The Dividend Dilemma

In my late April newsletter, I devoted all of it to the enduring power of dividends. And to be clear, I love the dividends produced from a low-cost, globally-diversified, passive portfolio. In that environment, I am extremely pro-dividend.

But this article includes 5 reasons why I am staunchly against devoting your entire portfolio to dividends. Asset managers frequently sell a strategy like this–“We just put your money in dividend-paying blue-chip stocks.” It usually comes with a promise of safety and/or outperformance.

It’s an easy message for a salesman to sell. It sounds great. But don’t do it–and don’t spend $40,000+/year in fees to do it.

How Stocks Produce a Return

Let’s spend 30 seconds reviewing how you make money when you invest in a stock (or 100s of stocks in a fund). A stock price is largely the result of future earnings. Without getting technical, this overly simple equation helps:

Total Return=Appreciation + Dividend*

*you could add  “/buybacks” Despite the strange war on stock buybacks, CFAs from both sides of the political aisle agree buybacks are essentially dividends.

The Case Against Dividends:

1. Total return is all that matters. Period. Yield means nothing if total return lags. Look at this from Ben Carlson. As Ben shows, AT&T is an incredible example. AT&T has been famous for its dividend–and it’s been a great dividend!–Let’s go back to the above equation for AT&T over the decade in question (see Ben’s article for specifics):
   Total Return = appreciation (next to none) + dividend (uniquely high)
   AT&T (and a lot of other high-dividend stocks) produced horrible returns during arguably the greatest decade to own stocks in US history.–How does this equation stack up to Amazon (and 100s of other non-dividend paying stocks) during the same period?
   Total Return = appreciation (huge) + dividend (none)
2. Obsessing over one part of this equation instead of total returns just doesn’t make sense. It’s like a basketball player obsessing over assists instead of whatever it takes to win the game.
3. To drive home point #1, Value investing is often conflated with dividend investing. We love value investing! But the two are not the same. History shows that high dividends can lead to lower returns.I’m trying to make this article short–so let me just link Meb Faber’s research on the topic.
4. Taxes: What you keep after taxes trumps pre-tax returns. In a logical world, you would never have dividends–the freedom to “pick your own dividend” in the form of capital gain harvesting is far superior.Something like 94% of our clients are from large Oil & Gas companies. So a ton of our clients own their employer’s stock (and one of our goals is to make it a manageable portion of their overall portfolio) and receive a qualified dividend. This is fine, but in a *perfect* world, you would never want to own a dividend-paying stock in a taxable account.Your income often changes wildly in the decade that you transition from working full-time to retirement and finally to Social Security/RMDs. If you receive $50,000 in dividends every year during this decade, you’re looking at taxes during your higher-income years (usually while you’re still working and then again at age 72).But if you have no dividends, you can simply not liquidate anything during the high-income years. And during the low-income years, you can liquidate more than $50,000! If you’re married filing joint, you could theoretically liquidate ~$80,000+ at a 0% capital gains tax bracket. So, you could have the exact same “dividend” over a decade–except you have control over when you receive the dividend–and you avoid taxes on all of it if it’s planned properly (disclaimer: if have material pre-tax assets, Roth conversions must be considered.
5. Dividend stocks do not protect you from crashes. 21st-century market corrections and crashes have emphatically shown this. As I pointed out in my last newsletter, companies have historically done a great job of protecting the dividend during crashes (see I don’t really hate dividends!) but remember our equation:Total Return = Appreciation (or in the case of a crash it’s hugely negative) + DividendYes, companies may keep the right side of the equation intact. But if your stock is down 40%, your 4% dividend hasn’t saved you. And as we all know, there is no guarantee that the appreciation side of the equation won’t fall further than a stock without a dividend.
6. Dividends may not be the best use of capital. Warren Buffett’s Berkshire Hathaway is a perfect example. In 1967, they paid one $.10 dividend. Buffett jokingly says that someone must have snuck that past him in his early years.Why hasn’t Buffett paid a dividend? Berkshire has cash holdings that rival a first-world country. But Buffett’s first order is to do what’s in the best interests of shareholders. He genuinely believes that he will be a better allocator of cash than shareholders will–and history has proven him right!That lens is an amazing way to challenge your confidence in a pure dividend portfolio. Why are dividends valued at a premium? An amazing company can likely reinvest your cash and produce an even higher return. And the cherry on top: If a Berkshire Hathaway shareholder wants a dividend, they can simply sell some of their position. Buffett’s reinvestment has easily afforded shareholders this luxury.

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