Dividend Growth Investing

One of the new blogs I’ve been enjoying of late has been the site of a lively debate on investing for dividends.  Dividend Mantra presents a guest post there on his Dividend Growth Investing approach.  Blog reader Dan, in turn, makes some very astute observations.

I, of course, joined in.  You can follow it all here:

http://www.mrmoneymustache.com/2011/12/22/guest-posting-from-dividend-mantra-what-is-dividend-growth-investing/

While you’re there it’s worth checking out Mr. Money Mustache’s other offerings.

My last post there gives my view:

(Note:  well my intention was to also post this over there but it seems Mr. MM has closed the comments on that entry.  Ah well, at least I got this blog post out of it. :))

Dividend Mantra, Dan….

Thanks for the lively debate.  For those readers with some basic knowledge it has been  fun to sift thru the conversation.  However, for those who are new to this whole investing thing, they are likely more confused than ever with the conflicting claims.

At the risk of stirring up the dust again, I believe it is important that beginning investors be very clear on what is accurate information here.

Basically Dan makes three key points:

  1. With vanishingly rare exception Index Investing bests all other methods.
  2. Receiving dividends in a taxable account is a taxable event.
  3. The payment of dividends represents a reduction in the company’s value that precisely matches the amount paid.

In each of these he is absolutely correct.

  1. With vanishingly rare exception Index Investing bests all other methods.

Far and away this is the most important point.  You can’t consistently pick winning stocks.  I can’t either.  The vast majority of pros can’t.  Warren Buffet has, but suggesting that his act is easy or even possible to follow is simply wrong and dangerous.

Here’s my take on why:

http://jlcollinsnh.wordpress.com/2011/06/02/why-i-can’t-pick-winning-stocks-and-you-can’t-either/

Here’s my take on what works:

http://jlcollinsnh.wordpress.com/2011/06/14/what-we-own-and-why-we-own-it/#comment-190

Dan said:  “I strongly believe the research of the last 40 years has shown that any benefit achieved through active stock research and picking is due to sheer luck – not due to any true ability on the part of the stock picker.”

This is not just what you believe, Dan, it is absolute fact.  The research is stunningly clear and precise on this.

2. Receiving dividends in a taxable account is a taxable event.

Every penny of dividends you receive in a taxable account is taxable in the year you receive them.  If you believe this not to be true simply don’t report them on your 1040 this year.  You will shortly receive a private invitation from the IRS to explain your error in detail.

You may not share Dan’s concern with paying these taxes or be interested in the ideas he offers to gain more control over how and when you pay taxes on your investment gains.  Indeed it is my opinion that taxes are not necessarily the first consideration in investment strategy.  But if you hold in taxable accounts investments in companies that pay dividends you will give up a portion of those to your Uncle Sam.

This is an absolute fact.

3. The payment of dividends represents a reduction in the company’s value that precisely matches the amount paid.

This, too, is an absolute fact and I think Dan did a sound job of explaining it.  Indeed I have been puzzling over why people seem to be stubbing their toe on it.  Perhaps it is simply a bit counter intuitive.  Let me take a stab at clarifying it a bit.  Maybe Newton’s Law of Gravity can help.

As we all know, Newton was the first to describe (not discover: it was always there) gravity and its principles.   In short, any object with mass exerts an attractive force on other objects of mass.  The strength of that force is directly proportional to the mass of the object.

In the classic story an apple falling to the earth illustrates gravity in obvious action.  What might be less obvious is that the apple exerts gravitational force as well as the earth, just on a far smaller scale due to its far smaller mass.

So if, as Newton’s law claims, apples have gravity why aren’t two apples sitting on a flat table drawn together?   Two reasons.  One, gravity is a very weak force.  (Consider the entire gravitational force of the planet isn’t strong enough to pull an apple from the tree until it is fully ripe and the tree releases it.)  Two, there are other, stronger, forces at work on the apples.  The friction of the table surface.  The resistance of the air between the apples.  The much larger earth’s gravity trying to pull them down thru the table.

With that in mind, let’s take a look at KO (Coke Cola) and the example of its dividend, letting KO represent the Earth and its dividend the apple.

Like the Earth, KO is huge:  159Billion in market cap, 171B in Enterprise Value, 46B in annual sales.

