6 Reasons I Don’t Like Dividends

by JT McGee

Dividends have disadvantages and advantages.Dividends are a hot topic, usually because they’re associated with passive income. Bargaineering, a popular finance blog, asserts that dividends are good, and he even tackles a few common objections.

In the spirit of going deeper into every issue, here are a few reasons I don’t always dig dividends:

Why I don’t dig dividends:

  1. Risk – Dividends may soften the blow to share price during periods of economic contraction, but that doesn’t mean they’re always good. In fact, one of the best ways to kill a company’s share price (if only temporarily) is to cut a dividend. Investors who have become accustomed to dividend payments will sell off companies like seniors do to would-be entitlement-reforming politicians when the dividend gets cut. Many strategists have said that buying after a dividend cut makes a lot of sense as weak hands sell out, and bad news unfairly punishes stock prices. In many cases, the additional cash may provide for a better, quicker turnaround, as was the case with La-Z-Boy.
  2. Better Uses for the Money – Dividends are generally associated with slow-growing companies anyway, so we’re going to ignore that companies could make capital investments internally. Instead, I would prefer a company actively buy back their own stock with their cash on hand, which increases my percentage of ownership much like a DRIP would, but does not increase my tax bill. I’ll admit there are opposing views to this policy, mostly that buybacks aren’t always used to generate net decreases in available shares. In some cases, repurchased shares may just negate stock options given to executives. However, dollar for dollar, buybacks go 15% further than dividends.
  3. Higher Multiples – The name of the game on Wall Street is cash flow. Investors don’t want to carry assets that are negative carry—those that don’t pay out a stream of positive income and may sometimes require further injections of capital. Since Wall Street likes cash flow, it loves dividends, and often overpays for companies (on an earnings-multiple basis) that provide a stream of cash to their shareholders. This is especially true right now as blue chip dividend yields are virtually interchangeable with corporate debt yields. Distributing cash in the form of ownership with buybacks pushes away investors who are looking for an external return, and keeps all the goodies for investors like me who are cool with internal returns. 😀
  4. Taxes – Companies have a record amount of cash, but most of it is overseas. To bring cash to the US is costly; the US corporate tax rate isn’t exactly low. This is, among other reasons, why I think Google decided to issue $3 billion in bonds even though it has $37 billion in cash—they needed some US money on the cheap. I don’t want companies to be spending their highly-valuable cash (US-based cash) if they don’t have to.
  5. Dividends Increase Available Purchasers – One of the best ways to increase the value of something is to make it so that more people can afford to buy it, or buy more of it. In the United States, many mutual funds are limited to purchasing only companies that pay a dividend, which is why so many companies decide to pay out a $.01 quarterly dividend to maximize immediate shareholder value. (Citigroup recently declared a quarterly dividend to draw in mutual funds.) I want to buy companies other investors can’t buy because then I’m more likely to buy them at a cheaper price to their peers. Structural advantage strikes again!
  6. Dividend strategies are half-baked – The Dividend Aristocrats index might be a popular index for dividend investors, but it does throw off some errors. To be a so-called “Aristocrat,” a company must be a S&P500 stock, and raise its dividends for 25 years straight. This strategy might sound fool-proof, but it recently tossed aside one company, Nucor, because the firm paid out a special dividend in 2008 that couldn’t be matched in 2009.

There you have it: six reasons (that aren’t already plastered all over the internet) I don’t like dividends. This isn’t to say that dividends are bad; they’re just not criteria for a quality investment.

Readers,

What do you think of dividends?

Do you like them, or would you prefer other incentives like share buybacks?

Are dividend stocks a large part of your portfolio? Do you live off the income; if not, would you like to?

Photo by: btk120

{ 9 comments… read them below or add one }

Sustainable PF June 22, 2011 at 09:52

I like dividends.

I think your take on risk is a bit off. The companies that *usually* pay dividends are usually older and established. I don’t see a lot of risk in the giants of industry …

Here in Canada dividends are taxed very favourably compared to other types of “income”. Compared to take home income or capital gains dividend profit is taxed really low.

