The Myths of Dividend Investing
Investing in high dividend paying companies is a popular trope in the personal finance community. Here are 10 reasons to reconsider this approach.
1) Taxes – The first word after “income” is always “tax.” Dividend income is no different. Ordinary dividends are taxed at standard income tax rates. Long-term capital gains tax rates, achieved through a buy-and-hold portfolio of stocks, are much lower.
2) Diversification – About half of dividend payers come from the technology and financial services sectors alone. This can leave you overexposed to these industries if you are solely focused on dividends.
3) Performance – Dividends do not increase the value of a company. They represent cash that is leftover after paying all expenses of operating the business. Dividends are often viewed by the market as an indicator of a healthy company when the truth is more nuanced.
4) Share Price – Dividends can come at the expense of growth in the underlying performance of the share price of a company.
5) Revenue Growth – If you are uncertain about your revenue growth, you are not going to increase dividends and risk not being able to pay it in the future. This creates a lag effect between the profitability of a company and their decision to return cash to shareholders via dividends.
6) Safety – Dividends are not safe. There is an expectation baked into the market that when a company issues a dividend, it is safe, and it will continue to pay it for a long time. If they run into cashflow issues and need to cut the dividend, this perceived safety goes out the window. Monitor payout ratios and dividend coverage to spot companies that can’t afford to keep paying their dividend.
7) Efficiency – Sometimes companies pay dividends because they are not investing in other parts of the business like R&D. Stock Buybacks also get a bad rap here, but the fact is that buybacks are much more accretive to shareholder value than paying dividends.
8) Inertia – Some companies continue to pay dividends just because they always have. Companies hold back on increasing dividends until they are sure their revenue growth is sustainable and can support the new higher dividend. This can lead to financial inflexibility if it is assumed they will always have to pay the dividend.
9) Stock Buybacks – Stock buybacks are more flexible than dividends. If you are unsure of your future revenue growth, you will not want to increase dividends and risk having to cut them later on, because the stock price will get penalized. However, stock buy backs are viewed by the market as a “free option” to increase shareholder value.
10) Bottom Line – Total return (income + price appreciation) is what matters when building your portfolio. Dividends should be viewed as part of the return profile of an investment, but not as the only consideration.
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