What’s the Deal with Dividends?

Welcome everybody to "The Informed Investor." I'm Mark Gochnour, and I will be joined today by Dr. Wes Crill and the Jake DeKinder. Today's topic is dividends. All right, so let me read some headlines. We will come back and think about this a little bit more. So a couple headlines for all of you. The first one, "These Dividends Stocks Can Protect You From the Next Market Drop." "Dividend Stocks Are Primed for a Comeback in 2025." And then one with a little bit different tone. "When Chasing More Dividends Leaves You With Less." So gentlemen, a couple different ideas there on dividends, sort of a tendency, you read these to think, "Dividends help me." But then there's also that last one about, "Hey, it can be concerning as well." So before we dive into how to think about dividends in, say, our portfolio, let's take a step back and just think about where do dividends come from? Almost go back to it, Wes. These companies have earnings and they do different things with these earnings. So maybe walk us through that. Yeah, I mean, certainly they have options of what to do with their earnings. They could reinvest that back in the business. If they have investment opportunities, they can use that cash accordingly. They could return it back to investors. And it's not just dividends. You can also, you know, buy back your shares that are on the open market. So it's just different decisions you can make with your earnings. Well, and you look how that ebbs and flows over time as well. If you go back to 1970, about 70% of companies paid dividends, today, it's somewhere around 30, 38% or so. So one thing to note about that though, well, that has dropped in terms of dividend paying, the cash paid to shareholders is a similar total amount because you've seen these share buybacks pick up over time. That's right. Yeah, sometimes that gets lost in the conversation about the decrease in the number of companies that pay dividends. It's not that corporate America is no longer returning cash to investors. In fact, if you look at the combined total payouts between the share repurchases and dividends, that overall ratio has been very stable through time. It's just you've seen a larger proportion go into share repurchases versus dividends. All right, now let's focus on dividends. Jake, we read some of the headlines. Let's talk about some of the motivations we hear of why investors want to own dividend paying stocks. Yeah, I think there's, you know, a couple broad categories you can think about. I mean, first one is I do think there's this idea of income, and I like the idea of getting income on a regular basis. Maybe it's, I'm retired, I like the idea of the checks come, all of that. So that's maybe one motivation. There's a narrative out there around, "Hey, these dividend payers are more stable stocks, so I wanna own those more stable stocks." And we'll unpack that one a little bit. And then I think there is a belief too of, "Hey, it's higher returns, right? Not only am I getting the stock price to go up, but then I get this additional dividend that they send to me." And we can unpack that one as well. I'll talk about kind of the income piece of it around that motivation. And you know, listen, this idea of, "Hey, I'm gonna get a regular stream of income to meet my spending needs." Maybe I'm in retirement, maybe I'm approaching retirement. That comes in a lot of different forms. I mean, let's think about fixed income, right? There's a reason that people are attracted to fixed income as well. But the thing you have to understand about that income is, first off, on the bond side, on the fixed income side, that's a little bit more of a contractual payment. And companies need to pay their coupon payments and their interest on their bonds before they actually have to pay their dividends as well. And so those dividends are not guaranteed over time. And, Mark, to your point, you've actually seen the number of companies paying dividends go down over time. And in periods where we hit rough times, like 2020, you saw a number of companies that had to cut their dividend, 'cause literally, to your point, they didn't have the money to pay it, but they still need to meet their bond payments- Yeah. As well. And the seed I wanna plant for our discussion is this idea of income, I mean I do, I get it, but I think maybe we want to think more in terms of the cash flow that I need instead of I need to have this income that's kicked off of a dividend-paying stock. I think some investors like the idea of something more tangible. Oh yeah. Yeah. Like I'm getting a check- I think you're right. I see and coming into my account. Yeah. Where sort of the offset of that, unrealized gains. It's a little bit harder to see at times. But I wanna go back to a comment you made there on how dividends ebb and flow over time. Periods of uncertainty, it does have an impact on what companies pay with dividends. Certainly. I mean, you're pretty low in the pecking order when it comes to an investor if you're counting on your dividends. Like Jake mentioned, they have all sorts of other obligations they have to meet before they pay the dividend. And during tough times, those dividends can be suspended, they can be cut. You know, we had a great study from a couple years ago where we showed that in the first three quarters of 2020, so this is a very pronounced economic downturn, the total dividend payout from firms in the U.S. fell by 22% relative to the same three quarters in the previous year, in 2019. So it does show that, you know, this perception of stability, while there might be some element to that, from a psychological standpoint, it is subject to whatever the policy of the firm is and their ongoing fiscal health. All right, let's go back to the other one then when we think about the returns of dividend-paying stocks, and I think for some investors out there, they think that, "Hey, if I'm getting a dividend yield, I'm still getting my full upside in terms of a capital gain." So, Wes, walk us through