Dividends: real cashflow or fake cashflow?

If you’ve noticed, I made a couple of adjustments to this blog:

The first is that I have reduced my posting schedule to (generally) twice a week; I’m trying for a Mon./Thur. posting schedule, but – if you enjoy reading this blog (near-future multi-millionaires need only apply!) – your best bet is to sign up for the RSS/e-mail feed on my home page because I’m fickle … if I get the urge, I’ll post daily, or simply shift days to suit my increasingly challenged schedule 🙂

The second is that I’m posting more business-related posts (e.g. my Anatomy Of A Startup occasional series) … I am funding a series of startups with the ultimate aim of a Y-Combinator style of early stage entrepreneurship mentoring / funding program and what I am sharing in this series is real ‘special sauce’ stuff … like everything that I do, it’s usually simple but works!

Back to the first change: if I write less frequently, I’m hoping to challenge myself and my readers even more. To whit, my last post (inspired by Canadian Couch Potato’s brilliant post on the same subject) inspired a one week long comment-debate … one of the best that I have seen on this blog.

The main thrust was the debate around income v capital growth.

Jeff stated the ‘for’ argument best when he said:

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.

But, there’s a key difference between so-called ‘Income Real-Estate’ and its stock market equivalent – Dividend Stocks: Income RE produces REAL cashflow, Dividend Stocks produce FAKE cashflow!

To illustrate, let’s take a look, first, at income-producing real-estate:

Tenants pay rent; you pay costs; what’s left (if any) is real, spendable, excess income/cashflow that generally increases with inflation. Bad RE doesn’t produce an income. Period.

Now, let’s take a look at so-called Dividend Stocks (i.e. Company stocks that you buy specifically because they produce a nice, steady dividend stream):

Dividend-paying company sells stuff; they pay their suppliers and other costs; Good company produces profits / Bad company produces losses.

In either case, the Board meets and says “we gotta pay some dividends”.

The CFO says “But, we got bills to pay!”; CTO says “I got R&D to do!”; COO says “I got warehouses to build!”; CEO just wants to keep his job (he is hired/fired by the Board, remember) and says nothing …

The Board says: “Too bad. If we don’t look after our shareholders they’ll crucify us … even worse, they’ll vote us off our nice cushy board positions and we’ll even have to buy our own lunches!”

“Let the CEO deal with poor cashflow and working capital, insufficient warehouses space, outmoded products and technology, lack of marketing, and so on … heck, we’ll even borrow money from our provisioning funds or the open market, if we have to. No matter what, those Dividends must be paid … after all, we are a Dividend Stock!”

So, they say “no” to the CFO, COO, CTO, CMO … and, every other shmo’

Do you want your board fussing over distributing cash that it may or may not be able to spare? Or, would you rather that your Board focussed on building a GREAT company, with GREAT long-term growth and profitability prospects?

In order to answer that question, there’s one more feature of dividend stocks that we still need to examine; Kevin @ Invest It Wisely says:

The pro-dividend guys do have a compelling case that dividends grow more smoothly than the ups/downs of the markets.

To which I say, “so what?”

As we have already seen, the apparent  ‘smoothness’ of the dividend stream can be illusory.

And, what are you going to do with any dividends that you have received pre-retirement?

I presume that you are going to reinvest them so that you, too, can get to $7 Million in 7 Years (or, at least to your own relatively large Number by your own relatively soon Date).

In other words, you’ll just take that relatively nice, smooth dividend stream and throw it right back into the choppy market [AJC: Next, you’ll be telling me that you’re Dollar Cost Averaging … somebody, grab me a Tylenol, please!].

If you’re going to be fully invested in the stock market, for a number of years, then why don’t you at least buy some stocks in great companies that are going to grow, grow, grow … profits?!

If they happen to pay dividends, well great [AJC: you’re going to give it straight back to them, anyway, aren’t you?], and if they don’t, well who cares?

I mean, would you rather own “this dividend stock [that] has delivered an annualized total return of 3.10% to its loyal shareholders”? Or, would you rather own this never-ever-paid-a-dividend stock that has delivered an annualized total return of 20+% to its loyal shareholders for over 40 years?!

However, there is one special case (i.e what if you are already retired?) that I want to examine next time …

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16 thoughts on “Dividends: real cashflow or fake cashflow?

  1. You’ve got quite a few assumptions here. Sure, some companies will continue to pay a dividend no matter what – even if it is at the expense of cash flow, but most companies will cut or suspend the dividend until the company’s growth can afford it.

    I don’t believe in buying a stock just because they have a high dividend yield, of course, but I do like stocks that pay dividends because it forces management to be selective with how they invest the shareholders’ money.

    Good rental real estate is clearly the better bet for higher returns due to the ability to use leverage more easily along with tax incentives. But renting out real estate is also a lot more work than choosing a stock, and doing nothing for 40 years.

  2. Also I’d like to see your take on REIT’s, which are supposed to be a way for people to invest in real estate without actually doing any of the work.

  3. “I don’t believe in buying a stock just because they have a high dividend yield”

    @ Chris – My point exactly!

    My take on REIT’s? I don’t invest in them specifically because they “are supposed to be a way for people to invest in real estate without actually doing any of the work.”

    I don’t invest in Flying Pig Futures, either 😉

  4. I’ve got to agree with Chris. Many companies with good leadership will cut / suspend dividends for growth or cashflow reasons. And lets face it – good investors DO take note of the reputations of those in leadership roles.

    It’s no different to finding a good tenant if you’re leasing a building. You look at the tenants history and their employment / business prospects to see if they are reliable and can service the lease.

    Selecting a good stock (growth or dividend) is the same. You examine the companies history and those of their leaders. Sometimes you get one wrong, but the same thing happens in real-estate.

