As the trend in dividend growth investing rises, I would like to point out reason why you should not buy dividend stocks. I’ve seen a lot of investors argue that it’s only wise to invest in companies that pay out a dividend, supported with questions like “Warren Buffet only invested in companies that paid dividends” or “what’s the point of investing in a company if you don’t get money out of it?”. Thus, I would like to use today to discuss a popular topic in Finance called the Dividend Discount Model.
There are also the more intelligent investors that support their investment thesis using Modigliani-Miller’s dividend irrelevance theory, which states that in a tax-free world, it would not matter if a company paid dividends or not because an investor can also sell the shares to create their own capital gain.
Dividend Irrelevance Theory
To understand this theory, remember that a stock’s price drops by the dividend amount on ex-dividend date. This means that if you’re holding a $100 stock that pays $1 in dividends, then on ex-dividend date the stock will drop to $99. As an investor, you will receive the $1 in dividends but also retain the $99 in stock so your total worth stays the same.
Of course that only applies to a tax-free world. However, in the US, both long-term capital gains and qualified dividends are taxed at most 15%, so the theory sorta applies here, at least to us commoners. Therefore it’s wise to be mindful of why you should sometimes consider capital gains and not buy dividend stocks.
So then why is everyone rushing into dividends instead of capital gains?
The biggest reason I could think of would be the bird-in-hand theory.
“A bird in the hand is worth more than two in the bush.”
Owning a stock that guarantees a future cash payment into your bank account is easy to see, concrete, and measurable. Capital gains on the other hand is not as concrete and who knows where the stock will be tomorrow?
Because of this, many investors gear towards dividend paying stocks. Some even devote their entire portfolio into dividend paying stocks. Many people who work towards financial independence use dividend portfolios in order to model out all future income streams versus future expenses, and this is a very common and rational way to do it. However, there may be characteristics of the companies that the investors have not taken into account which may indicated that they should not buy dividend stocks.
The Dividend Discount Model
The Dividend Discount Model describes a company’s life cycle in three distinct phases:
Most dividend paying stocks fall within the Maturity phase. If we are investing for 30 years, the question we want to ask is, will the our “mature” company be the same in 30 years? If not, then are these companies optimal for our retirement portfolio?
Let’s look at a few good examples and a few bad examples
Strong Dividend Companies
Companies that I consider that could withstand the test of time would be Coke (KO) and Johnson and Johnson (JNJ). They provide consumer staples in every day use, can generally weather market turbulence, and have provided 50+ years worth of dividends.
Questionable Dividend Companies
I’m looking at Ford(F) and General Motors(GM). GM already had a government bailout after the financial crisis. They are paying a high dividend of 4.24%, double of what the S&P is paying. Ford has lingered in the mid-teens for 5 years, their share price is abysmal and continues to bleed. These two companies are not innovative as everyone switches to more fuel-efficient vehicles. The question is, will these companies still be giants in 30 years? This represents the mature phase in the Dividend Discount Model and may have no where else to grow and could be a supporting evidence to not buy dividend stocks.
High Yielding Companies
I’m also generally wary of companies that pay too high of a dividend. These are the ones you see with 10+% yields. Heck even anything over 5% I consider to be unsustainable. I generally follow the rule of 2-4%. Basically anything within the possibility of GDP growth. 4% is very high for US’ GDP growth. Yes. But as an individual company, 4% is not as difficulty to sustain as the Nation’s economy. Again, in terms of the Dividend Discount Model, these are usually fully mature companies that have exhaustively expanded and can only grow laterally.
So What Would I Invest In?
I’m currently in my thirties with 30+ years to go until official IRS/SSN retirement status. I’m currently invested more in companies that are in their transition phase. Small dividends with the potential of growth. Companies like nVidia and Southwest are my favorites. That said I’m also invested in some companies purely for dividends to diversify. Realty Income (O) is a company I have written about that provides monthly dividend payments. I, too, am victim to the bird-in-hand theory in that I like to see some dividend accumulation and compounding.
What Should You Do If Not Buy Dividend Stocks?
So when picking out your stocks, consider your time frame, and consider the company’s time frame. You don’t want to inadvertently pick a well-known, mature, giant in the industry then find out tomorrow that they’ve shut down because no one drinks or wears whatever it is they make anymore.