Often I’ll come across a blog or investor devoted to creating the perfect dividend portfolio. By investing in the Dividend Aristocrats they hope to put together a portfolio that will spin off dividend income indefinitely, thus setting them up for a lifetime income stream.
In fact, the dividend policy of companies is often highly reported and something you’ll find quite easily if you look up a stock’s symbol on Google Finance. But it’s rarely explained why this is a good policy for the investor. Instead, a company may simply state that their goal is to spin off 40% of profits and to increase dividends in line with inflation going forward.
So we have two issues here. Is dividend policy a good one for a corporation? And, regardless, does a professional lawyer with above-average income want to own a fistful of dividend producing stock?
Unrestricted earnings: distribute or retain?
Not all company earnings are created equal. Each year, thanks to inflation, some of the increase in earnings simply reflect that prices are increasing as inflation rises. Since inflation tends to happen universally, it’ll increase both the price of the goods sold and the price of goods purchased. If a company were to distribute the earnings associated with an increase in earnings associated with inflation, they wouldn’t be able to maintain their position in the marketplace or would lost ground by weakening its financial position. We’ll call this “restricted earnings” and agree that a company distributing its restricted earnings is bound for ruin.
More interesting is how to handle unrestricted earnings, the true profit generated by a business.
Unrestricted earnings follow two paths: they can either be distributed or retained. The allocation of capital is one of the most important decisions management makes and from my perspective, whether the unrestricted earnings should be distributed or retained comes down to whatever is best for the owners of the business.
There are a number of reasons why managers retain unrestricted earnings, not all of them good. Some use the unrestricted earnings to expand their empire. Why manage 1,000 employees when you can manage 2,000? Why operate with $100,000,000 in the bank when you can operate with $200,000,000 in the bank? All of these don’t necessarily do anything for the owners of the business.
The only valid reason for retaining earnings is when there is a reasonable chance that for every dollar retained by the company at least one dollar of market value will be created for the owners.
In other words, if the company has a hot product and needs capital to expand to other markets, it would be foolish to distribute $1 to its shareholders when it could invest the $1 in expansion and ultimately return $2 to the shareholders.
Yet, dividend investors put pressure on companies to distribute earnings immediately, regardless of the best use of the dollar, because dividend investors need the money now. Their desire for current income overcomes the desire to get the most long term value out of $1.
Of course this isn’t a perfect science. The company can’t know for certain whether a $1 invested in the business will lead to greater value rather than returning the $1 to the shareholder but it’s a decision that must be made. It’s also a decision routinely made by a manager of multiple subsidiaries. She wouldn’t hesitate for a second to instruct Subsidiary B to allocate all of its unrestricted earnings to Subsidiary A if Subsidiary A earned 15% on its invested capital compared to 5% for Subsidiary B.
Capital appreciation vs dividends
Let’s assume there’s no right answer to the distribution vs retained earnings question. A company is faced with a choice: either distribute $1 to its shareholders or retain it and generate an extra $1 of value per shareholder.
Which does the lawyer with an above-average income want?
They definitely don’t want the ordinary dividend. Ordinary dividends are taxed at your marginal income tax rate, thus shearing a significant portion of the dividend away for the government. Qualified dividends are a better option, since they’ll be taxed at your long term capital gains tax rate.
But I have enough taxable income right now. I’m not really looking at increase it when I have an option to count that income in a non-taxable category, like a pre-tax 401(k).
Therefore, it seems pretty clear to me that I’d prefer for the company to retain the earning. Since the retained earning will increase the value of my underlying stock holdings, I’ll see the corresponding bump in my net worth calculation but won’t pay a dime of tax.
Of course I’m just delaying this tax until some point in the future, since the capital appreciation will ultimately be taxed at long term capital gains tax rates when I sell the underlying security but we already know that a tax delayed is a taxed not paid. In the future, I may be able to sell the appreciated security for no capital gains tax at all. I may donate it to charity, thus getting the full write off myself and where not even the charity will pay for the appreciated gains.
