You might see headlines such as a fund or a company has announced a 1000% dividend or also how some funds and smart managers only invest in dividend-paying stocks. In this article, we cover the basics around dividends and whether or not they are the right strategy for you.

The two main traditional methods for making money in the stock market are through dividends and through capital gains. Both styles boast their merits and drawbacks, and both are suited to different investment goals.

Mechanics of stock pricing and dividend payments

Before we get into specific scenarios, let’s first look at how dividends affect stock prices. There are both positive and negative implications for stock prices, some based on hard market pricing mechanisms while others are based more on psychological finance considerations.

The Logical Pricing Mechanism

Paying out of dividends is a redistribution of assets or profits by the company to the shareholders. Let’s say the stock price of a company is £100, and they decide to pay a dividend of £20. The £20 paid out is not on top of the £100 and is a part of the £100. Hence, logically, now the company is worth £80 per share, and the price of the stock or your overall return (excluding the impact of taxes) should not be affected in any way.

The market may, however, react differently to that above. When a company announces a cash dividend, it is common for the price of the stock to rise to incorporate the expected dividend before the ex-dividend date (the day on which buying the stock no longer grants the buyer the right to the dividend). On the ex-dividend date, the stock price tends to fall by the amount of the dividend. Conceptually, this occurs because the dividend is no longer available to new buyers and the stock price should reflect that fact.

In reality, the stock price is dependent on a plethora of factors, so price adjustments for small dividends may be completely absorbed by market noise. Bigger dividends will likely be noticeable in the stock price change, though.

Perceptions

Outside the purely mechanical price changes are the psychological reasons. One way dividends impact the stock price psychologically is via perception. If a company announces a higher-than-expected dividend, the stock price may rise more than the expected dividend before the ex-dividend date because the outlook for the company is more positive. If the outlook remains very rosy, the price may not fall much relative to the size of the dividend, even on the ex-dividend date, because longer-term investors, expecting positive prospects in the future, vacuum up shares, effectively stabilizing the price.

High-dividend-yield stocks may suffer from perceptions, too. Many investors view high yields as a positive sign, and a downward revision of expected yields is viewed as bad news. For struggling companies, this commonly-held perception can be destructive. The dividend yield is a function with the stock price in the denominator, so as the stock price falls, the yield rises. Stock prices move every day while a reference point for the dividend (i.e., the payment) only occurs periodically.

If the stock price falls due to poor performance, the yield will rise. In an effort to avoid further damage to the price by announcing lower dividends, management sometimes continues to pay the higher dividend. But this means less money is spent on debt reduction, capital restructuring, or other areas that improve competitiveness. Over the long term, the motivation for management to keep stock prices high backfires as the company runs out of cash – which it could have saved by paying lower dividends.

In Seth Klarman’s book Margin of Safety, the famed investor points to this particular perception-driven managerial decision as the reason dividend yield as a measure of performance has become a “relic”. Furthermore, the term dividend yield trap is a real term, and such a stock is often characterized by unsustainable capital structures and underperforming management.

Tax Implications

If you ask yourself: “Should I buy dividend stocks?” then you should also consider the tax implications of dividend investing. It depends on the investor’s country of domicile, but dividends are often taxed at different rates than equivalent amounts of capital gains. We have recently written extensively on the tax implications of investments in the UK, and dividend income is often subject to greater taxes than capital gains income. The tax hit is even starker for high-income individuals. For top-bracket UK taxpayers, capital gains tax will top out at 20% while dividend tax rates can be as high as 45%.

In the United States, any “qualified” dividend is taxed at a much lower rate than wages, the maximum qualified dividend rate being 20%. Most dividends American residents receive will be qualified, and the biggest issue for most American residents is the holding time frame: at least 60 days including the ex-dividend date for common stock and at least 90 days including the ex-dividend date for preferred stock. Falling short of this timeframe implies the dividends will be taxed at normal income rates. For American taxpayers who do receive non-qualified dividends, the dividend is also taxed at normal income rates, which can rise to nearly 40%. One should note that dividends from LLCs and REITs are not qualified.

For those that invest in American companies via USD-denominated accounts residing in the United States, the tax rate depends on any tax treaties in force with other countries.