Like the apple, KO’s dividend is relatively small.  At .47 per share paid to 2.27B shareholders it is just over one billion dollars.  That is real money leaving the company and that lost value is precisely the same as the dividend itself.  However, just like the gravity of an apple is hard to perceive in the shadow of the earth, so too it can be easy to miss the lost value to KO of the paid dividend against the scale of the company itself.  But the loss is no less real for it.

This is why traders pay close attention to the ex-dividend date (this is the date that determines who gets the dividend if the stock is being sold.  Before it the div goes to the seller, after to the buyer.  BTW, this is not the day the div is paid.) of stocks.  The value of the stock will be affected by precisely the amount of the dividend paid.

But wait!  If this is true, how come sometimes a stock price will rise on the ex-div date?  Or maybe fall even further than the dividend would call for?  For the same reason two apples on a table aren’t drawn together.  It’s not that Newton was wrong, it is that other, stronger forces are at work.

In the case of stocks those forces are largely traders working with many variables, only one of which is the dividend payout.

Like everything else in life, there is no “free lunch” when it comes to dividends.  When KO pays out that billion dollars in dividends, that is a billion dollars that is gone forever.  It is a billion dollars they could have used otherwise.  Could they have wasted it?  Of course.  Or they might have deployed it to great advantage creating more value per share than the .47 they paid out.

Basically there are four things (at least that I can think of off the top of my head) that companies can do with their profits.  They can pay them out as dividends.  They can use them to build the company.  They can buy back their own shares.  They can buy other compaies. They can sit on them waiting for opportunities.   See I came up with a fifth!

Which is best?  Depends.  On the management.  On the company.  On the industry.  On the economy.  To name a few.  But none are magic.

Those are the facts.

So, what about Dividend Mantra’s Dividend Growth Investing approach?  I think he hits the value it offers best when he says:

“I live in a different world-the real world. Where stock prices move up and down, are at times overvalued and undervalued, sometimes react stronger to dividend payouts and sometimes completely ignore dividend payouts. This is a world where a company can grow earnings by 100% and see the stock price stay flat, where the stock price can go up and down by 10% or more for no apparent reasons. It’s because of these drastic up and down gyrations in my world that I invest in dividend growth stocks. The extreme gyrations do not affect my steadily rising dividend checks. It will, however, affect people who sell shares for income. They’ll have to sell more or less shares to net a desired dollar amount depending on the day, and they are completely subject to the crazy market that operates in my world.”

In other words, it provides a smoother ride.  As far as it goes, this is true.  Companies that pay dividends tend to be larger, more stable operations.  Management is loath to declare dividends and then have to pull them back.  Although, make no mistake, this can and does happen and the crash of 2008 was filled with companies forced to cut or eliminate their dividends.

The price you pay is lower potential growth.

Some observations:

  1. These same large stable companies tend to grow at a slower pace.
  2.   You will pay taxes on those dividends.
  3.   If you implement this approach with individual stocks you take on all problems of point #1 above.  This is easier and safer:  https://personal.vanguard.com/us/funds/snapshot?FundId=0602&FundIntExt=INT
  4. Or this:  https://personal.vanguard.com/us/funds/snapshot?FundId=0623&FundIntExt=INT
  5. Focusing on dividends is trading income for growth.

As I mentioned elsewhere in this blog, while I am a firm believer in indexing I haven’t entirely given up on trying to outperform with a few individual stocks.  As I’ve said, I’m a slow learner.

Actually, this year my efforts have done pretty well.  You might be interested to know that this was do to a focus on high-dividend stocks.  I also had a nicely profitable short term Netflix trade, but that’s an outlier.

As is typical after a crash, since 2008 growth stocks have been shunned and value (dividend) stocks have been the stars.  I’ve been riding that wave.  I’ve even been doing it in my (sorry Dan :)) taxable account.  I wanted the tax loss if it had gone against me.

But the wheel, as it always does, continues to turn.  Value will fade and growth will rise again.  Over time, as the research shows, the difference in return between them negligible.

If you’ve read this far you know I think there are better choices.  But if the dividend approach is comfortable for you and you go in with your eyes open and willing to accept the downsides, it can get you where you want to be.

Far more important:  Spend less than you earn, invest the surplus and avoid debt.

Cheers!

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