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Rupert Hargreaves
Rupert Hargreaves
Articles (542)  | Author's Website |

To Buy Dividends or Not to Buy Dividends?

Are dividends an essential part of an investment strategy?

July 11, 2018 | About:

One of the primary truths of investing is that, over the long term, dividends have been a significant component of the stock market's overall returns, especially during volatile periods.

According to data from Guiness Atkinson Funds, between 1940 and the end of 2011, the average stock market total return for each decade is 228.6%, of which, 125.9% has come from price appreciation and 102.7% has come from dividends.

On average, dividends have accounted for 52.7% of the market's total return. Based on these numbers, Guiness Atkinson calculates that $100 invested in the S&P 500 at the end of 1940 would be worth approximately $174,000 at the end of 2011 with dividends reinvested, versus a total of $12,000 if dividends were not included.

Moving away from dividends

It is difficult to argue with these figures. Over the long term, thanks to the benefits of compounding and dollar cost averaging, investors can turbocharge returns by reinvesting dividends.

There is another side to this argument, however. Some of the largest and best-performing companies on the market today, such as Amazon.com Inc. (NASDAQ:AMZN), Alphabet Inc. (NASDAQ:GOOG) or Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), have achieved market-beating returns without paying dividends. In fact, if we crunch the numbers, it quickly becomes apparent that even though these companies haven't paid out a dividend, they have compounded investor returns at a rate significantly above the S&P 500 total return over the past five decades.

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There is another factor to consider here, which is tax. At the best rate in the United States, qualified dividends are taxed at 15%. If you invest in a tax-advantaged account, then the dividend tax is not payable, but for most investors, this obligation will significantly impact returns over the long term.

The question is, then, is it really worth it to invest in dividends?

Are dividends worth it?

The answer to this question will be different for each investor. Some investors like to see their dividend checks and live off the income. This is a perfectly acceptable strategy, but you can create your own dividend cheques by selling off positions gradually. Even Warren Buffett (Trades, Portfolio) has said the best way for investors to develop dividend income with Berkshire Hathaway is too slowly sell their shares.

By using this approach, there is more money left in the business to be redeployed and less money going to the taxman. There are other key advantages to investing in companies that don't pay dividends. Assuming the management in charge are astute capital allocators, it is more than likely the return on investment will be higher with the money retained in a company than paid out.

This approach suits some companies better than others. Companies like Berkshire Hathaway and Amazon that have a wealth of investment opportunities in front of them can quite easily reinvest capital into new businesses to help drive long-term earnings growth. On the other hand, businesses like utility providers and tobacco companies have more limited options. They could diversify, but breaking out of their core markets might result in wasted opportunities. Buybacks are also an option, but because these companies tend to trade at high multiples (due to the stability of income), buybacks may also be a waste of capital.

In reality, there are very few companies out there that I trust enough to redeploy capital effectively. For most businesses, I would rather they return the capital to me as a shareholder so I could redistribute it into other companies, which have a proven record of capital allocation. Companies such as Berkshire Hathaway. That being said, I don't have many dividend stocks in my portfolio for this reason and because I don't what to have to pay more taxes than I need to, especially when Berkshire Hathaway has a long history of investing successfully at much higher rates of return than I could ever consistently achieve.

Conclusion

So overall, dividends are a crucial component of long-term equity market returns, but this does not mean they are essential. A company's record of value creation is more important. If management has proven itself to be successful at reinvesting shareholder funds, distributing the cash makes little sense.

Disclosure: The author owns shares of Berkshire Hathaway.

About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. Prior to his investing and writing career, Rupert was as a proprietary currency trader. Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website


Rating: 5.0/5 (1 vote)

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Comments

benlawson
Benlawson premium member - 1 week ago

Hi Rupert,

Great article! I'd like to know what you think about dividend growth stocks in a tax sheltered account like an IRA? When these companies raise their dividends, the yield on cost increases since the original purchase price doesn't change. For example, if I purchased a $100 stock currently paying a $4 annual dividend, I'm getting a 4% return from dividends but 10 years later, they are now paying $9 annual dividends, my return is 9% each year based on original $100 purchase price and it's increasing each year. Does this play a factor in your decision?

Rupert Hargreaves
Rupert Hargreaves - 5 days ago    Report SPAM

Hi Ben,

Tax sheltered accounts would be my favorite method of owning dividend stocks as they remove the tax issue. In theory, both dividends and buybacks produce the same gain for investors IF the dividend is reinvested at the price it is paid and IF there is no tax. Removing the tax issue levels the playing field a bit but in my opinion, it still comes down to reinvestment. Even if you have a tax-advantaged dividend it's still a trade-off between who can reinvest $1 at a better rate, the company or investor. Some companies just struggle to reinvest, so in this case, it's probably the investor. Other firm's are more suitable for dividends. There's really no one size fits all solution in my opinion.

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