My Personal Finance Journey

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Why I'm Not A Dividend Investor

Contributed by mm | December 6, 2007 6:37 AM PST

dividend2.jpgMy individual stock portfolio is full of dividend-paying stocks, leading by Citigroup (6.5% yield), Bank of America (5.5% yield) and Pfizer (4.9% yield). As a matter of fact, all but two of my 13 individual stock positions at the end of November is paying regular dividends.

I do believe a long dividend paying history and consistency on dividend increase are good indicators of a company's long-term performance. However, I don't really think myself as a dividend investor. Why?

First, company can create shareholder value in many ways other than returning cash to investors as regular dividends. For one, great companies can always find opportunities to invest for future growth. But even when cash generated by operation exceeds tangible investment opportunities, dividend is not necessarily the best way to return cash to shareholder. Depending on the stock price, shareholders can be better off when company buys back stocks at cheap, and pays dividend when stock price at high. Therefore, companies with no dividend or low dividend payout ratio have more flexibility in maximizing shareholder returns.

Second, regular dividend payment means regular IRS assessment on investors' gains and it is detrimental to long-term investment gains. The reason that 401(k) is a good tax-saving vehicle is not because it can defer the tax you otherwise will pay on your contributions -- mathematically, it makes no difference on the end results whether you get taxed at the front-end or back-end -- but is because you don't get taxed annually on your investment gains, and therefore more of your investment gains can make money for you in the upcoming years. Investment in dividend-paying companies, if not in tax-advantaged accounts, will actually grow slower.

So all in all, I do pay attention to a company's dividend status and history, but I discount such information and focus more on business opportunities and valuation. Call me a value investor if you will!

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This Post Has Received 9 Comments. Share Your Opinions Too.

The Dividend Guy Commented on December 6, 2007

This one is just begging for me to respond! I appreciate the viewpoint here.

I don't particularly agree with your viewpoint of not focusing on dividends just because you don't need to file with the IRS every year. Keep in mind that I am Canadian and don't know your tax system, but I would not use that excuse to make any investment decision.

I think your overall premise is not to limit your investment horizon, which I am ok with. I just think that this reason you give does not make sense to me.

Google thought provoking piece!

The Dividend Guy Commented on December 6, 2007

I meant 'good' thought provoking piece!

MM Commented on December 6, 2007

The Dividend Guy,

It is really a quick math:

1) Assuming you invest $10,000 on an investment that always yields 10% annually, and you continue to reinvest dividend after being taxed 20% on the dividend, after 10 years, you will have:

$10,000 * (1 + 10% - 2%) ^ 10 = $21,589

2) For a similar investment that appreciates 10% every year but don't pay out dividends, after 10 years your investment will be worth:

$10,000 * (1 + 10%) ^ 10 = $25,937

And if you sell it and get taxed on your capital gain at a rate of 20%, you can keep:

$25,937 - ($25,937 - $10,000) * 20% = $22,750.

That's a difference of $1,161!

2million's dividends Commented on December 6, 2007

MM, I totally agree with you on paper. Mathematically speaking it is more efficient for the company to retain the earning and reinvested them as double taxation is avoided.

But what is good on paper is not always best for your wallet. I like to think of it this way - If a company never pays a dividend how are you going to get any return on your investment? The only way you can get a return is to SELL your investment. Being a value investor yourself you know that puts you in a potentially untimely situation if you need to develop cash flow off your investment. Your 10% annual return might only be worth 5% to mr. market at that time.

VMD Commented on December 6, 2007

How about if you automatically reinvest the dividends, do you still have to pay tax on the dividends then?

MM Commented on December 6, 2007

VMD, yes, you still need to pay tax on dividends even if you automatially reinvest.

J.C. Commented on December 6, 2007

2million, your point is valid only if you are trying to live off of your investments.

Most people though are trying to grow their investments, and dividends are a not the best way to grow your investments, since they are taxed and not necessarily in the shareholders' best interest, just as MM wrote about.

VMD Commented on December 10, 2007

MM thank you for you article suggestions, I am actually an undergraduate student, and I always try to find information of this type put in a very straight forward manner.

Jim Commented on December 20, 2007

MM, your basic assumption appears to be that the companies that invest the money in themselves will do so in such a way that they continue to operate as efficiently as do the companies paying dividends. I disagree with your basic assumption. Companies paying dividends are less likely to take foolish risks knowing that they still need to meet their dividend obligations to shareholders.

As I recall, during the tech bubble, a lot of the tech companies frowned upon dividend payouts and instead invested accumulated cash back via stock re-purchases. Ironically, the overall number of shares outstanding rarely decreased because the incredible amount of stock options that had been granted substantially increased the number of shares outstanding. Those companies had to repurchase all of those shares just to maintain the same number of overall shares. In my opinion, that was a waste of shareholder value. If those companies had been paying decent dividends at that time, they would have faced a shareholder revolt over the shareholder dilution caused by the stock option grants.

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