In short, I have a lot of options to negate the tax entirely if the company retains the earning. If the company distributes it to me today, I don’t have a choice. I have to pay the taxes immediately (assuming I hold this security in a taxable account).
Mandatory dividend vs creating your own dividend
Another interesting quirk of dividend investing is that you can create your own dividend. Let’s imagine that you need the dividend for your current income. It’s critical that you receive it. Should you prefer the dividend or the capital appreciation?
It actually doesn’t matter. Here’s why.
If a company has $1 of unrestricted earnings and is faced with the same dilemma discussed earlier where it must either distribute the $1 to its shareholders or retain it and increase its market value by $1, the result is the same of the investor in need of cash. It simply doesn’t matter whether the company distributes it as a dividend or the share price increases and the investor sells a portion of his holdings in the market.
Example. A company has 100 shares worth $1 each. The investor owns 10 shares. The company generates $100 in unrestricted earnings. If the company distributes the earnings, each shareholder receives $1 for every share they own so our investor receives $10. He pays the long term capital gains tax rate because the dividends count as qualified dividends. If the company retains the earnings, the company is now worth $200. Each share is now worth $2. The investor sells 5 shares, thus generating $10 in income, taxed at the long term capital gains rate. He now owns 5 shares worth $10 total. He’s in the exact same position either way.
Between these two options, I’d rather have the choice of creating my own dividend stream at my choosing. Maybe one year I need a little more current income while another year I need less. With a dividend policy, you don’t have much choice. The dividends keep coming in.
This is why Berkshire Hathaway has a no dividend policy. There’s no need. If you need current income, simply sell some of your appreciated stock to match what you need.
I used to think dividends were the path to passive income but now that I understand the mechanics, I’d love to own a zero-dividend index of the stock market if possible. Of course this does assume that retained unrestricted earnings are put to the best use possible and I already discussed why that might not be the case. However, I’m of the view that as a whole those unrestricted earnings are often better retained and invested in growing the business than distributing the money to shareholders.
Joshua Holt is a practicing private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Personal Capital keeping track of his money. He's also exploring real estate crowdfunding platforms like Fundrise which are open to both accredited and non-accredited investors.
Thirty-three thoughts on Dividend Investing: Enemy of High-Income Professional
This is the primary reason why I started trimming back our dividend holdings a few years ago. We are in the highest tax bracket and don’t need the income, yet. Holding bundles of cash is not a great capital allocation strategy. I’ve come to like companies that focus on share repurchases at a reasonable price. Its more tax efficient. However, this brings up another debate as to how good management is at repurchasing shares at the right price.
Excellent point. I didn’t even touch on share repurchase. I agree that it’s more tax efficient and a great strategy if done at the right place. It’s effectively like a dividend, except management is nice enough to lock it up in the capital gains so you can realize it on your terms.
Well, share buybacks work in some cases, but not in others. If we are talking about a company that makes buybacks and ultimately fails, you ended up receiving nothing and would have been better off receiving a dividend.
If the company succeeds wildly beyond your imagination, share buybacks would have been a wonderful way to defer taxes.
With share buybacks, some shareholders are screwed and the others do well.
With dividends, everyone receives the same result.
Ok, I will bite. I will structure my response through a series of questions:
A.If you had the choice in late 2007 or late 1997, which one would you have chosen:
1) Invest in the dividend aristocrats
2) Invest in your current asset allocation
Which one would have done better?
B.The biggest misconception by investors is that companies should reinvest all of their earnings back to magically grow earnings. Think of it this way – you have a successful accounting or law practice. If your goal is to grow earnings over time, you should just reinvest into growth, right? Then if that is the case, is your law firm doing that? Why isn’t your law firm simply reinvesting all the earnings back into growing that monster?
C.Let me ask you another question. What is the yield on your portfolio, and what percentage would you pay in taxes.
Now look at the gross yield on dividend growth portfolios like NOBL or SDY or VYM (before expenses, because we hold our stocks directly). How much would be lost to taxes?
Now compare the two.
Also, ask yourself – do dividend investors have access to retirement accounts such as Roth? How does that affect taxes.
