Individual investors love dividends. Many academics and financial professionals are not so enamored. It is important to explore the source of this difference of opinion no matter which camp you fall in. Considering different opinions provides perspective and can improve results by challenging assumptions.

Detractors of income investing have the following critiques:

  1. Total returns should be the primary focus of investors
  2. Dividends are inherently inefficient from a tax perspective
  3. Paying dividends reduces earnings growth
  4. Income strategies require investors to actively manage their portfolios

Critique one: Total returns should be the primary focus of investors

Total returns combine returns received from dividends and capital gains which is the appreciation in the share price. Some people argue that focusing on dividends distracts investors from what is most important – total returns.

The crux of the argument is that if an investor becomes captivated by a share yielding 4%, they will ignore a better opportunity for capital growth that doesn’t pay a dividend. The theory is a dividend focused investor will give up the opportunity to own a share that appreciates 12% a year to buy a share that appreciates 2% a year and pays a 4% dividend. Instead of a 12% per annum return they will earn a 6% per annum return.

In my opinion this is a preposterous argument. It assumes that the only thing holding back an investor from selecting the highest returning shares is a fixation on dividends. Apparently ignoring dividends transforms the average investor into Warren Buffett.

It also ignores data. Hartford Funds and Ned Davis Research looked at average annual returns and volatility based on dividend policy. The study looks at large US shares as represented by the S&P 500 between 1973 and 2022. Dividend payers generated a 9.18% annual return. Non-dividend payers had annual returns of 3.95% per year. Companies that grew their dividends had an annual return of 10.24% a year. Those that didn’t change their dividend had an annual return of 6.60%. Only companies that cut or eliminated their dividends underperformed the non-dividend payers with a return of -0.60% per year.

Not only do these dividend paying shares deliver higher overall returns but they also do it with less volatility. Two commonly used measures of volatility are beta and standard deviation.

Beta measures how the swings in a share or a group of shares responds to overall market movements. A beta of under 1 means that a share experiences price swings that are smaller than the overall market. A beta of 1 indicates movement in the same proportion as the market. The price of a share with a beta of over 1 exaggerates market movement.

Between 1973 and 2022 the non-dividend paying shares had a beta of 1.18 which means they are more volatile than the overall market. Dividend payers had a beta of .94 which indicates less volatility than the overall market.

Standard deviation measures volatility as a dispersion of returns around the average return. Higher standard deviations indicate more volatility than lower standard deviations. Non-dividend paying shares had a standard deviation of 22.17%. Dividend payers had a standard deviation of 16.90%.

I don’t think most long-term investors should be overly concerned about volatility. That focus likely changes as investors approach retirement or are in retirement. But either way dividend paying shares deliver higher returns with lower risk. That is not supposed to happen. There is supposed to be a relationship between risk and return. Taking on more risk is supposed to be compensated with higher returns.

There is a high degree of irony when professional investors make the argument that dividends are a distraction from focusing on total return. Very few of them manage to beat the index. The Morningstar Active Passive Barometer report measures how many active investors beat their index. In the 2023 report just over 10% of large-cap managers managed to beat the index over a 10-year period. Results improve in the mid-cap and small-cap space. However, in no category did even 50% of managers beat the index.

Picking individual shares is extremely difficult. That is true if an investor chooses dividend paying shares, non-dividend paying shares or is agnostic to dividends. Yet the chances of outperforming increase if a dividend paying share is selected as they outperformed as a group. This is not a call to find the highest yielding shares and invest in them. It is a call to use a thoughtful approach to build a diversified portfolio of dividend payers.

I don’t fault professional investors who make the argument that dividends are a distraction. They are a distraction when you invest the way they do. Most professional investors are short-term focused and are simply looking for a catalyst for a share to outperform in the next year. They all say they are long-term investors. But their actions indicate otherwise.

According to a former Morningstar researcher named Michael Laske, the average turnover ratio for US domestic equity funds was 63% in 2019. That means that every year more than half of the positions are new. Dividend investing is a long-term strategy. The key is finding shares that grow dividends over time and holding them so that your overall income stream increases. And having this mindset – pardon the pun – pays dividends. If an investor trades more it is likely it will lead to a poorer outcome.

Critique two: Dividends are inherently inefficient from a tax perspective

Another argument against income investing is that a dividend is inefficient from a tax perspective. Dividends and capital gains are both taxable events. A dividend and a capital gain is either taxed at an investor’s marginal tax rate or at 15% if the assets are in super during the accumulation phase. The difference is that an investor can choose when to sell appreciated shares and realise the capital gain. The tax on a dividend is due when a company decides to pay a dividend.

Having the power to determine when a taxable event occurs is advantageous. An investor could decide to sell shares when they are in a lower marginal tax bracket. If the investment is held in super the investor can wait until they are in pension mode and there may be no taxes. Another advantage is that there is a discount on long-term capital gains if an investor holds shares for more than a year. These tax benefits to capital gains are offset by the benefits of franking credits for Australian investors who invest in Australian shares. For full franked dividends these offsets are significant.

This is undoubtably an advantage. However, this advantage requires a couple assumptions. Investors sell shares to rebalance a portfolio or because there is a better opportunity to invest the funds. Investors also sell shares because they need the money. This may be in retirement to pay for day-to-day life or to fund a purchase.

