Another case AGAINST dividends …

The graph shows the promise of dividend-investing, but Canadian Couch Potato states the reality – the case AGAINST dividends – far more eloquently than me:

Why do shareholders believe so strongly that a $1 dividend is preferable to a $1 capital gain? Meir Statman looked at this question in a 1984 article called “Explaining Investor Preference for Cash Dividends,” coauthored by Hersh Sheffrin. He also reviews the idea in his new book, What Investors Really Want, pointing out that receiving $1,000 in dividends is no different from selling $1,000 worth of stock to create a “homemade dividend.”

Even when this idea is explained to people, most refuse to accept it. Statman suggests that it comes down to a cognitive bias called mental accounting. Investors categorize $1,000 in dividends as income that they will happily spend, but the idea of selling $1,000 worth of stock is “dipping into capital,” which causes them great anxiety. This idea is deeply ingrained in many investors, but it is an illusion, because a company that pays a dividend to shareholders is depleting its own capital.

If you want to understand the arguments – both for and against – investing in so-called ‘dividend stocks’ for the sake of the dividends, you would do well to read Canadian Couch Potato’s whole blog post AND the comments … all for/against arguments are well thought out.

Here is my argument against dividends in a nutshell:

Since you can create a dividend stream yourself (“ignoring taxes and transactions costs, a stock that pays no dividend but increases in price by 6% provides precisely the same return as one whose share price rises 4% and pays a 2% dividend”), it boils down to what could the company do v what can you do with the ‘spare cash’ that the company plans to issue (or not issue) as a dividend:

1. If the company keeps the dividend:

– They could buy more inventory: if their business is a volume business, more inventory = more profits. Consumer products companies such as Kraft and Unilever are great examples.

– They could do more R&D: investing in R&D is necessary gambling on the future; often it will be money wasted (in which case it’s better off in your pocket as a dividend), but sometimes it will provide a huge payback, such as when a pharmaceutical company develops a breakthrough medication, or a venture capital firm finds the next FaceBook.

– They could invest in marketing: more marketing = more sales; pretty simply, huh? Consumer products and technology companies are classic examples; the more often they put their products in front of the consumer, the more sales they seem to get.

– They could invest in more infrastructure: more factories, more locations = more revenue and more profits. Manufacturing companies, high tech businesses, and retailers are all tied to physical infrastructure.

– They could invest the cash – Many companies (think Microsoft, Apple, the tobacco companies, and the brewers) are sitting on a ton of cash. Heck, Berkshire Hathaway is sitting on so much of it, even Warren toys from time to time with giving it back to the shareholders (i.e. by issuing a dividend); after all, if they can only get 3% while it’s sitting in the bank and you can get …? Inevitably, though, they use this cash to make a spectacular purchase that transforms the company: think Google’s $6.5 billion offer for Groupon, or Berkshire Hathaway’s $44 billion purchase of BNSF Railway.

2. If you take the dividend:

– You could buy more stock in the same company: this is the basis of the automatic ‘dividend reinvestment policy’ that most companies now offer. So, let me see … you invest in company ABC because it issues a dividend, and you use it to, what? Oh, buy more stock in company ABC?!

– You could buy more stock in another company: why invest in another company? Oh, because it provides a better return. So, why not pull ALL of your money from the worse-performing dividend paying stock, and put it all in this company?

– You could buy more stock in a bunch of companies: diversification is often seen as a good thing [AJC: by many reading “how I became rich” blogs; rarely by those writing them]. The more you diversify, the more you tend towards average market returns. Why would you want to take your cash out of a company that produces spectacular returns [AJC: that’s why you invested in the ‘dividend stock’ in the first place, isn’t it?!] in order to put your money into something that produces average returns?

– You could keep your cash in the bank: strangely enough, this one makes sense; if the company can’t do anything better with their ‘spare cash’ than give it to you, wouldn’t you rather have it sitting in your bank account rather than theirs, so that you can at least have the flexibility to make the decision what to do next, eg leave it in the bank, buy some index funds, pay down debt, or even buy back into the company stock when they get out of the ‘sit on a ton of cash with no vision for the future’ doldrums.

… but, if any of these things are better than leaving the money in the company, wouldn’t you be better off taking all of your money out of the company all in one go (i.e. sell the stock) rather than in dribs and drabs (i.e. taking small dividends)?

Let me finish off with a story:

Warren Buffett got started by purchasing a textile company and immediately canceling it’s dividends!


So that he would have more money to invest in growing the company.

Potential investors who wanted dividends invested elsewhere … those who didn’t invested in Berkshire Hathaway and became multi-millionaires!