I do agree that the definition of “aristocrat” is flawed. For example, here in Canada where our financial institutions are some of the best in the world (read: no 2008 bailout here!) the recession did cause a number of the banks to not increase their dividend for one year and they were tossed from the list. Any Canuck will tell you the banks are the backbone of dividend payers up here.

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JT McGee June 22, 2011 at 12:10

I should have been more clear. I don’t think there is any risk in failure of a super large cap stock, just that there is the potential for the share price to dive when mostly-dividend seekers run off for another company after a dividend decrease. At some point, dividend yields have to be weighed with corporate debt yields.

Do you really think Canadian banks are immune? Your real estate “bubble” (whether we can call it that, I don’t know) is only just beginning. With so much foreign hot money flowing into Canada, surely rising home prices can’t last forever. Can they? Also, can Canadians walk away from properties as easily as American homeowners?

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Ian June 22, 2011 at 10:54

The longstanding record of paying and increasing dividends ( mature large caps like PG or JNJ ) not only helps to provide downside protection in bear markets but also encourages efficient cash management on the part of the business; i.e., if they know they have to make the dividend payments they have to budget properly. This doesn’t necessarily them from making inefficient, empire-building acquisitions or other wasteful decisions, but it manifestly *does* stop them from using the cash earmarked to pay the company owners.

Buybacks are largely negative, either being used to provide cover for managerial stock perks or to justify a non-dividend policy. Unless the firm actually buys back shares continually throughout the business cycle ( a la XOM ), it is almost guaranteed they will overpay for the own stock. Tax policy will always fluctuate with the whims of politicians; Uncle Sam is every investor’s silent partner. Even so, studies (Jeremy Siegel, et al) have proven that the majority of the returns made in the stock market have come from dividends.

It is quite a risky assumption that the “internal returns” achieved through tax savings will eventually translate into actual cash for the shareholder. They may or it may not. However, receiving the cold card cash *now* allows the shareholder to decide whether to keep the cash or reinvest in company. As a partial owner of the business, I would like to make my own decisions with my share of the profits. Internally held cash is only valuable if it results ( eventually ) in my obtaining a portion of that cash; I prefer to hold a stake in a good business that provides me with cash now and the promise of continuing to do so in the future.

Quality goes on sale often enough, and if the market environment is so euphoric that no bargains exist, it’s just as well to build cash and wait for the inevitable change in Mr. Market’s mood. First and foremost the investor should establish a disciplined capital allocation methodology supported by fundamental analysis. Given that foundation, you don’t have to wait all that long to find quality dividend paying companies trading below their fair value.

Dividend strategies are only half-baked if the person assembling their portfolio has done so in a half-baked manner. Nothing forces an investor to ape the S&P Aristocrat ( though you could do much worse than following that particular index ). I think you would agree the Nucor example is comparatively rare with regard to the Aristocrats.

I don’t know what else to say except that there is plenty of company information via mandated SEC filings and annual reports along with numerous independent sources investors can draw upon to conduct fundamental analysis. In the end, there is no absolute guarantee of investing success, but dividends, over the three centuries in which stock markets have existed, have been the primary reason people paid for shares in the first place. The exceptions have been, alarmingly, during periods of manic trading and irrational exuberance.

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JT McGee June 22, 2011 at 12:21

Correct me if I’m wrong, but I think this is your first comment here? If so, I welcome future comments. If not, I still welcome future input. 😉

In studying performance from dividends and buybacks, there is a natural bias in these studies. A company that can pay dividends can obviously generate consistent free cash flow. It’s also more likely that they have a reasonable debt-to-equity ratio, as well. It shouldn’t surprise anyone that these companies outperform.

I would like to make my own decisions as well. However, in a pure apples to apples comparison, I’d rather have consistent buybacks over a dividend. I just found the Nucor example to be interesting. I won’t throw out the lot for that one item, but it shows the weakness in arbitrarily picking securities based on past history.

Dividends have proven to be indicative of great companies, and have lead investors toward good performers. I just think the link between dividends and success is a false one, in that dividend-paying companies can generate free cash flow–they have to. Non-dividend payers don’t have to. In comparing companies that consistently generate free cash flow to those that do not, it’s pretty obvious why one group outperforms the others.

