Dividends Are Like Desserts
Many investors love dividends and often look for high dividend yielding stocks to supplement their income.
Dividend investing and desserts are similar in that eating a slice of cake means less of the cake remains.
Dividends doesn’t magically appear out of nowhere, it represents a portion of the company’s value being paid out to shareholders.
A sample of 20 quarterly dividends for the 10 largest companies in the S&P 500 High Dividend Index reveals this relationship. The average dividend paid by these companies was $1 per share. On the ex-dates when the dividends were reflected, the prices of these companies share prices drop an average of $1.15.
A slice of cake eaten means less of the cake remains.
This relationship has also been well established in financial literature dating back to 1961 when economist and Nobel Laureates, Merton Miller and Franco Modigliani wrote in their paper ‘Dividend Policy, Growth, and the Valuation of Shares’. In it they noted,
“Before frictions like trading costs and taxes, investors should be indifferent between $1 in the form of a dividend, which causes the stock price to drop by $1, and $1 received by selling some shares”
Dividends are a part of the total return story for investors but if investors are only focusing on dividends, it is almost akin to taking money from your right pocket and putting it into your left pocket.
In reality, there are frictions
Dividends are not only a draw on the value of the company, it also attracts the dreaded tax man. As global investors, dividend withholding tax apply to a broad range of markets such as China, Australia, Japan, and the U.S. to name a few.
We can see the effects of taxes by examining the returns before and after the treatment of dividend withholding taxes. Because these taxes are automatically applied, this seepage escapes the attention of most investors.
Since 1970, an investor in global stocks would have a gross return (before dividend withholding taxes) of 9.64% p.a. Compare this to 8.87% p.a. net returns (after dividend withholding taxes), a difference of 0.77% p.a. (which compounds over time)
That difference compounded the investor’s lifetime leads to large differences in ending wealth as illustrated below.
Investors are able to improve investment outcomes by reducing or even eliminate frictions such as dividend withholding taxes through efficient execution.
When it comes to dividends, it is a case of you cannot have your cake and eat it.
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