Arguments Against Dividend Stocks
The most obvious argument against dividend investing is this:
Many companies could pay a dividend but chose not to. Berkshire Hathaway is a perfect example. Actually, Berkshire has been a fantastic investment precisely because it doesn’t pay a dividend!
Confused? How a company allocates capital is extremely important, and paying a dividend might not be the best option.
This is a rather long lesson, but below we list many arguments against paying a dividend:
Argument 1 – flexible capital allocations:
A dividend policy is often reported but seldom do we see explanations justifying the particular course of action.
A dividend is just one of five possible allocations for retained earnings (see the previous lesson on this topic), and the focus should be to do this in a value-enhancing way. Allocations done intelligently could be just as value-enhancing as the underlying operations.
Argument 2 – Berkshire Hathaway and its owner-oriented shareholders
Warren Buffett realized early on that attracting the correct shareholders are a very important part of long-term returns, yet usually neglected. The most underrated aspect of Berkshire is how Buffett has managed to attract shareholders that understand long-term value creation and where capital compounds the best: In the hands of the company or in your hands.
Why pay a dividend if the company can use the capital efficiently by retaining it?
Argument 3 – sell shares to generate “income”
Dividend “Income” is a complete misnomer. Investors don’t have “income” from dividend-paying stocks. You either have gains in the form of share price appreciation, or you receive distributions of retained earnings in the form of dividends. A dividend is a distribution of capital. Income is something you receive in compensation for providing services or selling products. Investing doesn’t include “income”.
The alternative to a dividend “income” is to sell shares (if you need “income”).
But dividend growth investors don’t want to sell shares to get “income”. They believe this is like sawing off the branch they’re sitting on. But they are wrong. A dividend is the same as a partial liquidation of the company, it’s a transfer of funds from the company to the shareholders, and has the same effect as selling shares.
Argument 4 – dividends are distributed at book value, but mostly reinvested above book value
This is a very important point, and not well understood among investors. Dividends are transferred as value for value. It’s simply capital moved from the company’s account (as retained shareholder’s earnings/equity) to your account.
But here is the catch: usually a stock trades above book value, and thus any reinvestment is done at a higher multiple, for example, 2x book value.
Ask yourself this:
Why would you accept to receive a dividend, distributed from shareholder’s equity, only to reinvest at a premium to the equity? As Buffett says, you take a beating in doing so.
Argument 5 – are dividends rewarding shareholders?
A dividend might be a tactical move, not a strategic one. The appeal of a stock increases with a dividend, for example to institutional shareholders which for many reasons want “income”. A dividend might also serve as a source of “income” for owners who might otherwise demand higher compensation. There is no definite answer fitting all companies. That’s why capital allocations should be flexible.
Dividends seem to be the preferred method of being “rewarded”. But at the end of the day, any investment should boil down to total long-term returns. Whether or not you need cash to pay for living expenses or reinvestment, you need to find the optimal way to make the most off of your capital and withdraw your capital efficiently. We believe dividends often distract from the real issues: growth and the marginal rate of return (reinvestment return).
Argument 6 – a growing dividend attracts “coupon clippers” – not business owners
Benjamin Graham wrote in the Intelligent Investor that a growing dividend has the potential of attracting ignorant coupon clippers, not business owners. We believe this is more true now than in the old days due to the falling yields in both Treasuries and corporate debt.
One of the most underrated aspects of Warren Buffett and Berkshire is that he has managed to attract shareholders that both have a very long-term view and act like owners. The same applies to a certain extent to other stocks like for example Markel, Alleghany, White Mountains Insurance (and of course others).
All these companies have an advantage over many other companies: It’s much easier to have a rational and flexible capital allocation when shareholders are long-term and do not require a quarterly “coupon”. They simply think like business owners, not coupon clippers.
Argument 7 – “coupon clippers” treat stocks like bonds
Bonds offer a coupon of x% and have a reasonably predictable return, although the value can fluctuate together with market rates and perceived risk. However, bonds are less risky than equity. Thus, “income” streams from dividend stocks will never be as safe as bonds. Even high-quality companies can’t compensate for that.