“The exceptions have been, alarmingly, during periods of manic trading and irrational exuberance.” Agreed. Still, this isn’t reason to throw out the lot of non-dividend paying companies just because their peers may not be the best.

At the end of the day, I can deal with both dividends and share buybacks. But I’d prefer consistent share buybacks to a dividend. Surely you can agree with me that dividends buffer share prices. I’d prefer to buy at a lower price than pay more for a stream of income.

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Financial Uproar June 22, 2011 at 14:43

A cat picture? Really? 🙂

For me, it depends on the company. Certain companies should pay dividends. Others shouldn’t. And Citi’s 1 cent dividend is a joke. But I digress.

The majority of mortgages in Canada are recourse mortgages, meaning the bank can go after other assets if you don’t pay. Most of our mortgages are directly guaranteed by the federal government, so usually insurance pays up. Since our real estate market has done so well over the last 15 years, nobody is really sure what would happen if a large segment of the population is in some sort of negative equity situation.

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Hunter June 23, 2011 at 10:37

Dividends are over-rated, no argument there. One aspect to stock ownership irks me, above all others irks. The top 1% wealthiest people own just about everything. They benefit from the Bush tax breaks on dividends. Ok, there it is. This was a brief rant.

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PKamp3 October 15, 2011 at 12:19

Channeling Warren Buffett here – well, actually he recently announced a buyback. Capital flows to its most useful purpose – so a dividend is a declaration that a company is either too large to grow, or doesn’t see a useful place to reinvest the money. Considering that dividends are double taxed in America (with very few exceptions, such as MLPs), it’s a miracle that dividend paying companies have gotten such a following.

I think that Risk is a definite number 1. While dividend payers tend to attract retirees relying on the dividend payment, there is a huge taboo with cutting dividends. Share repurchases? No such problem. You can declare them and cut them off with impunity. God forbid a dividend gets cut!

Maybe I’m biased; I work in tech.

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JT McGee October 15, 2011 at 12:29

I really think dividend paying companies are so popular because people hear the statistics about how dividend-paying firms beat those that don’t pay a dividend. In my view, this is focused on the wrong level of analysis–outperformance doesn’t come from the dividend as much as it comes from the capacity to pay a dividend. Consistent, above-average dividend yields require consistent (and hopefully above average) generation of free cash flow.

Speaking of tech, when are these firms going to start paying a dividend, or start doing buybacks? Driving me nuts. Look at Cisco, for example. CSCO generates $9 billion a year in free cash flow against a market cap of $95 billion. That’s nearly 10% a year in cash flow yield.

The company sells for two times book value, which tells us there’s equity of $47.5 billion. Look to the balance sheet and what do you see? Total cash is equal to $45 billion.

Essentially, CSCO generates $9 billion in FCF against a valuation less cash of $45 billion, or 20% per year. It’s sickening how cheap this company is, and how pricey the cash on hand is, given that investors seem to price the company as if the cash doesn’t even exist.

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PKamp3 October 15, 2011 at 12:43

‘We’ (am I qualified? Haha) probably would, but the cash and short term investments on the balance sheets aren’t exactly in America. The cash is sitting on the sidelines since these companies would have to take a large tax hit to repatriate it.

Take Cisco, your example – 50% of their sales are overseas. (http://blogs.cisco.com/tag/repatriation/). From a NYT article in 2009, $29 Billion of Cisco’s $35 Billion in cash at the time wasn’t on our shores. It’s the reason why mega cap American companies (not just tech) are buying up small cap companies overseas – and, as you probably guessed, one of the reasons for all the debt financing going on in the US.

Some of the larger tech companies do pay, but they are definitely a rarer breed. More common is the ‘special dividend’ which, hilariously, causes a rush into a stock so only those invested at the time are really gaining from the price appreciation. Being a tech worker, I have way too much tech exposure anyway, so I trim my exposure when something vests – but I feel your pain.

Full disclosure: I’m biased, because my company is sitting on an overseas cash horde as well. Good news, I’m not an insider, so swing away!

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