… the fallacy of dividend paying stocks!

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I have been itching to write this post for some time now, and yesterday’s post about investing in income-producing real-estate v speculating in (hopefully) appreciating RE should have provided the necessary comments/questions …

… but, it didn’t 🙁

However, Steve chose this particular day to finally complete his comment on a post that goes back 6 months … a comment that is right ‘on topic’ for me … and, is a question that all of us should be asking … so, thanks Steve!

Here’s what Steve had to say:

I don’t purport that he is write [sic] in his article but would really love to hear your views on [this] story…

http://seekingalpha.com/article/84850-investing-in-dividend-paying-companies?source=d_email

what i liked about it is the dividend paying stock situation. certainly i wouldn’t consider as an only avenue to wealth, but do you feel dividend paying stocks are a better choice than non dividend paying stocks?

The article promotes a method of investing that the author claims returns “a little over 8.68% annually … while not earth shattering by any means, compare[s] very favorably with the market’s performance over the same period. From July 1988 to now, the S&P 500 has advanced … around 7.86% annually.”

The ‘now’ is actually July 2008, so only reflects some of the recent stock market losses, but the principle is clear, at least according to the author: invest in dividend-paying stocks …

… and, this is certainly ONE (of many) Making Money 301 tactics that I recommend when you have made your Number and are trying to preserve your wealth. However, it is just that – a tactic – and, certainly not the best one there is.

Given this, and my strong recommendation that you invest in RE for income, you might be a little surprised to hear me say:

As a Making Money 101 or 201 strategy, seeking out dividend-paying stocks is almost irrelevent!

Why?

Well, let’s take a look:

Stocks return in TWO main ways, just like real-estate:

1. Capital Appreciation

2. Dividends

Capital Appreciation

Just like real-estate, the price of a stock tends to go up according to the profits of the company. When I say “just like real-estate”, I mean just like commercial real-estate … residential real-estate has other, less tangible drivers of future value. So commercial real-estate tends to rise in value as rents rise, and stocks tend to rise in value as the company’s profits rise.

Naturally, inflation is a key driver (forcing rents/profits up, hence the price of the real-estate/stock) but there are plenty of other ‘micro’ and ‘macro’ factors as well e.g. for real-estate it could be job growth, for companies it could be competitive pressures, etc.

This is what I would call the Investment Factor that tends to drive up the value of such investments, and you can generally be confident that prices will increase according to this factor – over the long-haul.

An equally important factor is ‘market demand’ for that type of investment, which is reflected in ‘capitalization rates’ for real-estate and ‘Price-Earning (PE) Ratios’ for stocks … this is essentially a measure of how long somebody who buys that investment is willing to wait to get their money back via future rents/profits.

This is what I would call the Speculation Factor that tends to drive up or down the value of such investments, and you can never be sure which way this will drive prices – over the short-haul.

Unfortunately, as recent market events in both real-estate and then stocks have very clearly shown – the Speculation Factor has a much greater effect on pricing than the Investment Factor … unless your time horizon is very long, indeed.

This is why it is much better to look for the underlying investment returns, unfortunately often mistakenly confused with …

Dividends

Because Real-estate produces rents – and, hopefully positive cashflow after mortgage and holding costs are taken into account (which, should be your main criteria for investing ), people often confuse dividends paid on stocks with returns on real-estate investments.

This is not the case:

Whereas real-estate returns are simply the rents that you receive less the costs (e.g. mortgage, repairs and maintenance, etc.), stock dividends do NOT directly reflect the profits of the underlying business.

Commercial real-estate usually provides an investment return set by a ‘free market’ (for things like competitive rents, competitive interest rates, etc.) …

… but, the dividends on most stocks are simply set by a board of directors according to whatever criteria makes sense to them at the time.

People who invest in dividend-paying stocks are confusing dividends with company profits … but they are NOT directly aligned: a company may make super profits and not pay a dividend at all (for example, Warren Buffett’s own Berkshire Hathaway has NEVER paid a dividend).

A company that makes NO profit may still choose to pay a dividend (perhaps from cash or even borrowings) … just to keep their shareholders happy (for example, in 2004 Regal Cinemas paid a $5 per share dividend; “to make the $718 million payout, Regal first had to borrow from its banks”).

Is it a sound financial strategy TO invest in Regal Cinemas because they DO pay a dividend, or NOT TO invest in Berkshire Hathaway because they DON’T?

I’d love to hear your views …

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19 thoughts on “… the fallacy of dividend paying stocks!