Inflation is currently running at 2-3%, meaning holding cash is a sure way of losing purchasing power. This has lead to increased interest in dividend investing. We suspect that many investors in reality treat those stocks more like bonds than stocks.
But stocks are a lot riskier than bonds!
Argument 8 – no reasoning behind why a company pays a rising dividend
Why is a dividend a smart allocation? Rarely is an explanation reported to the owners, and just as likely are the owners happy to receive whatever dividend is thrown at them. Supposedly, returning capital is “shareholder-friendly”. But intelligent capital allocation is usually a bit more complex than that.
Argument 9 – a dividend gets “sticky”
If you do not have potential high-return investment projects, consider paying dividend. Be aware, however, that dividend decisions can be hard to reverse and that dividends can be tax inefficient.
– The Outsiders, William Thorndike.
When a company starts paying a regular dividend it becomes hard to stop or undo, for several reasons. To cut a dividend is supposedly bad, and a whole business in the investment world spends considerable time and resources to separate which companies can sustain or cut their dividend. Very few dividends are cut unless the company is forced to. Opposite, buybacks can be stopped without any reaction from the market.
Argument 10 – a dividend is not necessarily shareholder-friendly
Returning capital to shareholders is considered shareholder-friendly (“rewarding” shareholders). Why? A dividend is only a distribution of retained earnings or paid-in capital. Dividend payment decisions generally don’t create or destroy long-term value, it’s just a transfer of capital, mostly less taxes.
Argument 11 – dividends do nothing for shareholders
Managements often mouth that paying a dividend is doing something for shareholders. It is precisely the opposite. Instead they are saying, “Sorry, we can’t do anything with it; see what you can do. Good luck!
Dividends do nothing for shareholders unless it’s reinvested. When the burden of reinvesting is transferred to the shareholders, it means you have to get off your ass!
Argument 12 – opportunity costs
Most investors are usually ignorant of what we don’t see or observe, we only value what we see. But every investor has both limited capital and time, and priorities need to be made. At the same time, the board and management must carefully evaluate the best use of capital.
To our knowledge Philip Morris (PM)/Altria (MO) has been the best performing stock over the last century. Both companies, after the split in 2008, happen to pay a juicy dividend. What is not to like?
Well, perhaps the performance would have been better if they focused less on the dividend and more on buying back shares? “Unethical” companies have historically been trading at lower multiples than the average of the market, according to US Mutual’s Vice Fund and Marcin Kacperczyk/Harrison Hong research called The Price of Sin: The Effects of Social Norms on Markets (2006).
Perhaps Altria would perform better if they alternated between dividends and buybacks? Unfortunately, we can’t calculate the alternative with certainty because the world unfolds differently under changing assumptions, but we can make some rough estimations.
By reinvesting the dividend, Altria has returned almost 18% annually in the ten-year period from January 2009 until the end of 2018. Not bad! But this assumes no taxes on the dividend, which means most investors would not manage this return. If Altria instead had focused on buybacks (which is tax-free) and skipped the dividend altogether, we can safely assume total returns would have been 18% (all things being equal).
Argument 13 – dividends are taxed, capital appreciation less taxed, and buybacks are Not Taxed
Focus on after-tax returns, and run all transactions by tax counsel.
The Outsider, William Thorndike, page 219.
Unless you have a sheltered or tax-deferred account, you receive the dividend less taxes, which obviously means less to reinvest. This is of course a real headwind when compounding.
Opposite, capital appreciation is only taxed when the gains are realized and only taxed on the difference between the cash proceeds from the sale and the cost basis of the shares. You can “engineer” your tax bill by for example selling less appreciated stocks to create “income”.
Buybacks are tax-free, and potentially more powerful if done at opportunistic valuation multiples, and add more flexibility.
