When I was growing up and first learned about dividends, I thought it was the greatest thing that I had ever heard to be true. “You mean if you own some stock, you can really get paid cash every so often, and potentially live off of it?” No doubt, I was hearing about people who were making thousands in dividends. Wouldn’t that be nice? It wasn’t until later I learned how much stock you would need to be able to live off of dividends, and even later still did I learn that maybe dividends aren’t the greatest thing in the world.
The average annual dividend yield for the S&P 500 is ~2.00%. With this in mind if we were to receive $100,000 in dividends per year, we would have to have $5 million invested in the S&P500 index or equivalent yielding portfolio of companies. The $100,000 a year sounds nice, but setting aside $5 million for the average person is not an easy task. Taking it a step further, assuming long-term capital gains tax, we would have about $85,000 left over to live on that year. If you’re living in a high-cost city, that $85,000 won’t be going very far. Being able to sleep and collect dividends, now this really does sound like something Sleepy Capital would like, right? You could work a little, get paid dividends and sleep fairly well. I think it gets a bit more complex than that, though. There is more to know about dividend paying companies when it comes to considering an investment decision. So the question is, do we investing in dividend yielding companies or non-dividend yielding companies?
What is a dividend?
What is a dividend in itself, really? A dividend is cash paid out to an investor that owns preferred or common stock in the company. While preferred stock holders are guaranteed a fixed dividend, common stock holders are not guaranteed any dividend. In the case of a cash payout to stock holders, preferred stock holders get paid first before common stock holders. Where does the dividend come from? Dividends are typically paid out of a company’s earnings each quarter.
Capital Allocation Strategy
Being a good allocator of capital is something that Warren Buffett looks for in all of his managers. If you’re looking for a great book on some very successful capital allocators, I recommend reading The Outsiders by William Thorndike. Capital allocation consists of the following:
- Re-investing current earnings back into the operations of the business (Starting a new line of business or investing in core operations)
- Paying dividends
- Share repurchases
- Raising debt
- Issuing equity
Effective capital allocators will utilize a combination of these strategies to create shareholder wealth. Capital allocation can be in and of itself a long discussion, so I am going to focus on the dividend aspect, one tool in the tool box of capital allocation. Dividend paying companies have excess cash flow to distribute to shareholders. We often see that when companies issue their first dividend or raise their dividend, there is a pop in their share price. Now, why is that? We will discuss below and see that there are pros and cons to having a dividend.
Paying a dividend often signals the market that the company is healthy
A company that issues a dividend is generating so much cash flow that they can pay some of it out to shareholders. Note that once a company pays out a dividend, they must be able to continue to do so for years, or else the market will discount them for not doing so. Often the share price jumps significantly because of this “healthy” outlook. Short-term traders will buy in at the announcement because they know that mutual funds and other income-oriented buyers will enter the stock, bidding up the share price. Likewise on the opposite side, a company’s share price will fall dramatically if they suspend their dividend, usually because they are not generating enough cash flow to aoord the payments, or that they want to build up a cash pile to weather a coming storm. Sometimes, though, companies will issue a dividend to give this “healthy” signal to the market, despite having some operation troubles. In essence, they are masking their problems with a strong facade from their dividend.
Paying a dividend also means the company may have hit an inflection point – slower growth
Issuing a dividend also means that the company may not have anything “better” to do with their excess cash flow. We’ve all heard the term Cash Cow. These are dividend paying companies such as Johnson & Johnson, P&G, McDonalds, among others. If they are paying out cash as a dividend, then they are allocating less towards growing their own company. They have hit an inflection point, where the higher historical growth they have seen in the past will now likely slow due to less opportunities to grow>cash then builds up>company then decides to pay it out as a dividend. So while a dividend may signal the company is healthy, it also signals slower growth. What would you rather invest in? A company that will either continue to compound their capital, or one that pays it out?
What does Warren Buffet think of dividends?
Warren Buffet prefers investing in companies that do not pay a dividend, but that doesn’t mean he hasn’t done it before. How could we forget the Kraft Heinz merger, where Buffett helped finance the transaction through 9% yielding preferred stock in the company. Remember, preferred stock gets paid before common stock, so he was locking in a fixed rate that yielding him in quantum of about $720 million annually. I would take that any day, especially in today’s market. Whether I invest in dividend paying companies really just depends on the price paid for the stock, not whether they pay a dividend or not.
Back to Warren – Despite investing in some dividend paying stocks, Warren does not have a dividend payout for Berkshire Hathaway holders and likely won’t for many, many years (if ever). This is because Warren believes he can generate higher returns (in intrinsic value and in turn eventual share price) through investing in the purchase of new businesses, rather than the returns to shareholders through payment of a dividend. I wouldn’t bet against him, as we know he has been fairly successful. The trade off for Berkshire shareholders is higher return for less liquidity by having to hold on to the stock for many years. This less liquidity is one of the reasons Warren eventually allowed Berkshire Class A shares to be split into Class B shares, so owners could sell part of their stake or hand down stock to their family and friends.
When I’m analyzing a company, the dividend is not a make-or-break it decision, it is rather something to take account of. While I would prefer that the company to reinvest and growth their business, there are companies that are trading at a meaningful discount to their intrinsic value that also pay out significant dividends. This value disparity while collecting regular income from the investment may be worth investing in the lower-growth asset. After all, a company does not to be growing much (if at all) for the price and value to diverge, and if you can collect income while you wait for that to change – why not?
Readers, what are your thoughts on investing in dividend vs. non-dividend paying companies? Are your portfolios weighted toward income-generating companies? Would you trade regular dividends for higher long-term growth? Let me know your thoughts on the comments below.
Chris @ Sleepy Capital