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 distribute 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.
Let’s talk about it. Are you a fan of dividend producing securities? Are you building a dividend portfolio? Let us know in the comments below.