Argument 14 – dividends are inflexible
A dividend doesn’t leave you with many choices: you have to accept delivery, whether you want it or not.
Let us summarize the reasons why a buyback is much more flexible than a dividend:
- You are forced to receive a dividend, while a buyback reduces outstanding shares. If a company buys back 3% of the company, your holdings increase by 3%. To pay yourself a “dividend”, simply sell 3% of your holdings. Or, you can do nothing and be happy with increased ownership.
- You can defer taxes, even engineer taxes, via capital gains when you sell shares to get “income”.
- Dividends are paid out from shareholder’s equity, while the sale of shares is usually done at a premium to shareholder’s equity (above book value).
- Dividends are taxed, buybacks are not.
- Whether or not to pay/increase/lower a dividend is up to the Board of Directors. This means the BoD is your “income trustees”. The same goes for buybacks, but the latter offer to defer taxes: Because buybacks are a tax-free distribution it provides shareholders with the option to defer taxes until they chose to sell their shares.
Argument 15 – a dividend disciplines the management
A company with a goal of growing the dividend has made a commitment. Dividend investors believe this creates accountability from management. Perhaps it will, but we doubt it.
Some shareholders are happy to receive a dividend to avoid management “wasting” capital. Supposedly a regular and growing dividend limit “empire building”. This statement is repeated endlessly, but we’re not sure it makes any sense. These are more relevant questions to ask:
- If they can “waste” retained earnings, what makes you sure they don’t “waste” for example the working capital?
- Why would you invest in a company in the first place if you fear the management will squander the capital?
- Management is one of the key decisions in any investment, and you need to “hire” only the best people. Does Costco’s regular dividend make Craig Jelinek a disciplined CEO? What does paying a dividend contribute to Costco’s intense focus on customer service? We fail to see the connection.
Argument 16 – a dividend makes the shareholder complacent
Perhaps the management makes the shareholders complacent by paying a dividend? Shareholders are happy as long as the quarterly check arrives, and apart from this management can do whatever they want with suboptimal decisions and allocations.
Furthermore, perhaps the dividend track record becomes more of a liability than an asset for the management? If a company has paid a growing dividend for 30 years, it has become “sticky”. Somehow management and investors think it’s more important to keep this track record, instead of allocating resources to for example a promising investment opportunity. Exxon in 2016 comes to mind.
Argument 17 – dividends make management less flexible
I know a lot of people have very strong and definite plans that they’ve worked out on all kinds of things, but we’re subject to a tremendous number of outside influences and the vast majority of them cannot be predicted. So my idea is to stay flexible. …My only plan is to keep coming to work…I like to steer the boat each day rather than plan ahead way into the future.
– Henry Singleton in The Outsiders by William Thorndike, page 53
Making a “promise” to pay 50% of earnings as dividends certainly do not make the allocations flexible. In the shareholder letter of 1984 Buffett argues that management should choose whichever course that makes sense, retained or distributed, although he mentions a consistent dividend is understandable. However, it’s just a very few companies in the stock universe that has a business model and economics that can sustain a steadily growing dividend.
Argument 18 – management makes suboptimal decisions to continue raising the dividend
Sometimes it makes sense to pay a dividend, and sometimes it does not.
For example, back in 2016 after the sudden fall in the price of oil, the dividend of Exxon Mobile was questioned. Countless articles on for example Seeking Alpha centered around if Exxon could maintain its dividend aristocrat status.
The dramatic fall in the price of oil forced Exxon to practically borrow money to pay the dividend because the dividend payout ratio was above 100%, which of course is pretty absurd. S&P downgraded Exxon from AAA to AA- in April 2016, partly because of the dividend:
“We believe Exxon Mobil’s credit measures will be weak for our expectations for a ‘AAA’ rating due, in part, to low commodity prices, high reinvestment requirements, and large dividend payments.”
When companies borrow to pay dividends, do they have a vision on how to best build their companies? This is yet another example of how sticky a dividend becomes, and is more of a liability than an asset.