
Lest you think I outwardly hate dividends, I believe that dividend investing with certain constraints can prove to be profitable. In fact, we allocate a portion of our portfolios to companies that pay dividends, with additional screening criteria. As with anything else, a thorough examination of how an investment fits into a portfolio is a necessary precursor to its inclusion. If you are unsure, consult a professional (like us).
Author: David Rath, CMT, CFA
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