Over the past few weeks, we’ve taken a deep dive into a strangely emotive subject: stock dividends.
In fact, the two articles (the first being a reader poll) that I wrote on a hypothetical real-estate transaction was not really about real-estate at all … it was also about DIVIDENDS.
Did anybody pick up on that?
You see, the problem with the real-estate deal is that if the property isn’t good enough to generate its own profits, the Rental Guarantee forces the developer to dig into project reserves, excess cashflows, or even future profits (by borrowing more money to pay the investors the ‘guaranteed’ amount) … none of these things are good for the project, the developer, or (ultimately) you as an investor!
Lets face it, everybody who invests wants to make a profit … so, do your due diligence before you get in and let the project deliver what it can …
Similarly, a company that focuses on issuing ‘high’ dividends through thick and thin to attract shareholders – with a board of directors that doesn’t adjust their dividend strategy to market realities quickly enough – is facing just the same problems as the developer forced to offer income guarantees to attract investors to a real-estate project … it’s all great when things are going well, but when the economy sours, things change – for the worse – very quickly, under these sorts of deals.
Now, I haven’t said that you shouldn’t invest in dividend-paying stocks … others, are just saying that you should – just because they are dividend payers – which is just plain dumb.
To my mind, the fact that a company offers dividends is just one factor – a relatively small one at that – in my decision to invest in a stock …
… to my way of thinking, it’s like choosing a dentist for your kids on the basis of the volume of candy that he hands out at the end of the visit:
– Shouldn’t we choose the dentist on the overall quality of his work (and, maybe price as well)?
– Doesn’t handing out candy at a dental practice seem somewhat strange to you?
Well, that’s exactly what you are doing if you choose a company because it pays great dividends …
… now, you may use other criteria as well, but if you are EXCLUDING great companies from your list because they DON’T happen to pay a dividend, then this also applies to you!
– Shouldn’t you choose a stock on the basis of its great past/future BUSINESS performance?
– Since CASH is the lifeblood of a business and the driver of future investment and growth (eg for R&D, retooling, opening new stores, etc., etc.) shouldn’t we prefer a business that conserves it, rather than one that doles it out like candy to attract shareholders?
Look, just because a company issues dividends doesn’t mean that it’s making profits … the two SHOULD be directly related, but often they are not:
1. Profits (better yet, free cash flow) are a function of a sound business model,
2. Dividends are at the whim of the board of directors.
So, why not go direct to the source: look for companies with a strong current and (expected) future cashflow, and take your money out when YOU need it, not when the board of directors says you can have it?
So, is there a place for investing in dividends … surprisingly, YES.
But, not when and how you think:
Instead of laying out dividend paying stocks against other Making Money 101 and Making Money 201 activities, hold your thoughts until you reach your Number and are looking at preserving your wealth (i.e. with various Making Money 301 strategies).
You COULD then invest in solid, dividend-paying stocks (although, you may elect to go for a company’s Preferred Stock, rather than their Ordinary Shares) because having a semi-reliable income stream may be more important to you than overall return (i.e. you are trading off convenience for you against leaving your children or church a sizable inheritance) …
… or, you could try one of these MUCH better Making Money 301 strategies:
1. Buy Inflation-Protected TIPS (treasury bonds) or inflation-Protected MUNI’s (municipal bonds) with 95% of your portfolio, and put the remaining 5% in year-long call options over the S&P 500, to give you exposure to the potential upside of the market.
2. Buy (and hold) a rental property or five – live off the income (well, 75% of the income – leaving the rest as contingency against vacancies, repairs & maintenance, etc.) and bequeath the capital appreciation to your children/charity/church.
3. If you MUST look for dividends, buy Preferred Stock instead of ordinary/common stock (just as Warren Buffett has of late); these are a special class of stock that act more like corporate bonds, but: are less volatile than a stock; have more upside/downside than a bond; often produce higher dividend returns than the dividend on an ordinary share in the same company; and, are more likely to be paid … the issuing company usually pulls out all stops to maintain the dividend on these Preferred Shares even while lowering dividends on Ordinary Shares (a.k.a. Common Stock).