Berkshire Hathaway still operates on the same principle: why pull money out of BH when Warren can grow your money faster?!

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22 thoughts on “Another case AGAINST dividends …

  1. Adrian,

    I can see the temptation of wanting to spend some dividends that are left as cash. You can also do the opposite- enroll in a DRIP (dividend reinvestment program) that automatically reinvests your dividends. Most companies have them, because they would rather have people purchase their stock with the dividends then spend them elsewhere.

    -Rick Francis

  2. @ Rick – then why invest to get the dividend? Surely a 2% dividend + DRIP gives the same result (tax issues aside) as a stock that appreciates at 2% more but pays $0 dividend?

  3. I also wrote about dividends in 2009: (english translation available by clicking the english flag).

    This is also good reading:

    “The academic consensus is
    that dividends really don’t matter very much.
    The market does not, and should not be expected
    to, pay premium prices for firms
    adopting what are sometimes called “generous”
    dividend policies. If anything, generous
    dividends may actually cause the shares to
    sell at a discount because of the tax penalties
    on dividends as opposed to capital gains.”

  4. So you are saying: don’t buy a company’s stock for dividends, but buy it for the stock’s future value potential?

    Couple of thoughts:

    a.) Fundamentally, the value of a stock is ONLY driven by the expected future cash flow to the holder of that stock AND how that cash flow is expected to evolve in the future. A stock that NEVER promises to yield any cash flow is worthless. However, a stock that delays the cash flow in exchange for massive growth of the cash flow can be quite valuable. Dividends are the typical form those cash flows take. So a stock that will never deliver any dividends is worthless. A stock that currently doesn’t deliver dividends needs to promise rapid growth of potential future dividend payments in order to be valuable. So don’t dismiss dividends altogether.

    b.) Totally agree that dividends vs. selling stock is pure mental accounting.

    c.) However, disagree that you should pick winning stocks vs. diversifying. Very easy in hindsight, near impossible to do in real time. If you work really hard on gathering information, are disciplined, and have deep enough pockets to not cry uncle when hard pressed AND get lucky you might come ahead of average returns. More likely you will come in at below average returns. Investing the average however is quite straightforward via index funds, much lower risk and requires no talent.

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  6. Berkshire Hathaway doesn’t issue dividends – true, but BH also has a track record of providing value to investors to the magnitude of 20+%. Very few other companies can say the same thing. Further, most of BH’s investments DO pay dividends making your story about a textile plant irrelevant as clearly Buffett does value dividends.

    I like a company that pays dividends for many reasons, but primarily because of the mindset it puts on Management. With a steadily increasing dividend, management has to be selective about what initiatives they pursue – rather than wasting shareholder value like many companies that don’t pay dividends do.

    As far as DRIP (dividend reinvestment plans) go, I love those too because they allow you to build up your position in a company over time.

  7. ” Dividends are the typical form those cash flows take.”

    @ Jake – most prudent companies routinely follow a Dividends [LESS THAN] Cashflows policy, otherwise where would they find the retained profits to grow the business (other then by continually asking you to by new shares that they issue).

    There have even been cases of companies borrowing money so that they can issue a dividend to investors:

    @Chris – BH retains 100% of profits to fund future expansion, hence you get 20+% returns, which can produce a fantastic self-manufactured “dividend stream” (sell a few B-class shares each year). Of course, that isn’t a 1:1 correlation; my point is to find and invest in such wonderful companies REGARDLESS of their dividend policy.

    PS Thanks, Kohti. As usual, your Finnish is flawwless 🙂

  8. At the risk of reducing the argument to an absudity:

    1. companies seeking to optimise shareholder wealth should pay out as dividends any cash that cannot be reinvested in projects that yield a return higher than the cost of capital;

    2. companies that can reinvest with the expectation of earning more than the cost of capital should not pay dividends;

    3. it follows that one should only invest in companies that do not pay dividends (and if you want to be aggressive, short sell those which do pay dividends);

    4. however, if the market is efficient (another debate), market prices of dividend paying companies and non-dividend paying companies alike will adjust until they are priced to reflect their expected returns (whether through share price appreciation or dividends or both);

    5. which means that “which is better” will depend on the circumstances and needs of the individual investor. As an example, an investor who needs to live of his/her investments may be better off having at least some dividend payers in the portfolio to reduce the risk of selling at sub-optimal prices. The tax treatement will also be highly relevant.

  9. @ TraineeInvestor – Absurd … yet, strangely sensible 😉 Thanks!

