Let's get real about dividend stocks

Like many good stories, the narrative is better than the reality

Sep 19, 2017 @ 3:25 pm

By Michael Finke

If you want to promote dividend stocks, you can draw from a number of good stories that can help make you and your client feel good about it. Dividends were responsible for nearly half of the total return on equity investments in the 20th century. Today's high dividend stocks provide yields that are near corporate bonds, but offer price appreciation and lower taxes. Dividend stocks outperform the average stock.

All of these stories are true. Like many good stories, however, the narrative is better than the reality. Most financial economists don't understand why anybody invests in dividend stocks. They consider dividends irrelevant, and believe that dividends appeal to investors who suffer from a behavioral bias known as narrow framing. They frame dividends as income rather than as a forced sale of stock.

To understand why academics are such a buzzkill at the dividend party, it's important to review some basic facts about dividends. First, dividends are one way a company returns cash to shareholders. The other is repurchasing shares, which accomplishes the same thing as a dividend but is unambiguously better for shareholders according to the eggheads.

Why is repurchasing better? When a firm issues a dividend, the value of the stock drops by roughly the amount of the dividend on what's known as the ex-dividend date. If I own the stock the day before the ex-dividend date, I'm entitled to the dividend. If I sell it the next day, the new owner isn't entitled to that dividend but the price has just dropped by the value of the dividend. If the dividend is $1 and the price is $100, the price is $100 on the day before the ex-dividend date and drops to $99 on the day after.

This is important because it means that if the firm hadn't paid out the $1 dividend, the company would still be worth $100. The stock value would grow over time, and investors could choose when to take money from their stock investment by deciding when to sell shares. This is what's known as synthetic dividends. If firms don't pay a dividend, I can just make my own dividend by selling off a few shares. But I can do it when I need it, not arbitrarily ever quarter.

The real problem with dividends is that if I hold a dividend stock in a taxable account, I experience a return drag that gets more significant every year. It is a common misconception that an equal capital gains and dividend tax rate means that dividend stocks aren't at a disadvantage if the investor reinvests the dividend cash. This is wrong.

When I receive a qualified dividend, I'll have to pay 15% in taxes right now. If I turn around and reinvest this in company stock, I'll have 15% less stock that can grow over time. I lose the compounding benefit from being able to achieve growth on the larger amount. Even after I eventually pay taxes on this growth, I still end up with a higher net return (roughly 12 basis points per year over time) from holding a stock with the lower dividend and an equal holding period return. Of course, the non-dividend stocks will also provide a greater benefit from a stepped-up basis at death.

This would all be a moot point if dividend stocks outperformed. They do, but that's because the types of companies that pay dividends have also outperformed historically. Even if they didn't pay a dividend.

Which companies pay dividends? Between 1992 and 2016, the average dividend yield on small cap growth stock mutual funds was 0.66%, but 2.40% on small cap value. The dividend yield on large-cap value was 2.88%, compared to 1.50% for large-cap growth. Which companies pay dividends? Value companies. Which companies outperformed during this period? Value companies. But did value stocks outperform because of their high dividends? Did low-dividend value stocks have returns that were similar to high dividend value stocks?

Meb Faber, Chief Investment Officer at Cambria Investment Management, did a recent study to find out, and the news isn't good for dividend fans. In a blog post (sympathetically titled "dividend stocks are the worst"), Faber cites research that breaks out the returns on value stocks with the lowest dividend yields and finds their return to be about the same as other value stocks, but higher when held in a taxable account – even at a 15% marginal tax rate. Compared to the highest 100 dividend paying stocks, the low-dividend value stocks trounce in total performance and demolish in after-tax performance.

Don't just take my word for it. Warren Buffett refuses to pay dividends on Berkshire Hathaway. Why? Because he believes that investors should choose when to take income from the company, and that repurchasing shares is a better way to get rid of unneeded cash. Despite many investors who would rather be told when to take income from their Berkshire Hathaway shares, Buffett makes them do the work. He'd rather not make long-run investors suffer because of the biases of investors who can't shake their need for a dividend.

Michael Finke is dean and chief academic officer at The American College.


What do you think?

View comments

Recommended for you

Upcoming Event

Apr 30


Retirement Income Summit

Join InvestmentNews at the 12th annual Retirement Income Summit - the industry's premier retirement planning conference.Much has changed - and much remains to be learned. Attend and discuss how the future is full of opportunity for ... Learn more

Featured video


Joe Duran: How to compete in a technologically changing world

The CEO of United Capital explains why advisers should have a strong presence on smartphones, make the most of video capabilities and go "bionic" to free themselves from time-consuming chores.

Latest news & opinion

Raymond James executives call on industry to keep broker protocol

Also ask firms to pay for the administration of the protocol to 'ensure its longevity and relevance.'

Senate committee approves tax plan but full passage not assured

Several Republican senators expressed reservations about the bill, and the GOP cannot afford too many defections.

House passes tax bill, focus turns to Senate

Tax reform legislation expected to have more of a challenge in upper chamber.

SEC enforcement of advisers drops in Trump era

The agency pursued 82 cases against advisers and firms in fiscal year 2017, down from 98 the previous year.

PIABA accuses Finra of conflicts of interest

Public Investors Arbitration Bar Association report slams self-regulator over its picks for board of governors.


Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print