There, you are now better equipped to make decisions on dividends – at all stages of your financial life – than 99% of so-called ‘dividend experts’ 🙂
Great info, thanks!
Adrian – Dividends are to stock investing what depreciation and expense deductions are to real estate investing.
It’s icing on the cake, not the fundamentals for decision making. Thanks for the reminder.
I agree that dividends shouldn’t be the only factor and that a company’s dividends should follow earnings. However, I think that there is a very positive feature of dividends- they prevent businesses from accumulating too much cash and making poor investments with it.
I’m very much in favor of a company good invests in capital goods, R&D etc. that will make money in the long run. However, if there is too much in the corporate coffers I think there is a danger that the money will be wasted or even worse buy liabilities. Some examples that come to mind are acquiring unrelated and poorly run businesses, extravagances for management like corporate jets, etc.
On the whole I would much rather see a company that does not intend to invest its profits pay dividends or do stock buy backs to transfer excess wealth to the shareholders.
@ Jeff – I see what you’re saying: it’s like buying a bad investment merely because it gives you a tax deduction: you may get a poorer future return, but more cash in your bank account (by paying less income tax) today. Interesting comparison.
@ Rick – there is a very positive feature of LOWER dividends – they prevent investors from accumulating too much cash and making poor investments with it – or worse, spending it! 😉
“… to my way of thinking, it’s like choosing a dentist for your kids on the basis of the volume of candy that he hands out at the end of the visit”
Weird analogy because candy from a dentist would be a trival side benefit, while dividends typically provide a non-trival proportion of the overall stock return. If a dentist (with good dental skill) gave you a non-trival amount of candy, i.e., a pallet of candy, that you could sell, reducing or eliminating your bill for his services, wouldn’t you take that into consideration? What if the dentist just handed you cash at the end of the visit, i.e., to cover a co-pay or your out-of-pocket expense?
“there is a very positive feature of LOWER dividends – they prevent investors from accumulating too much cash and making poor investments with it – or worse, spending it!”
Are you really saying that the problem with dividends is that investors don’t know what to do with the postivie cash flow they provide? I thought cash flow was king (or something like that)…maybe only if you have a mortgage to pay.
@ Jeff – If their customers begin to go to the dentist because they expect the candy, where does the money go if there’s a ‘cash crunch’ (as there will be from time to time in any business): into new staff/equipment/training or into the ‘candy fund’ instead?
I guess you’re assuming that the business is poorly managed and doesn’t keep adequate reserves for such occassions. Maybe when there’s a ‘cash crunch’ the dentist decides to take home less bonus money. Also, if the company is poorly managed and decides to cut “new staff/equipment/training,” affecting the quality of the service, it is not that hard to find a new dentist…
@ Jeff – If you’re truly interested in becoming a better investor, then you should read some research; you could start with this report:
Interesting response…you finally presented a fallacy…too bad it was your choice of argumentation and not in the underlying information (See, e.g., http://www.don-lindsay-archive.org/skeptic/arguments.html#hominem).
@ Jeff – Let’s just call it “Argument By Gibberish (Bafflement)” and leave it at that 🙂
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Adrian, you say (( . Buy (and hold) a rental property or five – live off the income (well, 75% of the income – leaving the rest as contingency against vacancies, repairs & maintenance, etc.) and bequeath the capital appreciation to your children/charity/church. ))
Bit I am wondering, shouldn’t we treat these properties like any other business? You have stated we shouldn’t enter a business unless we intend to some day sell. Maybe thats what we should be doing with these properties instead of leaving them to the kids, church, or place of your choice.
Any thoughts to share?
@ Steve – Great question: a business is a MM201 (reach your Number) strategy; buy/hold investments as described in this post are a MM301 (keep your Number safe) strategy … the rules change.
Thanks(Salamat) for Clarifying that Adrian. 😉
I like your analogy using a dentist. Thanks for the post. I found it very insightful.
If a dentist (with good dental skill) gave you a non-trival amount of candy, i.e., a pallet of candy, that you could sell, reducing or eliminating your bill for his services, wouldn’t you take that into consideration?
@ Dentist – Yes, and it would also have excellent long term benefits for his (and your) business 😉