D. Where did you invest in 2007 – 2008? Have you stuck to the same asset allocation for the past 10 – 20 years?
E. To answer your question on how I invest:
I don’t understand the dividend bashing from index investors to be honest. Is this an attempt to justify the choice they made?
The difference is – plenty of dividend investors, myself included, model our retirement on the predictability of dividend income. Dividend income is more stable and more predictable than capital gains. This is a fact – which is why Jack Bogle says retirees should focus on the dividend income and social security income, and just ignore the stock market.
I’ve never bought into the dividend producing company nirvana as an investment strategy. Those can often be cash cow companies that can be prone to complacency and market disruption. Eg oil industry recently hit, or taxi medallions disrupted by uber.
As you point out it makes most sense for management to make the decision on capital allocation. Acknowledging agency conflicts.
As an investor i don’t want to see too much revenue retained, but as a producer of labor I don’t want to see my firm distributing so much capital to the shareholders in the form of dividend increases and buybacks. So I flip flop on the issue!
Yes, if it’s a capital intense company like in the oil industry, it might seem like a nice steady income stream to receive the cash from the company but how much of that is related to inflation? If the company isn’t properly replacing the capital, I worry that they’re simply shrinking the company by paying you a dividend each year. Obviously that’s not sustainable over the long term.
Agreed. Given the choice, I prefer the ability to decide when I pay taxes on income. During my working years I wanted to defer paying any taxes I could. Now that I’m no longer working, and have way less income, I can harvest capital gains and pay a 0% capital gains tax since we’re in the first two tax brackets 🙂
Beautiful. The government clearly values leisure over work and capitalists over producers of labor. Hard to argue with them and amazing that you can harness the industrial power of the US and then not pay taxes on the gain.
Great points. The companies that generally pay dividends don’t have as much growth potential…I’d prefer to focus on growth in the accumulation stage. I do see the allure of having an income stream and while you can sell appreciated stocks, it’s emotionally harder to do depending how the stock market is doing. Much easier when the company just sends you a check quarterly. This is why I’m really liking real estate as an asset class these days, I get the passive (somewhat) income while also getting beneficial tax treatment.
That’s a good point. For someone that writes a lot about the behavioral aspect of finances, this article is a pretty logical piece without taking into consideration that it’s definitely more difficult to sell appreciated stock than to collect a dividend check each quarter. Maybe though that has the side benefit of putting pressure on someone not to spend as much money. 🙂
I have long recognized that dividend investing as a strategy had some serious shortcomings but this is the first time I’ve read a post that treats the issue in detail. Thank you so much for treating the subject with just the right amount of detail and in an even handed manner.
I can’t believe you haven’t attracted the ire of the dividend investors. But I agree 100%. The only individual stock I own is Berkshire Hathaway, and I’m grateful for the fact that they distribute no dividends.
For a high income professional, even qualified dividends are subject to capital gains of 15% or 20%, plus the 3.8% NIIT, plus state income tax, city income tax, etc… 1/3 of your dividend could be given to the tax man in high income years.
Ok, I will bite POF.
If taxes are your biggest objection to dividend investing, then you should really hate earning compensation from your job. Hence, why you want to quit asap.
Think about it – you pay ordinary tax rates, FICA, state taxes, city taxes, and you also pay for licensing fees to operate as a professional, and you pay money to drive to and from work, etc.
For each incremental dollar you earn, you may end up paying more than half of it to the tax person.
If taxes are the only thing you look at, you should all just quit your high paying jobs. That would take care of your dividend taxes 😉
Also, if you are particularly lucky, it is possible that your index fund picks decline in value by a higher amount than the dividend for many years. Therefore, you will be able to harvest capital losses to infinity ( well up to zero). Would that make you happy in your quest for minimizing tax liabilities?
I just took your logical arguments to the extreme, in order to demonstrate the fact that you should not let the tax tail wag the investing dog 😉
Man, you bite hard!
