Divi-Then, Now What?
Last week, we looked at how dividend income is not “free” and represents a portion of the company’s value being paid out to shareholders, reducing share prices.
Today, we further examine the investment merit of investing in a portfolio of high dividend stocks.
Think about fast growing companies like Google, Facebook, Amazon, or Tesla, these companies historically do not pay a dividend. Instead they reinvest into their business, rewarding shareholders with increasing company values.
A company can do four things with its profits:
Reinvest in the company (organic growth)
Acquire other companies
Repurchase shares
Pay dividends
Actions (1) to (3) should only be undertaken if the investment today will bear more returns in the future. For a matured company with little prospect for growth, the only logical thing to do is to return cash to shareholders through (4), paying dividends.
Plotting 10-year annualised returns vs. average dividend yield for U.S. large cap equity funds, there exists no meaningful relation between the two elements.
High average dividend yield did not lead to high returns to investors. In fact, the highest dividend paying funds underperform funds that pay no or low dividends.
All this to say that the data shows —
the best performing funds often do not pay dividends.
If you think about it intuitively, this makes sense — companies that pay high dividends often have less growth opportunities to pursue, and hence experience less growth. This is compared to companies that do not pay high dividends but rather opt to reinvest into growth opportunities, resulting in higher share prices and adding value to an investor’s holdings.
When it comes to constructing an income portfolio, investors should focus on a total return perspective. Balancing all sources of income such as dividends, coupons, and capital appreciation, and not solely relying on a single metric — dividend yield.
Doing so will introduce skews and unnecessary risk to your investments as we will see in our article next week.
There is a better way to invest
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