  1. I think the great thing about RE as an investment (ie; buy and hold for the long term) is that not only does the property produce you the passive income that you are looking for(hopefully you did your homework and picked a good investment property and leveraged it as such so that you can use it as a wealth-building tool and will be or eventually be heavily ‘positively geared’) but with time, those profits go up as rents go up as you said(protecting your investment against the heel-nipping inflation) and eventually, when you reach your number and/or the property is paid off, your profit now goes up greatly of course, with no debt owed on it, maximally gearing you on that particular investment.

    You can set this practice up according to your plan/number/date. In other words, stay just barely positively geared in the beginning or perhaps choose to be negatively geared for a while and maximize your leverage on the equity in these properties as they rise in value against the purchase of additional properties.

    Then as you begin to reach your number by your date, you can have it in your plan to get the properties rapidly paid off and clear the debts while the rents can work to both produce your ‘monthly number’ requirements to live your life’s purpose and double as an excellent Money Making 301 strategy to help you protect your wealth and grow it along with inflation to keep you living your life’s purpose.

  2. @ Scott – I think it’s the flexibility over leverage (i.e. borrowings) that you mention that tips things in favor of real-estate for me …

  3. Can the fact that dividends are decided by boards, and not on profit, be the exact reason why you might by a dividend stock over one that’s not? What I mean is, if you have two identical companies, let’s call them pomegranate1, inc. and pomegranate2, inc., and 1 pays dividends while 2 does not. The CEO’s of both companies suddenly come down with a “hormone issue” and step down causing their share prices to plummet. If you believe that the replacement management for these companies is good and their fundamentals are sound, but that the market is acting irrationally (but the dividend is of course unaffected) does it make more sense to buy the dividend paying company because of the higher yield and identical upside? Or are you saying that Pomegranate1 would simply not go as low as Pomegranate2 because it pays a dividend, which would likely be priced in?

  4. “Is it a sound financial strategy TO invest in Regal Cinemas because they DO pay a dividend, or NOT TO invest in Berkshire Hathaway because they DON’T?

    I’d love to hear your views…”

    I wouldn’t select a stock (or group of stocks) based solely on its past dividend yield. There are just too many other factors that contribute to future return of a stock.

    “The article promotes a method of investing that the author claims returns ‘a little over 8.68% annually…'”

    This quoted return is attributable to just the appreciation of the stocks. It doesn’t include the dividends received over the 20 years, which I guess would increase the overall return by several points.

  5. @ Ryan – Oh, let’s take Apple as a totally random example 😉 I am happy for Apple NOT to pay a dividend, because I know that they will use that money better than me:

    – Apple will put it into marketing, R&D, etc. and their shares will appreciate as these resulting profits continue to climb.

    – I will be stuck to find a place to invest the dividend that produces a better return … that’s why I bought Apple (hypothetically) in the first place.

    For that reason, your two scenarios CAN’T be equal, because one is robbing Peter (their customers) to pay Paul (you) earlier … risking future profitability for current spending – the EXACT opposite of what a GREAT company should do.

    That’s the long-term disadvantage … and, I think your guess that the dividend-payer might price themselves too high is as good a guess on the short-term disadvantage as any that I have seen 🙂

    @ Jeff – Meaning that you would vote FOR selecting stocks on the basis that they pay a strong dividend?

  6. @Adrian-

    “Meaning that you would vote FOR selecting stocks on the basis that they pay a strong dividend?”

    I would vote for considering past dividend yield (and historic dividend growth) when selecting stocks…just like how I would consider rental income history when selecting and investment property.

  7. @ Jeff – there are two parts of my post and you have picked up nicely on Part A: there is an analogy between INCOME on real-estate and INCOME from stocks; the ‘moral’ is that you should buy BOTH RE and stocks on the basis of INCOME … if you do, the capital appreciation WILL come.

    But, Part B of my post differs from yours in – my opinion only (well, reading b/w the lines: I suspect, Warren Buffett’s as well) – ad, that is:

    – YOU say Income on RE = Rents, and Income on Stocks = Dividends

    – I say Income on RE = Rents, and Income on Stocks = Earnings

    The small ‘catch’ is that you can’t spend company Earnings, but they are the real driver of reliable dividends AND stock appreciation … so, say, find a BUSINESS with good earnings, be it a business you own 100% of (e.g. small business) or a business you own 0.001% of (e.g. General Electric) and only draw down the min. that YOU need … that amount is UNLIKELY to match the somewhat arbitrary dividend that a board may decide to set, anyway.