a little bit that trade-off there and expect return of stock and sort of how that's comprised of dividends and capital gains. Yeah, I mean, income sounds great, but it's important for investors to realize that income, the dividend payment doesn't come out of thin air. So the value of a company is essentially a portion of that as being returned to investors, which means the amount of the dividend payment is the amount that the company's value is falling. Sometimes this is a very hard thing to see in the data. Stock prices are very noisy after all. They're impacted by millions of things, not just the dividend payment. But if you look at the highest dividend-paying stocks, you do see this trade off almost one for one. We had a study where we looked over a three-year period, the top 100 dividend paying stocks in the S&P 500. And we saw that the average dividend per share that was being paid out was 76 cents over this stretch. The average price change or price decrease at the same time was 79 cents. So it's almost one for one. You see it in the data. And that should show that that's not coming out of thin air. To your point, that means investors should probably be thinking about their total return. That total return is gonna be composed of not just the dividend, but also the price appreciation. And investors probably should be indifferent to where it comes from, right? If you have $1 in your left pocket, that's gonna spend the same as $1 in your right pocket. It doesn't matter where it came from, it's the total return to your portfolio. Before taxes. And that's another thing to think about here as well, right? 'Cause now we're starting to get into a discussion around, "Hey, how would I want to receive those cash flows and in what form, and how are those cash flows going to be taxed?" And depending on the strategy, you have to watch how dividend income sometimes can be taxed. Plus, there's a timing element to it as well. You know, to Wes' point, if I think in terms of kind of more of a total return approach, and I say what I think about is the cash flow that I need to generate to hit my spending needs, my living needs, and I take a total return approach. Now, I'm in complete control on when I ultimately sell stuff to generate that versus a company determining when I have to receive that dividend. And I think, if you go out and talk to a lot of financial professionals, financial advisors, they'll tell you, "I like the idea of being in control of how I'm going to handle that." Well, let's walk through that idea of a total return strategy, for example. So, Jake, you always give a good example. I think, for a real investor out there, when they get a dividend, what does that mean to the stock price? So, let's say a stock price is trading at $10. And to your point that you get, let's say, a 10% dividend, so that'd be a $1 dividend. The stock price after dividend goes to $9. So think about your left pocket. I've got a stock worth $9 and I got $1 of cash, I've got $10 of value. I've got 10 bucks. The right side, a company that doesn't pay dividends, that $10 stock no dividends. So I've got $10 of value of a stock, no cash. That's sort of your same total return on that stock. You still have $10 of value. I mean, I like how Wes said it, right? It's money out of the left pocket money in the right pocket. But as I'm, you know, depending on the form of that, there can be other implications as well. But he also said it well, right, you don't just generate these earnings out of thin air, right? There's only so much to go around. And you can either there's it out, you can keep it, or you can repurchase shares, but they're not magically making additional earnings. Yeah. Well, and even in the example where you had $9 of stock and $1 of cash, let's say you needed to spend that $1 for something, you had a cash flow obligation you had to meet. Okay, well you get the $1 out of your left pocket. Guess what? I can generate $1 out of my right pocket too. How do I do that? I just go and sell $1 worth of that stock. Yeah, exactly. I create my own dividend effectively. that's a control element. But you mentioned, you know, there might be some additional variables at play. Well, you know, maybe depending on what my tax exposure is, there might be scenarios in which that dividend could be costlier than actually selling a portion of my stock, because that's gonna be probably capital gains tax versus an income tax coming along with the dividend payment. So there's additional variables that could come into play. But I think just the fact that those are interchangeable scenarios shows that the total return is what ultimately matters and not dividend price appreciation. It's always nice to have options Yeah. In terms of meeting, you know, whatever your spending needs are around that. I have... What were you gonna say, Jake? No, go right ahead. You're good. Well, I wanted to go into, so I have a friend- Yeah. Who started a dividend strategy, I dunno, four or five years ago. And he said, "So what I do is I go find high-dividend-paying stocks." He goes, "But I do my homework. You know, I make sure they're good companies and so on and so forth." He goes, "I know I have to diversify." And so he goes, "I go out there and I'll buy 20 to 30 dividend-paying stocks." So I connect that to sort of the more, the article that was saying, "Hey, be careful when you're chasing a dividend strategy." And I think that's one of the things you absolutely are giving up on is the point around diversification. You have 30 stocks in your portfolio out of what, over 3,000 stocks here in the U.S. That's a lot you're potentially missing out on. Yeah, I mean you mentioned the number of companies that are no longer paying dividends relative to what, saves about half of what we used to see back in 50 years ago. And again, that's going to be your opportunity set for when you're building an investment strategy around dividend payers, is you have to start with the ones that are actually paying dividends. And if you look at, you