Why Dividend Stocks are (Sometimes) not the Best Option
Learn the important cost of investing in dividend stocks and why there isn’t a free lunch in the market.
When we speak about financial independence, investing in dividend stocks is one of the most researched methods that enable individuals to receive side income on a monthly basis.
When you own a stock of a company that distributes dividends, you are entitled to a portion of the company’s profits at the end of a specific period.
When speaking of dividend stocks, what’s normally not discussed is that dividends have a cost for shareholders. Warren Buffett discussed this topic several times and stated that he prefers that companies use their surplus cash on other things, such as:
- Reinvesting in the business for growth;
- Making acquisitions;
- Buying back stock.
Particularly when compared with reinvesting in the business, paying dividends to shareholders has two major setbacks for shareholders:
- As the money is not invested in growing the business, it can, potentially, impair future stock returns.
- Dividends are taxable and you, as a shareholder, will probably have to pay income tax on it.
In this post, we’ll discuss some of these ideas and how the FIRE (Financial Independence, Retire Early) community can approach their investment on dividend companies, relating the topic with time horizon and expected return!
Dividends are not Free
When a company pays dividends, this has a big cost for shareholders.
Dividends are generated capital that will not be invested in buying land, factories or spent in R&D. Assuming that the company has a competent management and they are able to grow the business by investing more money in it, it’s actually bad (in return of capital terms) that capital is distributed to shareholders.
So.. what will be the main impact of this for shareholders? The major setback is that it will, probably, reduce your future return on the stock.
Let’s imagine that we would hold a dividend paying company for 30 years (the time horizon we are looking for, as long-term investors!) and that it achieves a yearly average return of 10.06% (dividend + share price appreciation). Where am I getting this value from? I’m using iShares Core High Dividend ETF’s return since its inception as a baseline for our return.
If we invest 5.000 euros (or dollars) every year with a ~10% return:
At the end of 30 years, we will have around 900 k euros — compound interest really works on our favor.
Although this seems a great return, let’s imagine that we didn’t invest in a dividend stock but ended up going for a company that did not distribute profits. I’ll use the iShares Core S&P 500’s to represent the return of non-dividend companies (a fairly conservative approach as a lot of companies from the S&P 500 index distribute profits).
In the last 10 years (using this timeline to roughly match the inception date of the iShares Core High Dividend ETF), this ETF had an average 12.91% yearly return:
At the end of 30 years, we will end up with 1.4 million euros! A difference of around 500 k when we compare with the first example.
Main argument: As it is expected that the share price appreciation of a dividend company will be lower due to not investing profits in growing the business, the impact on compounding is huge!
Dividends are Taxable
But.. the detail above is not the only setback you have when you invest with dividends on your mind. If you are an individual investor, the fact that you will receive a dividend will have a double impact on your finances.
As we’ve seen before, when a company pays a large dividend it will, probably, have a lower return in its share price as it is not investing in its growth. Additionally, taxes will impair your compound interest.
Imagine that a company whose share price is 10$ has a dividend yield of 3%. For every share you own, you will receive 0.3 cents — isn’t that right?
Unfortunately, in most countries, that’s not correct. You will still have to pay taxes on top of that — for instance, in my home country, this value is around 30%. From the 0.3 cents, I will only receive 0,21 cents per share — a huge difference! There’s a way to avoid this by using dividend reinvestment plans (DRIP) that automatically reinvest the dividends in new shares without being taxed but not all brokers (or stocks) support them.
Imagine the following scenario:
- You invest 5.000 euros every year in a dividend stock that pays 3% yield.
- You expect, on average, a 7% of return from share price alone.
- You only reinvest the dividend after having it on your account.
- Your dividend is taxed at 30% by your government.
Based on the scenario above, the 30-year simulation is the following:
In the end, you will end up with around 650k euros. But what if we use a DRIP plan and avoid that our dividend is taxed? Using the same assumption without the 30% tax rate on received dividends:
In this scenario, you will end up with around 725k euros, a 75k difference. Of course, if the company decided to reinvest this directly in the business, this value wouldn’t also be taxable by the government and the company would be able to (potentially) return you even more value in the form of stock returns.
This same reasoning stands for ETF’s — when you choose an ETF that distributes money, you end up being taxed on those distributions, something that will impact your future returns, not letting your dividends compound.
The Dividend Traps
Another downside of investing in dividends — alot of companies end up being dividend traps. They lure investors by having higher yields than what they can sustain and end up blowing in the face of the investor that will lose one of the (single) reasons that led it to invest in those businesses.
Personally, I’ve had a few blunders of dividend companies that I’ve invested in and that ended up being dividend traps. For instance, I invested in AT&T in 2017, while it’s yield was near 5% — this ended up being an awful piece of business for me as the company wasn’t able to sustain its dividend throughout the years and couldn’t generate enough cash flow to pay it.
In some next posts, I’ll detail some metrics you can look for to avoid getting caught in a dividend trap. The most obvious one is that you want to make sure that the payout ratio is stable for these companies before buying them. If dividends are taxed and the impact on the future stock return is expected to be high, we really need to make sure that we bet on our “horses”, correctly.
The Other Side Of the Coin — Defending Dividends
Apart from everything I’ve described, there’s no silver bullet when it comes to investing in companies that reinvest their profits into the business. Non-dividend paying companies are, inherently, more speculative as there may not be a “tangible” return for a long time. An underperfoming management, an irresponsible CEO or just bad luck when it comes to reinvesting the profits make non-dividend companies more risky for stockholders (with the possibility of better returns in the future).
And, psychologically, as an investor, I love dividends. They provide me cash flow, give me immediate returns on my investments and make me feel that I’m working towards a financial independence plan. But, as I’ve detailed on this post, there’s a potential cost if you only invest with this goal.7
Conclusion
My plan was to start backwards — first understand what’s the amount of dividends I want to receive to cover my expenses and then build a plan on how to diversify my portfolio as a way that these companies achieve that goal alone.
Because I have a long time horizon, I have time to invest in non-dividend companies or ETF’s that do not distribute dividends.
Bottom line is: every investing decision you’ll do is tied to your personal goals — If your FIRE time horizon is from 20 to 30 years from now, you will be making a smarter investment by investing in an ETF that does not distribute dividends or subscribe to a DRIP plan so that your returns compound more easily. And worse that all these scenarios I’ve just presented is not investing at all — so why don’t you start right now?
