With fixed income investments like bonds and CD’s returning decade lows, some investors have turned to dividend stocks as a way to receive predictable income at regular intervals. Dividend stocks usually refer to companies that have a history of paying out dividends to shareholders. In fact, each year, the S&P 500 publishes a list of it’s dividend aristocrats. A company must increase it’s annual dividend payout every single year for 25 consecutive years to get onto that list. Many beginning dividend investors turn to this list because of that reason.
Now that we know what dividend stocks are, should we invest in them? It’s tempting to buy a few dividend aristocrats and see your dividends steadily increasing every year. Especially when many companies are paying out dividends in the 3-4% range and the highest online CD’s are just under 2%. But unfortunately dividends are a little more complex than that. Dividends may seem like free money, but companies that pay dividends are actually leaving themselves with less money to grow.
The Value of a Company
For simplicity, let’s say a company’s value is defined as it’s assets minus liabilities. Let’s take a look at two companies, Company A that pays dividends and company B that doesn’t. If both companies have zero liability and they are worth the same, what happens when one pays a dividend?
|Net Worth on 5/1/12
|Number of Shares
|Price per Share on 5/1/12
|Dividend Payout on 6/1/12
|Net Worth on 6/2/12
|Price per Share on 6/2/12
Regardless of what’s going on in the market, this is the effect a dividend payout has on a company’s net worth. As soon as company A makes a $100 dividend payment split up equally to all it’s shareholders, the value of that company is reduced by $100. Meanwhile, Company B is left with $100 more than Company A to invest in whatever the company deems appropriate.
Pro dividend stock investors will tell you they believe they can re-invest those dividends more efficiently than the company would. I’m not so sure. Unfortunately, this argument is very difficult to prove one way or the other. Instead, let’s take a look at some actual performance. I want to compare a fund that tracks dividend paying stocks and a fund that tracks the S&P 500 index.
Vanguard Growth & Income(VQNPX) is a well established fund that seeks both capital appreciation and dividend income. Let’s compare it to the S&P 500 Index and Vanguard’s 500 Index Fund(VFINX). The chart below, from Morningstar, estimates the growth of $10,000 starting at the fund’s inception in 1986 until today. It also assumes that dividends are re-invested.
What we can immediately see is that VQNPX, our dividend fund barely outperformed our 500 Index fund, but both were under the return of the S&P 500 during that time frame. Remeber, these are growth charts, so let’s take a look at the price chart.
In terms of capital appreciation, VQNPX fell far short of our 500 Index fund. However, since VQNPX’s dividends were re-invested, the total growth and total return on $1,000 is nearly identical for VQNPX and VFINX. This is exactly what our theory says should happen. All things equal, both companies should deliver the same amount of growth as long as their capital investment is the same. Our returns are nearly identical when we re-invest dividends.
Dividend Tax Disadvantage
The best reason to become a “dividend investor” stems from the belief that companies that pay dividends have a systematic advantage in their business acumen over non-dividend paying companies. As I’ve shown, the growth over long periods of time is equal. Although, these graphs do not take into account taxes on dividends. Due to the compounding nature of capital appreciation, this type of growth will lead to more tax savings than if you were to take out dividends every year. Let’s look at two identical investments that each have yearly returns of 100% and tax rates of 50%. Except Investment X pays dividends, and Company Y returns capital gains.
|Return After 1 year
|Taxes After 1 year
|Value After 1 year
|Return After 2 years
|Taxes After 2 years
|Value After 2 years
We can see from the chart, that deferring taxes allows you to pay less taxes in the long run. This simple example illustrates an argument against dividend investing for young investors. Anyone under 40, has 20-30 years or more of compounding to take advantage of, which is why I don’t like to tilt my portfolio too much in favor of dividend stocks.
With that being said, I hold dividend stocks as part of my US Stock Allocation in Vanguard 500 Index(VFINX). As I’ve mentioned before, I use the simple 3 fund plan of US Domestic Stock – 500 Index Fund(VFINX), International Index Fund(FSIVX), and Total Bond Market(VBMFX) for my retirement accounts. The diversification of any 500 index fund will expose me to dividend stocks and I don’t feel the need to further tilt my portfolio.
The Benefits of Dividend Stocks
Even though I’ve stated my case against “dividend investing,” it’s definitely one of the least harmless investing theories. You are still investing in proven, blue chip companies that have solid P/E ratios and decent growth potential. There are many great dividend ETF’s and funds with low expense ratios. Dividend stocks can be a great fixed income tool for older investors who may not care as much about capital appreciation. In addition, they provide tax benefits when compared to CD’s and other types of fixed income since they are taxed at the more favorable long terms capital gain rate.
This Vanguard paper on retiree spending from a potfolio(total return approach vs. total income approach – A really good read for investors nearing or in retirement!) compares high dividend funds to low dividend funds. They find that “in both scenarios, the yields were relatively stable, but the capital returns were volatile.” In other words, dividend funds may be more stable than capital appreciation funds. This should make perfect sense. In an economic down turn, dividend stocks will still try to pay out dividends regardless of how low their share price may go. I think it’s a good idea for retirees to sacrifice some capital gains to get less volatility.
Some investors like the idea of owning a stock that pays out dividends, but I’m more inclined to rely on the compounding nature of capital gains. I don’t think there’s a need to tilt my portfolio further towards dividend stocks since I already own them as part of my US stock allocation. Dividend investing is fine, as long as you know the risks. But replacing CD’s and bonds with dividend stocks greatly increases your risk. The last 10 years should serve as a reminder just how fickle the stock market can be.
Do you invest in dividend paying stocks? If so, how old are you and how have your returns been?
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(Note: Big thanks to my friends at the Bogleheads forum for helping out with some of the research for this article)