Do dividends matter?
Mainly income
investors should care about dividends
I first saw
the title of this article in a university textbook many years ago. It
challenged what many investors think intuitively, but it makes perfect sense to
those with “Spock-like” logic. This week we’ll see why some investors should
care about dividends and others shouldn’t.
A dividend
paid to holders of a company’s shares represents simply a part of the firm’s
net profits that a firm chooses to share with its owners – i.e. shareholders.
Companies have two basic choices when it comes to deciding on how best to use
its net profits. Net profits can be invested in projects they feel will be
profitable; or they can distribute some or all of those profits to shareholders
so that each investor can decide for him- or her- self how best to invest the
money. Generally speaking, unless a firm can generate a certain threshold rate
of return on profits they reinvest in the business, they will simply pay out a
dividend.
This is why
larger, more mature companies tend to have higher yields. Their higher growth
days are behind them and feel that they simply don’t have enough opportunities
to continue investing new money profitably; so they pay a portion of those
profits out to shareholders.
In other
words, paying out a high dividend is normally done at the expense of future
growth potential since less capital is directed toward new investments to fuel
future corporate growth.
However, it
can also be argued that companies that pay dividends usually have steadier
(i.e. less risky) profits – thereby giving management the confidence to pay a
dividend.
An
investment (be it a stock, bond, mutual fund, etc.) has two basic ways to
generate a return on the money invested. It can either rise in value or it can
pay out some type of income or cash flow – or some combination of the two.
The whole
idea behind the title of this article is that a rate of return is a rate of
return – and the form in which it’s realized doesn’t matter at the end of the
day.
Behavioural
researchers have found that investors would much rather receive a dividend than
have to sell some of their shares to generate some cash flow. The reasoning is
largely perceptual. Take the simplistic example of two stocks, A and B, and two
investors seeking an occasional income supplement, Joe and Jane.
Joe invests
$100,000 in stock A at $10 per share (10,000 shares) at the beginning of the
year. Jane invests $100,000 in stock B, also at $10 per share (10,000 shares)
at the year’s outset.
Over the
course of the year, stock A paid dividends totaling $0.50 per share, and ended
the year with a share price of $10, exactly where Joe bought it. The dividend
gave Joe an income of $5,000 for the year ($0.50/share x 10,000 shares) and
left him with his original $100,000 ($10/share x 10,000 shares) at the end of
the year.
Over the
same period, stock B paid no dividends but rose steadily through the year –
finishing with a share price of $10.50. At the end of the year, Jane simply
sold a total of 476 shares at the ending price to satisfy her $5,000 cash flow
needs. That left Jane with 9,524 shares at year’s end, which, at $10.50, would
leave her with a value of $100,000.
In summary,
Joe and Jane each invested $100,000; each received $5,000 in cash flow during
the year; and each ended the year with shares valued at $100,000. In other
words, the fact that each received their cash flow by different means makes no
difference to their investments’ worth at year-end.
(I’ve
obviously ignored trading costs to sell shares and taxes on the income.
However, the lower tax rate applied to capital gains when selling shares,
compared to dividends, for most investors may offset the trading costs incurred
in selling shares for income.)
While the
preference for dividends is one based mostly on perception, it’s a valid one
for those relying on their investments for the bulk of their retirement cash
flow. Since high yielding stocks tend to be issued by larger, more mature
companies with steadier profits and cash flows; it stands to reason that such
firms will be less risky than a company that pays no dividend, has greater
growth potential, but less reliable profits.
Hence,
dividends do matter but not for everybody and for varying reasons. The greater
consistency and generally lower risk should appeal more to income-oriented
investors. For investors not desiring income, but rather using dividends to
gain insight into the earnings power and consistency of a company’s bottom
line, it’s certainly a useful tool.
The point
of the numerical example of Joe and Jane above was merely to illustrate that
the form in which a total return is realized doesn’t absolutely make, for
example, a dividend superior to a capital gain – or vice versa.
StingyInvestor
(http://www.stingyinvestor.com/)
is an excellent site for researching North American stocks, including filters
for dividend yields.
Shakespeare’s
Investment Primer (http://www.telusplanet.net/public/kbetty/retireinvest.htm)
is a site run by a retired scientist with a passion for investing. There is a
tone of useful information on the site, including an essay on the author’s
methodology for finding his favourite type of stock – one that pays a high and
sustainable dividend.
Dan Hallett, B.Comm., CFP, CFA is the Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.