8♦ – Dividends Don’t Matter

Dividends don't matter - but don't spend them until you need to.

Dividends Don't Matter

This post is part of the MoneyDeck series, a pack of 52 playing cards that describe 52 “golden rules” for Private Investors in the UK.

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Dividends don’t matter – but don’t spend them until you need to.

Today I’m going to try to persuade you that despite everything you’ve heard to the contrary, dividends don’t matter.

  • There’s nothing wrong with them, but you don’t need them.
  • On the other hand, if you receive them anyway, try not to spend them until you have to.

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Let’s start by looking at why dividends might be important.

Here are the reasons that I’ve come across:

  1. people need them for income
  2. there are tax advantages to dividends (usually suggested by US commentators)
  3. they are the driver of growth in your portfolio
  4. they affect the capital structure of the company that issues them in a positive way
  5. they are an indicator of company performance and strength
  6. high-dividend payers are less volatile

We’ll take each of these cases in turn.

  • Throughout, the comparison will be between high-dividend stocks and low-dividend stocks.
  • We’re not comparing dividends with bond income, for example.1

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First, income.

  • It’s certainly the case that investors eventually (if they are lucky) reach the age where they need a regular income from their portfolio.
  • We usually call this stage retirement.2

It’s also true that in the current low interest rate environment, obtaining decent levels of income from fixed-income investments (eg. savings accounts and / or government bonds) has become almost impossible.

But you don’t need to get your retirement income from dividends.

  • You can just as easily sell some shares and withdraw the cash.
  • There will be some trading commissions involved, but if you don’t sell too frequently, they shouldn’t make a big difference.
  • And, depending on your circumstances, there may even be tax advantages.

It’s true that you don’t want to sell stocks in a bear market, but the way to cope with that is to use a cash buffer of several years living expenses.

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Here in the UK, the tax treatment ought not to be a big consideration.

  • Dividends aren’t taxed within SIPPs and ISAs.
  • Withdrawals from pensions are taxed whether they come from dividend income or capital sales.
  • And we have an annual £5K allowance to protect dividends from non-tax sheltered accounts.

For taxable accounts with more than £5K pa in dividends, the tax treatment of dividends will usually be worse than that of capital gains.

  • With capital gains you have an £11K pa allowance
  • And you can choose when you crystallise the gains so as take the best advantage of this.

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Next, let’s look at whether dividends drive the growth of your portfolio.

Stock returns are made up of three things:

  1. earnings growth
  2. multiple expansion (PE growth)
  3. and dividends.

Long term UK stock returns average 5% real, and inflation averages around 5%, though recently it’s been lower (2.4% over the past 10 years).

  • So gross returns average 10%, or 7.4% recently.

Over the long run, multiple expansion should have neither a positive nor a negative effect.

So with dividends at around 3.5% pa, they make up close to half of recent returns, or more than a third historically.3

But the key thing to remember is that the growth comes from reinvesting the dividends rather than spending them.

  • And companies that retain more of their earnings can be expected to grow more quickly.
  • So the end result should be the same.

In essence, the contribution that dividends make to your portfolio’s growth is driven by you:

  • do you choose high- or low- yielding stocks?
  • do you reinvest your dividends, or spend them?

If you want to maximise the growth of your portfolio, you mustn’t spend your dividends.

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Third, lets look at how dividends affect the company that issues them.

Miller-Modigliani’s theory says that the market value of a firm comes from its earning power and the riskiness of its assets, and is not affected by the way it finances its investments or whether it distributes dividends.

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Companies can finance their investments in three ways:

  1. issuing more shares
  2. borrowing money (debt)
  3. spending retained profits (that haven’t been paid out as dividends)

Note that investments can mean reinvestment in the company (organic growth) or acquisitions.

So more dividends means either more shares, or more debt (to make the same investments).

  • So the future returns are either more risky (from more debt) or are spread out amongst more shares.
  • Thus more dividends means that the share price will rise less in the future (as well as falling in the present, to reflect the cash that has been distributed).

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Companies can return profits in two ways:

  1. they can pay dividends
  2. or they can buy back their own shares.

The third option for what to do with profits is of course to retain them for future re-investment.

  • Assuming that the company has a high rate of return on capital, this should be the most profitable route in the long run.

If we ignore taxes (which – as we saw above – we probably can in the UK, because of SIPPs, ISAs and the dividend allowance) then the initial effects of dividends and share buybacks should be the same.

  • You get cash as dividends (and the share price falls to reflect this)
  • Or you get cash for selling your shares back to the company

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But share buy-backs have two secondary effects:

  1. they support the share price as there is a willing buyer4
  2. they increase the earnings per share (EPS – since next year’s earnings will be divided amongst fewer shares)

The increase in EPS should further support the share price, and perhaps increase it.

  • This is why share buy-backs are so popular with executives who own lots of share options.

The reason they are unpopular with other people is that quite often (we’d expect almost half of the time) the share price will go down afterwards, for reasons connected to the business performance, or the industry sector, or to the wider economy.

When the share buyback happened at 300p, and the share price falls to 200p, it looks like the company overpaid.

  • It did, but if it had issued a 10p dividend instead, the share price would now be 190p instead, and things would be no better.
  • The shareholder would have an extra 10p in cash, and 10p less in the share price.