    I think this article isn’t one of the better ones. It’s a bit of a straw-man argument, exposing risks on one side, and ignoring the risks on the other.

  5. @ Nathan – RE v stocks isn’t the issue here: making profits is different to distributing cash. One should be a pre-requisite for the other; unfortunately, that isn’t always the case 😉

  6. I look at my specified dividend portfolio as one more bucket to provide an income stream without having to sell the underlying asset. I read the 6 part series you link to (actually I found it through here) and I didn’t find it all that convincing that dividends are evil.

    It seems that people try to live in a vaccum saying that if they provide a dividend to me then that exact amount will be reduced from the market cap/value…and it just doesn’t seem to work like. I get my dividend and the stock continues to go up. Granted my small dividend portfolio is made up of the divdend aristocrats.

  7. In the theoretical world it shouldn’t matter because (i) companies should retain cash and reinvest where they can earn more than the cost of capital and distribute the cash as dividends when they can’t and (ii) in a rational and efficient capital market, investors will price securities to reflect the expected risks and returns associated with each security.

    In the real world, this is mostly bunk. Company management do not make decisions based soley on cost of capital, can’t always find suitable projects, get their projections wrong, are incentivised through stock options to keep excess cash to inflate the share price and (in some countries) double taxation of dividends acts as a disincentive to payment of dividends. The latter two points also expalain why share buy backs are so popular.

    Also, markets are (at best) only somewhat efficient and are definitely not rational.

    So theory is of limited use in arguing that one is better than the other. The lack of conclusiveness is supported by return data which show that neither growth nor value outperforms the other with any degree of consistency over any lengthy period of time.

    As to the ideal of finding a company that will grow indefinitely – Erich Beinhocker demonstrated pretty conclusively that such companies are very very rare and yoru chances of finding such companies before the fact are remote.

    Personally, I don’t think it matters that much. I like getting some dividends on a regular basis because it reduces my dependency on market timing to realise cash for living expenses but, at the same time, recognise that if I want to out run Ben Bernanke’s printing presses I need thise dividends (and the value of the portfolio) to grow over time and retained earnings are (usually) critical to achieving that growth.


  8. “rare and … remote” = Warren Buffett and a handful of others.

    @ traineeinvestor – I’m not much of a share investor for exactly that reason 🙂

  9. Adrian,

    I see where you are coming from and disagree to a point. It depends on what your outlook is. 7 mil in 7 years of course dividends aren’t going to get you their.

    But my grandfather who was a coal miner who cannot work into his 70s because of the type of job. He was able to be a dividend millionaire. When he did retire the income from dividends, his pension and social security was more than enough for him to live comfortable into his 90s and leave money for his children.

    At 90 years old he isn’t going to work,build a business or mess around with real estate. He wanted to check he dividend paying stocks once a month and enjoy retirement, drink a few beers and his biggest worry was cutting the grass.

    I also find it interesting you mention Berkshire Hathaway. Depending on when you look at BRK holdings they do invest a significant amount of money into dividend paying stocks even though they do not themselves pay a dividend.

  10. Pingback: Wrapping up …- 7million7years

  11. Real estate investment trusts are solid dividend investments with high yields because of the nature of their business; they are required to pay 90% of their net income to shareholders in the form of dividends. The best REIT that I like is the Realty Income Corp (NYSE: 0) which pays monthly dividends and has a history of 42 years of paying dividends.

    Realty Income Corp is a 42 year old real estate investment trust that pays monthly dividends generated from over 2,500 commercial properties in 49 states across America. Most of the company’s revenues come from retail office space including convenience stores, chain restaurants, movie theaters, health and fitness centers. Examples of their tenants include PetSmart, Taco Bell, Jiffy Lube, Children’s World Learning Center, KFC & National Tire & Battery. Source: http://www.highest-dividend-paying-stocks.com/ The company leases office space in the form of preferred leases where the tenant is responsible for the majority of the property’s operating expenses (taxes, maintenance and insurance).

    The company’s stock has a market capitalization of $4.3 billion and currently yields 5.11% dividend. It currently pays 14 cents a share monthly equaling $1.68 per share annually. This has grown from a modest $0.90 per share dividend paid when the company was young.

  12. I do not understand why you are so biased against dividends.

    In your example behind Abbott (ABT), you are comparing the ten year total return for the stock to the 40 year total return for Berkshire Hathaway. Why don’t you compare 10 year returns, and then 40 year returns?

    And also, why don’t you compare 10 year returns for ABT to 10 year returns for S&P 500?

    Also, why don’t you mention the story of Grace Hopper, who purchased 3 shares of ABT for $180 in 1936.

    You have very selective memory. I am actually starting to question whether you really are a millionaire, or just a person that pretends to be one.

  13. @ Shafik – Why would you pay somebody else to invest in real-estate, sub-optimally, when you can buy your won real-estate, add value and make superior capital and ‘dividend’ (actually, income) returns?

    “I do not understand why you are so biased against dividends.”

    @ Blogging Banks – please read my posts on this subject carefully, and you will see that I am simply not biased FOR dividends.

  14. Adrian I think you have a very valid point when you say that rents are different from dividends.

    That said I have a preference for high dividend yielding stocks.Here’s why:As a minority investor the only practical option left to me in case I dislike a management decision is to sell the stocks maybe even as a loss.Not very business has a wise capital allocator like Buffett at the helm.When businesses become tough or managers wish to try something new companies tend to enter new areas of business or less profitable associated businesses.A few bad decisions can wipe out the retained profits of many years.

    So I feel its best to pay myself back the initial investment ASAP in the form of dividends.After all cash in the hand is better than cash in someone else’s books.

  15. @ keerthikasingaravel – Couldn’t you achieve the same return of initial capital from a partial sale in the underlying stock?

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