know, you mentioned your friend liked the idea that these were good companies. Well, there's some merit to that because if you look at high-dividend-paying companies, they do tend to be larger companies. They tend to be ones with higher profitability. Again, to pay that dividend, they have to have cash, which means they probably do have profits. And that's a perfectly reasonable trade-off to attain. But you can do that through traditional input variables and portfolio design. You can focus on higher profitability companies, you can focus on larger companies. You don't have to build in the constraints around diversification that come with just a narrower cross section of companies paying dividends. It's a good point. You start, you cited something like 35, 36% of the broad market. If you do look at those larger cap stocks, something like the S&P 500, you do see in actually a higher percentage of those that are paying out dividends. So as a percentage. You're like, "Yeah, it's a little bit higher." But there's still a pretty decent chunk of those companies that either haven't paid a dividend over the entire course of their history or don't pay a dividend at all. And I think for some of those names, there's a decent chance you may want to see what those companies generate from a return standpoint. And in a diversified portfolio, maybe have exposure to them. Well, let's give some examples to that. Yeah. You know, Warren Buffett just had his last big session there as chairman of Berkshire Hathaway. Berkshire's never paid a dividend. Now, if I have a dividend strategy, that's a stock I wouldn't be owning. Uh-huh. Do you probably want Berkshire in your portfolio as a diversified investor? Some other examples, stocks that don't pay dividends, Tesla doesn't pay dividend, Amazon doesn't pay dividend. I'd probably want those in my portfolio as an investor. Yeah. And then how about a company like Microsoft? So they started paying a dividend in 2013. They went public in 1986. Now, would you have wanted the performance of Microsoft from 1986 to 2013? Might've been nice. Yeah, that would've been nice as an investor. So it's just not always so easy to say, "Hey, I'm just gonna go out there and buy dividend-paying stocks." I think it goes back to, again, what ultimately is your plan, what are your objectives you're trying to accomplish, and what's the best way to get there? Yeah, I think that's right. Also too, you know, you think about, if you constrain your universe of available choices, you want to be able to say, "Okay, I'm constraining it for this reason." And again, from a higher expected return standpoint, we sort of broke that down. That was the right pocket, the left pocket thing. Then you go to something like the income, and we'll come back to that because I think we've unpacked that quite a bit. But, you know, on the stability side as well, and that's one of the arguments there on the stability side. So I'm constraining my universe, but am I really getting a less volatile or a less ups and downs with a strategy like that? Yeah, I mean, you know, we alluded to the idea that just those dividend payments could be cut at any point in time. So the actual income you're getting, you know, might not be forever. But if you just look at the variability, we can measure that using standard deviation of returns for dividend payers versus non-dividend payers. Well, the volatility has been a little bit lower for the firms that pay dividends versus ones that don't pay dividends, but they both look like equity levels of volatility. This is not going to be a portfolio that has the stability of fixed income, for example. So, you know, I think that might be one counterintuitive data point for some people, which is you're not just getting a fixed stream of returns. Even if the dividends do stay stable over time, you still have the underlying volatility of the stock price. And real quick, I just wanna be clear. Like, this idea of I want income. Like, I don't beat investors up for having that view, right? But I think you really want to get to, okay, what is it that I really, really need? And I would argue that it's the cash flow that you need. So now once you've determined that, then you come back to, okay, so now what's the best way to achieve my goal? Do I wanna really concentrate it strategy? Do I want a strategy that is left pocket, right pocket, that, right? Do I want a strategy that I think is lower volatility, but when I look at the numbers, it's not really? And so rather than sort of saying like, "God, I love this idea of income," start with what's your true goal, and then back into, okay, what would be the best way to accomplish this? Yeah. And, you know, if you're thinking about, "Okay, my goal is to meet my cashflow needs in the future," well, one way I can do that is to have a more reliable way of having more money in the future than I did today. So again, you go back to total return. And if you look at high-dividend-paying indices, over the long haul, they've actually had lower returns than things like value indices or high profitability indices or other types of strategies that are formed around expected return propositions rather than just dividends. Well, that's a good point. As you think through those differences in returns among certain types of stocks as a driver for longer term performance in your portfolio. And, Jake, yeah, I thought you summarized it well. All the things you want to consider. And, of course, the tax. Yeah. Is a big one. Big one. And having control over how you manage your tax exposure as well. So a lot of things to think through there. I think you guys did a nice job of unpacking that in terms of some of those headlines and how to think about dividends. A big part that too was diversification. Uh-huh. And that's going to be a future topic here on "Informed Investor" is investing outside the U.S. and how do we think about diversifying among all the stocks out there globally. Thanks for joining us today on "Informed Investor" and have a great rest of the day.