Dividends: A Reality Check

One of the mantras you'll hear many investing experts preach is to invest in companies that pay dividends and have a long term history of paying dividends as well as increasing them consistently.

What is a Dividend? Some First Principles

When a company is profitable after paying its taxes, it has two options. It can reinvest the profits back into the business or it can pay it back to the owners of the company (i.e. the shareholders) in the form of payment called a dividend.

Companies that pay dividends tend to be in mature stages of their history or are in industries that in mature stages of their lifecycle. Classic dividend paying industries include utilities, financials, tobacco, and economically sensitive/cyclical companies. These are industries that have cash flows that are relatively more predictable. In some cases, some companies may have too much cash than they really need to run the business and might want to return some of it back to shareholders.

Conventional thinking associates companies that pay dividends to be more profitable, stable, with rising stock prices than companies that don't pay dividends and prefer to reinvest their profits back into growing the business. The principle sounds reasonable. There is enough research and analysis out there to show if you adopt an investment strategy of reinvesting dividend payments that are increasing back into buying more stock or another stock that your overall return in the long-term will be higher thanks to the compounding nature of reinvesting the dividend income.

Benefits of Dividends: It's about the taxes

There are tax benefits to receiving income in dividends rather than interest. From a tax perspective in Canada, there's special incentive to receive income in the form of dividends as dividends paid by Canadian companies are eligible for a dividend tax credit which can reduce your tax payable. The Government is not really doing this to encourage people to earn dividends but to encouraging people to invest capital in Canadian companies so they can grow and become viable long-term economic entities. It's also an attempt by Government to reduce the double taxation of income (one is at the corporate level and the other at the individual level). Interest income on the other hand is taxed at the highest rate when not within a registered savings plan like an RRSP or TFSA.

While these benefits are relevant and reasonable, they should not be considered as the sole reason for buying stocks. There are also other fundamental elements to consider. (Note: these elements revolve around the assumption of investing in commons stocks. Preferred shares tend to trade in a narrower range, but carry different ownership rights)

Protection in Market Downturns

One claim we've been hearing the past few years is that dividend paying stocks insulate investors from downturns or shocks in the market. In the midst of the financial crisis in 2008 when stocks were taking 25-35% haircuts, conventional thinking by many market strategists suggested holding dividend paying stocks as they would insulate you from further downturns. The financial services industry has been filling this demand by cranking out various dividend based mutual funds and ETF's. The issue with this line of thinking is that a stock that is paying a 2-3% dividend yield is not much insulation when the stock falls 20+ percent. Proponents of dividend investing cite that one-off downturns can be minimized as long as you retain a strategy of reinvesting dividends consistently over a long period of time. This is easier said than done.

Dividends as a Retention Bonus

When viewed under the lens of capitalism, which speaks to creating wealth by increasing the value of capital, dividends play a minimal role. When you buy a stock you are buying it primarily for its capital appreciation potential and not for dividend income. Stocks are considered the riskiest form of security because its value is driven by the ability of the company to identify and invest in projects and business opportunities that can generate sufficient returns on capital that exceed it's cost of obtaining capital. Companies that cannot do this will ultimately destroy capital invested and specifically the stock price. From this perspective, buying a stock to just to get paid 2-3% dividend yield (which isn't guaranteed, a company can reduce or stop dividend payments at any time) is a much more risky proposition than buying a bond and earning a contractually guaranteed stream of payments.

Dividends from this perspective are nothing more than bribe or hush money. A company that pays dividends is essentially telling its investors and the market as a whole that it either cannot find enough profitable projects or business opportunities to invest and by paying off investors with a dividend, it is asking us for additional time from investors to allow the firm to find other lucrative opportunities. It also could be viewed that management isn't capable of effectively managing its scarce capital resources and is returning capital back to shareholders because investors can do a better job of allocating capital than management can. It is paying investors to stick around and trust them to find these other profitable business opportunities. Paying a dividend could be viewed as an admission of failure to manage capital.

Stability and Reliability of Dividend Paying Companies

In addressing the claim that dividend paying companies are more profitable, stable and see greater share price appreciation, research as old as 50 years old by economists, Franco Modigliani and Merton Miller, have shown that a companies dividend structure did not impact the overall value of a company. Their research suggested that any value that shareholders derive from the payment of dividends is offset because "they must give outsiders a bigger share of the company's value" (source: Globe and Mail, October 31, 2012).

Dividends should viewed as a bonus and not a primary criteria for selecting stocks. I'm not trying to dissuade investors from buying dividend paying stocks as there are many wonderful, well-run, well-managed companies that pay dividends. It's just they should not be the top screen in your search for stocks to invest.