You’re right about the fact that I pay a heck of a lot on my earned income, which is why I do all that I can to optimize / minimize the taxes owed by maxing out a tax deferred 401(k), 457(b), HSA, and donating lots to our donor advised fund.
I don’t hate my job or the income it brings me; I just want to get the best post-tax return for the work I do. It’s the same with my investments. I want the best post-tax return for the money I invest.
If my index funds drop to zero, so do your dividend aristocrats, and the world has fallen apart, so I don’t want that any more than you do.
Minimizing dividends is pretty far down the list of priorities, but there are some advantages to doing so — my dividend tax rate is just under 30% and I don’t earn enough to qualify for the special 20% federal rate or it would be nearly 35%.
I am making one change to improve both my life and the tax situation from earned income — I’m dropping 40% of my shifts to work part-time. I’m doing it to reclaim some time, and a nice bonus will be a lower marginal tax bracket, and should lower the taxes on qualified dividends by 6% to 7% as I don’t expect to be subject to NIIT or in the top state income tax bracket in MN next year.
When I’m fully retired, dividends may start to look attractive but I’m not ready to make that happen just yet.
I understand the argument on taxes.
I agree on minimizing taxes in the accumulation phase. And the withdrawal phase too. I hope you can place most of your income in tax-deferred accounts today. Or you can just donate your excess income to me 😉
Some people reach certain conclusions which may or may not be correct when it comes to dividends. So I like to clarify.
Definitely agree with your points, especially the last one about wishing there was a zero-dividend index of the stock market. If I were willing to take on the risk of investing in individual stocks like I used to, they would all be zero-dividend companies. But for now I’ll park my funds in simple index funds and eat the tax burdens.
I think it all depends on what investment vehicle you are using. My employer 457 is all VFIAX which does have a 1.96% dividend right now but much of its value comes from growth. However in my Roth I am building a dividend producing machine using VDC, VYM, VIG, VHT, and VPU because I am never going to pay taxes on those dividends anyway, so I might as well try and get as much of it as I can. Taxable account I only own BRK.B right now and I don’t plan on adding anything to that position anytime soon.
Although Berkshire doesn’t issue a dividend. Warren Buffet loves receiving dividends.
I’ve been a growth investor my entire investing career (since 1997) because I wanted to become financially independent sooner, rather than later.
I would have bought more dividend stocks, but a career in investment banking was taxed at a high rate. I did have a couple year respite after leaving work, but for I just continued with growth investing.
At the end of the day, how quickly do you want to get rich? The best growth investing is in your own business!
I’m glad you keep making that point Sam. The best growth investing is in your own business! It blows away the other returns.
We don’t let dividends (or lack of dividends) impact our investing practices. We’re in indexes anyway, not individual stocks. So if those index pay dividends (generally they do) then that’s fine. If not, that’s fine too.
That’s pretty much exactly how I feel. Have you ever been tempted to create a dividend portfolio producing machine though?
Oh yeah, it’s tempting for sure. I’ve looked at the HDV EFT which has a 3.39% SEC yield. Not bad. Still not great though – at least not enough for us to live on. Also they total return (dividends reinvested) has lagged the market by about 4% over the past 6 years.
Seems that holing SOME high dividend funds might make sense, but perhaps not totally focusing on it as an overall strategy.
Some people do though. And a few of them do quite well.
Timely article 🙂 Somehow we never got into dividend stocks but was contemplating diving into them to create ongoing ‘passive’ income. I think I’ll just keep my investing life simple by sticking to index funds – my stock picking skills are terrible as it is. That being said, I can totally see this as a viable strategy for others.
People often think the simple path is the easy path. Au contraire! Simple is hard. Perfect is not when there’s nothing more to add, it’s when there is nothing less to take away.
I’m afraid your example is too simplistic. The real world is a far more more complicated machine.
If a company retains all capital and you sell shares, the company must realize a return on incremental capital that grows earnings faster than your rate of disposal. Don’t worry — Few companies can meet this test.
This might be maintainable at the height of a growth curve, but cannot continue ad infinitum. Eventually your earnings power will decline with time if you depend on selling shares annually to meet income needs.
