Monday, September 30, 2013

Dividends Don't Matter

Let's assume that you are an upper middle class dude who is more concerned with current income from investments rather than capital gains.  I am going to assume this as I am too lazy to find the data of what this demographic actually does like good economists, but suppose this is true.  You and your financial planner have mapped out your monthly expenses to match your income from investments.  This means that most of the investments will have to be the fixed income variety, the vast majority of which are investment quality and above bonds/bond funds which won't hold too many surprises.  The more adventurous may hold a few high quality dividend stocks, but if you are interested in monthly income, bonds are where you would least in the good old days.

And then Bernanke came on the scene and shitted all over your life of hedonistic luxury.  Now your checks are getting smaller over the past few years (although capital gains from these bond funds have grown nicely) and you ring up that nice young financial planner who keeps calling you sir to see if everything is ok.  He is a bit worried too as everyone around him is talking about some big bad bond bubble and the need to diversify away from bonds, even for conservative investors.  But you doth protest as you remember the horrors of 2008 and is not keen on buying up shares.  So you two compromise and start rebalancing your portfolio into mostly dividend oriented stocks.  They are perfect, you say.  They send predictably timed dividends, much like a bond's coupons that you are used to and are super safe with their predictable business, an awesome substitute to bonds, which everyone knows is in a giant bubble.  

I think there are a lot of people in this similar situation and they are forgetting that dividend stocks are still stocks.  The dividends don't come from thin air--they come from a company's retained earnings, or their accumulated net profits.  Suppose they didn't pay a dividend.  That money just wouldn't disappear; it would have been reinvested in their business, or at the very least stay on their balance sheets and thus would be reflected in their stock price.  This is why stock prices decrease by the same amount as the paid out dividend on ex-dividend day.  In other words, if the company didn't issue a dividend, your share price would have went up by an equal amount.  Net net, no money was gained/lost.  The company only issues dividends if it is mature and perceives that it no longer makes sense to expand.  This is why big "safe" companies issue dividends.  They are so big that they can't get any bigger.  There is literally nothing else to do with the profit other than to distribute it to the shareholders.

So when you see charts like this, realize they are insanely misleading.  

Having price returns only without dividends is akin to somebody stealing a bunch of your money since without dividends, your share prices should be adjusted to compensate for the fact.  Comparing the Spoo with/without dividends is blasphemy.  There is no reality in which you wouldn't get the dividends.  You either get them or the company keeps it on the balance sheet.  It just doesn't disappear.

Now you can argue that  dividend paying companies tend to do better than companies that don't issue dividends, but that has more to do with survivorship bias and low volatility phenomenon as dividend paying companies tend to be bigger/better financed and thus have an easier time surviving the rocky times.  So yes, dividend payers are on average safer, but it's not the dividend that makes them safe.  It just so happens that big safe companies are also unable to grow as much and thus distribute their retained earnings as dividends.  

If you like dividend payers, that's fine.  Just remember what the dividend represents.  You are buying a company that is not interested in using all of its profits to expand or to keep as reserves.  It is big and safe, at least in the short term, but history is littered with big and safe companies that never bothered to innovate and went bust.