"Do you expect me to eat those hot dogs? Because I will."

“Do you expect me to eat those hot dogs? Because I will.”

Not gonna lie, it’s a little creepy how much that kid looks like 15 year-old Nelson.

There’s a certain group of investors who, as the expression goes, are all about the dividends. Before we go making fun of these investors, let’s take a little closer look at the thought process.

There are many actual advantages to focusing on companies that pay dividends, including:

  • Dividends have historically been a large component in total return.
  • Dividends tend to be an indicator of consistent profitability, which is an attractive feature in an investment.
  • Dividends give a steady source of cash that can either be spent, reinvested, or tucked into stripper underwear.
  • Dividends take away the need for retirees to sell stocks to generate income, which is especially powerful in bear markets.
  • Dividends are taxed favorably, especially when compared to employment income or interest.
  • Dividend stocks are widely thought to be more stable.

But at the same time, I can offer counterpoints to each and every one of these points.

  • Dividends have been a large component in total return because they’re paid. It’s not dividends that drive profits for investors, it’s just the way investors get part of their return. It’s the whole chicken/egg argument.
  • It’s not a perfect indicator of profitability. Berkshire Hathaway, Google, and other companies consistently make money and don’t pay dividends.
  • There are many other sources of cash, like bonds, employment income, or rent from a house. Or, you can create your own dividend by selling some shares.
  • A diversified portfolio (including bonds, real estate, etc.) will minimize damage during bear markets, leaving more of a portfolio intact compared to just owning equities.
  • Prudent moves can minimize your after-tax income as well, like selling equal amounts of winning and losing stocks.
  • Again, it’s a cause and effect argument. Coca-Cola would be a more stable stock than Facebook even if it didn’t pay a dividend.

Now before I continue, I want to point out my own personal philosophy on dividends. I don’t hate dividends, nor do I refuse to invest in stocks that have the AUDACITY to pay monthly or quarterly distributions. The last three purchases I made for my value portfolio all pay dividends, and generous ones  too. I’m not opposed to getting paid if the company generates excess cash not needed to keep the business going.

The issue I have is when investors pigeonhole themselves into not only buying dividend stocks, but buying only a certain group of dividend growth stocks. It just seems silly to limit yourself to fifty or sixty of the “best” stocks of the last 25 years, a list that is ripe with survivorship bias. Just because a stock has done well over the last 50 years doesn’t mean it’ll outperform over the next 50. If you think the future for Philip Morris, Coca-Cola, and McDonald’s is as bright as the past has been, you’re delusional.

There’s another reason why folks are all over the dividend payers, and that’s because of the outperformance over time. If you’re any sort of student of the markets, chances are you’ve seen this chart.

dividend-payers-over-time

Okay, a little old, but you definitely get the picture. Dividend lovers will present this picture as the equivalent of DROPPING THE MIC on us maroons who don’t care about dividends, telling us exactly what’s up in the process. Who wants to miss out on those kinds of returns?

But wait. That data covers the last 40+ years. How about some more recent history? Will that change the picture?

Oh, there’s a graph for that.

Screen Shot 2015-06-10 at 2.00.27 PM

 

Source for this graph and the next one are here, btw. It’s interesting stuff if you’re into that.

The graph shows that for most of the last 20 years, non-dividend payers have outperformed dividend stocks. For the most part, the only time it paid to own dividend payers is during the recessions, since the dividend payers performed better. But after each recession, the non-payers rebounded much more quickly.

Keep in mind that this graph excludes Apple, which is large enough these days that it would skew the results.

The next graph busts another myth, which is commonplace in dividend growth investing. The thought process is that folks should choose reasonable dividends with the potential to grow, settling for 2-3% with a decent growth rate. Those types of yields would probably go in the 2nd or 3rd quartiles if you were looking to measure it.

But it turns out they got trumped by the very thing dividend investors aren’t supposed to do — chase yield.

Screen Shot 2015-06-10 at 2.03.56 PM

 

Essentially, the two charts say this:

  • S&P 500 stocks that don’t pay a dividend aren’t such a bad investment. The above graph which compares dividend payers to non-dividend payers compares every stock, not just the good ones.
  • Pick the highest yielding S&P 500 stocks to outperform. Note that this probably includes names like Coca-Cola, McDonald’s, and so on these days — names that probably won’t do as well over the next 20 years.
  • Like with everything, investing isn’t as easy as just buying dividend payers and holding forever.
  • The focus should be on high quality companies, not dividends.

That’s the big problem with the people who blindly say “dividend payers outperform non-payers.” It’s not quite that simple. It’s more accurate to say “dividend payers outperform garbage stocks,” but keep in mind that a dividend is usually the effect of running a successful company. Thus, all you’re really saying is “successful companies outperform terrible ones.” Well, duh.

Remember, dividends aren’t the be all and end all of figuring out whether a company is successful. There’s much more to it than just comparing payout ratios and growth rates. That’s the important message I want to get out, not that dividends are evil.

Tell everyone, yo!