    PS you make a good point about the relative short-term stability of dividends. Sort of non-timing-timing-of-the-market?

  10. I’ve had the same thoughts about the “mental accounting” of dividends versus capital gains, but the pro-dividend guys do have a compelling case that dividends grow more smoothly than the ups/downs of the markets.

    BTW what’s wrong with average market returns? 🙂 Well, excluding the last few years at any rate.

  11. @ Invest It Wisely:

    1. ~8% (after tax, before inflation) compounded does sh*t for any form of early retirement strategy (the core focus of this particular blog),

    2. However, AFTER you retire then the ‘smoothness’ of dividends is a benefit, perhaps a compelling one.

    Anyone have any thoughts on the relative merits of selling varying chunks of a variable stock to simulate a ‘smooth’ dividend/income stream in retirement v simply buying a stock that produces dividends?

    For example, dividends circa 2% mean that you need a much larger Number than my ‘Rule of 20’ contemplates to fund any set level of income.

  12. >hen why invest to get the dividend? Surely a 2% dividend + DRIP gives the same result (tax issues aside) as a stock that appreciates at 2% more but pays $0 dividend?

    Yes, but some times you don’t have a choice- for example if you buy an index you are going to get dividends. If you buy a REIT they are legally required to issue dividends.


  13. “Then why invest to get the dividend?”

    @ Rick – I’m not against dividends at all … I’m against investing specifically to get the dividend.

  14. “I’m against investing specifically to get the dividend.”


    Not wanting income from your investment seems at odds with many of your earlier posts (see, e.g.,, stating “[t]he best you can do is create your perpetual money machine: use your income to buy a little capital (real-estate is nice) which generates more income (from rents, after mortgage and other costs) which you pump back into buying more ‘capital’; repeat until rich!”).

    I know that your above quote was made with real estate investing in mind, but there are many companies out there that provide returns similar to those that a real estate investment can provide (a mix of appreciation and income).

  15. “specifically”, Jeff.

    I can create an income stream from stocks from ANY mix of dividends and/OR appreciation.

    For example, I would be VERY happy to book Berkshire Hathaway’s reported 20%+ annual growth rate (sustained for 40 years), selling some stock here or there to create (simulate) an income stream, rather than buying some so-called ‘dividend stock’ that gives me a 2% dividend and appreciates at 6%.

  16. Adrian,

    I see your point…but selling assets to generate an income stream is a bit different than what you were discussing above in your quote–having an asset generate income so you can buy additional assets.

    Selling assets to generate an income stream can also be less than optimal. For example, what happens if you want a cash flow and experience price depreciation? Is your simulated income stream really “income” or is it just a locked-in “loss”? Dividends provide a true income, i.e., one that doesn’t require you to sell your capital/asset.

    The reasons why people desire rental income from real estate are the same reasons why people desire dividends from stocks…you get a cash flow without having to sell the asset at an inopportune time.

  17. “1. ~8% (after tax, before inflation) compounded does sh*t for any form of early retirement strategy (the core focus of this particular blog),”

    Not if you reduce your income requirements and boost your savings level it doesn’t. If you’re seeking a full income replacement and you’re only saving perhaps 10% a year, then I agree that is not enough. Also, I think that people should have some measure of side income even after retirement and not rely solely on the market. Just sitting around and doing nothing is too boring.

  18. @ Kevin – Thanks! Throw some numbers at me … remember, though, this blog is titled “how to make $7 million in 7 years”; presumably, most of my niche readership wants to make a relatively large Number by a Relatively Soon Date 😉

  19. I find it funny that the title of the post is “against” dividends, yet the chart speaks volumes in favor of dividends.

    In the theoretical world, stocks go up when earnings go up and everything goes in a linear fashion.

    In the real world, things fluctuate. Dividends are the portion of total returns that are least likely to fluctuate.

    In addition, dividends offer a direct link between a company’s profits and total returns. I have seen many situations where companies would have growing earnings, but the stock price has failed to account for that for years. Yet, if the company is able to pay growing dividends out of those earnings, investors are profiting from the increased profitability.

    Of course, just because a stock pays dividends, doesn’t mean it is a good buy. It could be overvalued, or it might not be able to pay its distributions. However, the regular payment would likely provide you with a better edge than anything else.

  20. “Dividends are the portion of total returns that are least likely to fluctuate” + “dividends offer a direct link between a company’s profits and total returns” = profits are least likely to fluctuate?

    Does that sound right to you, Blogging Banks?

  21. @ Blogging Banks – Sure. What is less understood, is that sometimes companies pay out MORE than their earnings as dividends 😉

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