Remember: The market doesn’t value companies based on the value of total capital (as in your example), but on the future earnings potential of that capital. In other words — *how* that capital is employed matters more than how much capital is retained.
Far too many dollars are wasted on pointless “growth attempts” with poor returns on capital or share buybacks to cover-up share dilution by management.
Not trying to criticize you here Biglaw, these points have been made by many before you… and they’re still not entirely accurate in the real world. The real answer to this question is far more nuanced and complicated than can be written in a few thousand word blog post.
Mr. Tako, have you written an article about the reason why dividend policy is a good idea? I know you have a hefty dividend portfolio and that it provides much of your income now (which makes sense to me given that you’re no longer a high earner). I’d love to both understand why you thought dividend income made sense during your high income years and why you think dividend policy is the path for achieving maximum value. There’s much more to to this discussion!
I think the simplistic arguments are right on point. The complicated ones try to make this more difficult than it is. Valuing a company is pretty easy. It’s simply the discounted value of the cash that can be taken out of its business during its remaining life. That’s why if a company retains $1 of unrestricted earnings or distribute it to you makes no difference. Saying that it matters *how* the capital is deployed rather than how much capital is retained plays right into my point. By retaining the capital as cold hard cash it’s no different than distributing it to the investor. However, if the company can retain the earning and generate future cash flow from the dollar, you’ll see an increase in the market price to account for the $1 of retained earnings plus the discounted future cash flow from that dollar.
Putting that aside, I think the real crux of the argument is whether one thinks that management can make better use of the marginal dollar than the investor. I would guess (although I don’t mean to put words in your mouth) that you think management likely cannot whereas I think management likely can – or should be fired if they cannot.
“If the company retains the earnings, the company is now worth $200. Each share is now worth $2.”
…that is assuming Mr. Market prices the retained earnings correctly.
Dividends guarantee the returns are given to the shareholder in a form that she can actually use (cash).
Share price appreciation is nothing more than imaginary cost-basis-bucks until the shares are sold and the capital gain is realized.
The asset must be liquidated in order to recognize its value. After it is liquidated, it ceases to grow for the investor’s benefit.
This is not an inconsequential detail.
Dividend income can drastically reduce sequence of returns risk for the retiree which is a variable this post COMPLETELY ignores and is nothing to sneeze at.
Dividend income to reduce sequence of return risk? It sounds like you’re compartmentalizing the distribution of unrestricted cash as different from it being retained. My argument is that from a purely mathematical standpoint they are the same. Sure Mr. Market is an irrational actor that may not price the retained earnings correctly but most investors believe that the market will eventually evaluate a company based on its intrinsic value otherwise we all have a problem. Dividends might seem like they are the best for an individual investor because she gets the cash but that doesn’t answer the question of whether it’s the best capital allocation for that dollar (and it doesn’t touch on the question of what does that say about a company if the best capital allocation for a specific dollar is to distribute it to the owner).
If I’m being honest, I was expecting more fireworks in the comment section.
This is something I’ve thought for a long time but had never really put into any comprehensive written format. The fact that there are so many dividend investor bloggers out there made me question my strategy originally. When you stop and think about it, though, I’d rather invest in a company that is looking to grow than a company that is pressured to get cash out of the business.
I would love to see a comparison between high dividend and low/no dividend stock to see if that growth principle actually plays out in the numbers, but I haven’t seen anything like that. I’d imagine it would be extremely difficult to get those numbers because you can’t just compare indices and would instead need to compare individual companies, creating a whole host of other issues.
I thought there would be more fireworks too @matt! I’d love to see a great defense of dividend policy.
“I’d love to see a great defense of dividend policy.”
Hold on, let me get my father in law. He’s always talking about the Dividend Aristocrats when I mention that me and Mrs. Vigilante are about 90% invested in various index funds. I suspect he may secretly be blogging under the pseudonym Dividend Growth Investor…not that there’s anything wrong with that 🙂
We are not focusing on dividends at the moment but rather automating all our investing into index funds. I really like the way you lay it out and make it sound so simple.