    Again, only my view … I’m sure you can make lots of money with carefully selected dividend stocks, as well 🙂

  8. @Adrian-

    “YOU say Income on RE = Rents, and Income on Stocks = Dividends

    I say Income on RE = Rents, and Income on Stocks = Earnings”

    Not exactly…I would say “Income on RE =” cash distributions from Rents after costs, and “Income on Stocks =” Dividends paid to Shareholders. The statements atributed to you appear to be based on revenue/earnings received before costs. Just wanted to clarify…

    As for your main point…it appears that you place a premium on control over distributions. One question: would you take a lower expected overall return from an investment in order to maintain that control?

  9. # Jeff – of course, you are correct, it’s net rents v either dividends or (net) earnings.

    If I wanted ‘control’, I would never invest in 0.001% of a company (!) so, let me ask your question another way around: would YOU take a lower expected return from an investment in order to take a dividend?

  10. @Adrian-

    The more I think about it, the more I really don’t understand the fundamental argument backing your claim that there is a “fallacy of dividend paying stocks.” What is the fallacy again? Arbitrary distributions…lack of control over the dividend…? In other words, why do you feel that dividend stocks are a non-ideal investment vehicle? (Note: I don’t think they are great…just curious as to why you seem to not like them)

    “let me ask your question another way around: would YOU take a lower expected return from an investment in order to take a dividend?”

    Of course…if I desired passive income more than overall return (cash distributions plus appreciation). Foretunately, right now, I’m not dependent on cash flow from my investments, so I can compare investment options based on overall return (and risk), rather than the potential cash flow they can provide.

  11. @ Jeff – I really think the crux is that dividends are not net income, even though they both ‘seem’ the same … just as profit is not the same as cashflow … but, that’s a subject for another post 🙂

  12. @Adrian-

    “I really think the crux is that dividends are not net income, even though they both ’seem’ the same”

    How does this fact render dividend stocks a non-ideal investment?

  13. Adrian,
    To answer your question( Is it a sound financial strategy TO invest in Regal Cinemas because they DO pay a dividend, or NOT TO invest in Berkshire Hathaway because they DON’T? )
    Personally, I think if Regal Cinemas is borrowing money to pay these Dividends, its a stupid plan , as it puts them in Debt in order to pay these dividends,and the wise approach is not to go in debt unless it can increase the value of the company as a whole.Even then, you want to limit indebtedness,as too much debt can decrease the value of the business,as well as place it in a tight squeeze in times like today.
    But Dividend or no Dividend , any company should be purchased based on sound research,and this company should provide future Growth,sound management(with shareholder interest in mind) and they should have unique or consumable items that everyone needs.

  14. Adrian, let me try to make a point here ok? cause the reason I first asked your opinion about Dividend paying stocks is , we can look at stocks kind of the same as 2 beauties in a beauty contest.
    You have 2 ladies approx. same age, both have extreme beauty on their side, great educations,at some point you need something to set the 2 apart so you can make the decision who will be Miss America this year. That difference for them might be the talent contest, where as, for stocks(both leaders in their industries),both with little debt , Great management , quality products yada yada. The Dividend may be the talent part of the contest .

  15. @ Steve – Great summary in your first comment! As to the beauty contest, I’ll have to use the great set-up that all such hypotheticals require: “All things being equal …” 🙂

    All things being equal, I agree with both you and Jeff. However, all things are NOT equal for Company A (dividend payer) and Company B (non-or-lower dividend payer): one has more cash on hand to reinvest in paying down debt, opening new stores, buying more equipment, creating new product lines, doing more R&D, buying more advertising space, and so on … all the things that keep a GREAT company growing.

    That’s what I’m looking for in a business that I buy (whether it’s 100% ownership or 0.001%), how about you?

  16. Great explanation. Perhaps if people don’t understand the subject, they should learn how to read accounting statements from companies to see that dividends can be paid despite losing money! If you are going to invest in stocks, you must learn to understand basic accounting statements that are filed with the SEC or you really shouldn’t be investing in that medium. Unfortunately, most folks don’t bother with the basic education and will listen to “experts” pontificate with ridiculous assumptions. Thankfully, there are many places (including here) that will help educate people!

  17. @ ShaferFinancial – I think the same holds true (unfortunately) for many people who invest in Real-Estate, etc. So, they instead hold to ‘common wisdom’ without truly understanding what they are ‘buying into’ …

    Thanks for your comments.

  18. Adrian,
    To answer your(That’s what I’m looking for in a business that I buy (whether it’s 100% ownership or 0.001%), how about you?) Yes,I want a company that is Fairly Priced,relative to its peers, has great potential,is growing exponentially, and has products people trust,need, and use daily.

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