Either way the investor that needs to sell shares is at the mercy of the current price. Share prices can go through slumps based on temporary issues with an individual company or just overall market sentiment. If an investor needs to sell at an inopportune time that is also not in the best interest of an investor. It may involve giving up a valuable ownership stake in a company for far less than it is worth in the long run.

The other consideration is the fact that while dividends are a taxable event an investor gets a cash payment. And that has value. Nobody would argue that people should quit their jobs because salaries are taxed.

A dividend is a tangible way to extract a return from the purchase of a share with an unknown future. For every Google there are far more Zips and Enrons. I hold shares for the long-term and in some cases I’ve fully recouped my initial investment with dividends. No matter what happens to the share price in the future at least I’ve gotten dividends.

We also need to look at how dividends influence total returns. In a theoretical scenario an investor would likely choose to get the same total return from price appreciation instead of dividends. This theoretical scenario is not real life. In real life dividend paying shares have higher returns. And dividends also make up a large part of total returns. Over the previous 20 years as of November 2022 51% of the total return from the ASX 300 have come from dividends.

Critique three: Paying dividends reduces earnings growth

The argument is that if a company reinvested the cash in the business to fund growth instead of paying dividends an investor would ultimately be better off. This is certainly true for some companies.

Traditionally new companies retain all of their cash flows to fund growth. As they mature and growth opportunities dissipate part of the cash flow is diverted to dividends. A company that operates in an industry with little growth may pay out almost all their cash flows in dividends.

As an investor you are a minority owner of a company. You are entrusting management with making good decisions on how to spend capital – your capital. Some management teams are good stewards of capital and make good decisions on how to allocate it. Some make poor decisions.

Poor decisions include making unwise acquisitions, lavishing excessive perks and pay to employees and funding growth projects that earn low returns on the investment. What prevents poor decisions is discipline. And discipline typically comes from having restraints in place. That is why most companies have policies and structural frameworks to govern spending.

Another form of discipline is scarcity. My own propensity to spend foolishly is curtailed by not having an unlimited supply of money and the need to pay for essentials like my rent. A company is similar. A dividend imposes discipline through scarcity. A dividend is ultimately a choice but having an investor base that values dividends is an impediment to reckless spending that puts the dividend in jeopardy. And having a dividend policy that dictates a certain percentage of earnings are paid in dividends further amplifies this discipline.

A dividend can limit growth by tying up a source of funds. At the same time a dividend can impose discipline to not make foolish acquisitions, excessively reward employees and fund projects with low returns. It is a trade-off. In my opinion the discipline outweighs the impact on growth.

For a final example we can turn to Warren Buffett. Buffett has famously not paid regular dividends to shareholders. He argues that the best thing for Berkshire shareholders is to retain capital that he can allocate. Fair enough. He is arguably the best allocator of capital in history.

Most companies do not have Warren Buffett at the helm. And he does not use this same rationale when investing. Many of the top publicly traded holdings of Berkshire have healthy dividends. And cash flow generated by each wholly owned business unit is not retained in those privately held companies – it is returned to Buffett to make allocation decisions.

Critique four: Income strategies require investors to actively manage their portfolios

This last argument is convoluted. The theory is that everyday investors are not capable of selecting individual shares and trying to pursue an active strategy to generate income leads to poor results. There is nothing wrong with passive investing and I agree that it is the best course of action for many investors.

I also fervently believe there is nothing holding back individuals from picking shares if they are willing to educate themselves, put time and effort into the endeavour and establish a structure to make good decisions.

This argument also ignores the fact that there are other avenues to pursue an income strategy. There are passively managed ETFs and funds that follow an income strategy. And there are actively managed ETFs and funds where the decision making can be outsourced.

Final thoughts

I am clearly a proponent of income investing. It is a strategy I pursue. Investing is an intellectual exercise. But it is not academic or theoretical. The reason I invest is to pay for things I want and need to buy. I want to convert the ownership stakes that I take in companies into cash – now and in the future. A dividend is a way to do this. It is real money that shows up regularly in my account. I can spend it, reinvest it or let it sit. I hope someday that my portfolio generates enough income to pay for my life.

Pursuing a dividend investing strategy helps me make better decisions. When markets fall it is a reason to ignore the noise and stay the course – I am still getting the dividend. When markets surge and dividend yields fall it is a signal that I should find other opportunities for my savings where I can generate more income.

Focusing on dividends, the sustainability of the dividend and prospects for future dividend growth adds rigor and realism to my investment process. It also skews my portfolio where I want it – companies that are more mature and have less business risk. It steers me away from speculative pockets of the market. I accept that this is a trade-off and I will miss out on the exponential returns of small companies that grow into giants. My portfolio may not have a lottery ticket in it. But it is also less likely a company I own will go out of business.

Dividend investing isn’t right for everyone. And it isn’t the only way to be successful as an investor. But I strongly believe it is right for me. And finding a strategy that aligns to my goals and that I’m comfortable with over the long-term is the best thing I can do to be successful.

I would love to hear your thoughts at [email protected]. 

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