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Strictly speaking, share buybacks only make sense for a firm, when, as Warren Buffett puts it:

Its shares sell at a meaningful discount to conservatively calculated intrinsic value.

Now, calculating intrinsic value is not straightforward, and few management teams will be as conservative in this exercise as Buffett and Charlie Munger.

  • They use 120% of book value as their upper limit.

When used properly:

Disciplined repurchases are the surest way to use funds intelligently: it’s hard to go wrong when you’re buying dollar bills for 80¢ or less.

On the other hand:

Value is destroyed when purchases are made above intrinsic value.

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More importantly, Buffett explains that the reverse is also true:

  • when shares can be sold for more than book value and the company earns good returns
  • then selling shares for income will improve both the shareholder’s income and capital over time.

The detailed explanation of how this works is contained in the 2012 Annual Letter to Berkshire Hathaway, which we covered here.

In the end, whether you are better off with dividends, with share buybacks / you selling shares depends on:

  • what you do with the dividends (spend or reinvest them) and
  • the relative returns on the original stock and any reinvestment stock.

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Finally, let’s look at whether a large dividend is an indicator of company performance and strength.

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Quite simply it isn’t.

  • The level of the dividend is chosen by the board of directors.
  • It’s often set by reference to the level of dividends in previous years, since investors respond badly to dividend cuts.

Instead, the dividend policy should be maintainable in the long-term, providing stability for shareholders and sufficient new capital each year (from retained earnings) for management to reinvest enough to grow future earnings.

As investors, we want to own shares that generate returns higher than we can generate ourselves.

  • This will typically be higher than the dividend yield on a stock, and so in a sense, any distributed dividends are robbing us of future higher growth.

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What really matters is whether the dividend is covered by the current year’s earnings.

  • You don’t really want to be invested in a company that is paying out more than 50% of its income.5

You should also compare the dividend yield to that of the relevant index.

  • The FTSE All-Share index currently yields around 3.6%, slightly higher than it’s long term average of 3.4%.

Often a high dividend indicates that the market expects the dividend to be cut in the future.

  • A dividend yield of 5% in the UK might be considered safe (if supported by earnings), but above 6% or 7% you would need to investigate the reasons for the high level of dividends.

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It’s true that high-dividend payers tend to be slightly less volatile in price than low dividend payers.

  • In the industry jargon, they have a lower beta (the extent to which a stock tracks the index).
  • This is probably because they hold up slightly better in a bad market, as income seekers support their price.

But the real question is whether low volatility is the name of the game with stocks.

  • In a properly diversified portfolio, stocks are the growth asset
  • Bonds, property, commodities and cash are the diversifying assets that provide stability.

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By now, it probably sounds as though I hate dividends.

  • I don’t, I’m just indifferent to them.

I like diversification and hedging my bets.

  • So I will probably own a few dividend stocks, if only to use up the annual dividend tax allowance.
  • Heck, I even buy a few growth stocks these days.

But I’ll have more in value stocks, and in momentum.

Many dividend stocks are really value stocks (most of the time), and so you are adding a value tilt to your portoflio.6

  • That value factor should generally lead to outperformance over time.
  • But a pure value strategy would do even better, of course.

And in these days of low interest rates, dividend stocks tend to become expensive “bond proxies” whose prices have been driven up by the hunt for yield.

  • Dividend stocks may not be value right now.

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So remember:

  1. dividends don’t drive growth
  2. you can get any income you need by selling shares
  3. dividends don’t indicate company outperformance or strength
  4. stocks aren’t the asset to use to provide low volatility
  5. and dividends don’t have tax advantages in the UK

In short, Dividends don’t matter – but don’t spend them until you need to.

Until next time.

  1. Bond income is fixed whereas dividends tend to increase with time, if only because of inflation []
  2. Though industry insiders often call it decumulation, or distribution []
  3. You’ll hear higher figures quoted, especially over long periods, since the compounding up of reinvested dividends will have a greater cumulative effect over time []
  4. In a similar way that a growing dividend can support the share price over time []
  5. Unless its something like a REIT, which by law has to distribute 90% of rental income []
  6. Meb Faber has written a few articles about this, and is promising a white paper sometime in 2017 []

Mike Rawson

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 35 years, with some success.

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2 Responses

  1. Avatar Mark says:

    So one should avoid investing for dividend growth? I ask as I see several commentators (blogs) putting dividend growth forward as the holy grail.

    PS: Thanks for all your write ups.

    • Mike Rawson Mike Rawson says:

      It’s not so much that you should avoid dividends as ignore them. They are a minor outperformance factor for equities (a more visible proxy for value – but remember that value hasn’t worked for the decade-plus since interest rates were lowered), but there are better ones.

      The key points are:

      – dividends don’t come from the ether (the company becomes poorer by paying them)
      – they are not tax-efficient (outside of a SIPP or ISA)
      – relying on any single strategy is a bad idea.

      If you do receive dividends (as we all do) the most important thing is to reinvest them rather than spend them – but this needn’t be in the firm that you received them from.

      Earnings growth (and free cash flow growth) are more important than dividend growth – firms that stretch to maintain dividends usually run into trouble in the end.

      Mike

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8♦ – Dividends Don’t Matter

by Mike Rawson time to read: 6 min
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