To see how taxes have repercussions, we can look at the dividend payment pricing mechanics. Say you buy the stock for $20 and the dividend is announced to be $2. On ex-dividend day, the price will mechanically fall to $18 and you receive $2 in dividend payments (a couple days later on the payment date, to be precise). At first glance, it seems your capital remains unchanged. Unfortunately, that $2 is taxed, and thus the capital you own outright (i.e., do not owe in future taxes) is less than $20. Thus you have less than you started with, even if nominally you still retain the same amount of capital as before.

Importance of the Payout Ratio

One company may have a 4% dividend yield while another one has a 2% dividend yield. How could the 4% yield be more sustainable than the 2% yield? The answer lies in the payout ratio.

One way to determine whether a dividend yield is unsustainable is to look at the payout ratio. This is the amount of money the company pays out in dividends divided by the earnings for the same period. A 1:1 ratio, 100%, means the company paid out all of its earnings in dividends. Anything over 100% is clearly unsustainable in the long run, and either the dividends must fall or earnings must rise.

Ratios near 100% are probably also not sustainable. It implies the company is not investing in R&D, its personnel, or other factors that contribute to its competitiveness. In a globalized economy, competition in every sector is fierce. Companies that do not innovate or improve themselves will likely not survive.

Since the dividend yield is a direct function of the market price, it can be high and still sustainable, as long as the payout ratio is low. The market can irrationally price the stock too low, leading to a high yield. Accounting is not irrational. The earnings and the payout ratio are cold hard facts, and a high payout ratio is not a fluke of irrational markets but a factual indicator of low investment in the company’s future. A low payout ratio means the company is investing in itself (or at least hoarding cash), and with a low ratio, a high dividend yield is not a cause for alarm (and in fact may be a sign to buy the stock for capital gains and dividends).

Specific Scenarios

Certain situations are better suited to certain types of investment. The scenarios here are better suited to growth stock investing than dividend investing or trading dividend stocks.

Younger Investors

As the common financial wisdom goes, the young have more time to recover from setbacks. And that is why growth stocks are preferable for younger investors. There is more risk, but there is more reward. And due to the lower capital accumulation of younger investors, dividends may not be very beneficial. A 5% dividend on £10,000 is still only £500, and 5% is a generous yield.

High-dividend stocks could be just as risky as growth too, especially if the payout ratio is high: market pricing tricks may be keeping the dividend yield high or management may be ignoring long-term financial issues for short-term stock price buoyancy. Additionally, high payout ratios indicate little self-investment, and all the dividends paid out over 50 years won’t make up for a bankrupt company and a stock price of zero in the end.

With the combination of the riskiness of high-yield dividends, low capital accumulation, tax implications, and time, younger investors are more likely to benefit from growth stocks than dividends. As they become older, than can shift some of their holdings into dividends, but for the earlier years, growth investing is a better choice.

Low-Interest Rate Environments

Dividend-paying companies do not exist in a vacuum. Neither does the stock market. In a low-interest rate environment, dividends will also likely be meagre. Then, as the interest rates rise, the dividends will become less attractive unless their own yields also rise. But raising dividend yields requires the company to adjust its payout ratio in favour of more payments to investors.

For new investors, if the stock price rises along with the market, the company must pay more to simply maintain its dividend yield. For investors who already owned the stock, the incentive to capture capital gains is tempting, especially since the dividend payment in absolute terms is less attractive than previously when compare to the alternatives, like bonds.

So dividend investing is useful for the short-term when interest rates are low, but a buy-and-hold strategy may see a diminished benefit as other, more certain alternatives become more attractive.

Buying Only for the Dividend

One poor strategy for dividend investing is to buy the stock solely to capture the dividend. The tax implications outlined in the example above are the main drawback of this strategy. The only exception to this is when investing through a tax-free account (like a Roth IRA in the US, ISA in the UK, or TFSA in Canada). In that case, since the dividend is not taxed, there is no change to your capital. But you will need to reinvest the dividend before the price rises again (otherwise you will have lost time instead of capital).

Summary

Dividend investing is not always a poor decision. Some people and investment strategies may favour dividend investing over capital gains investing. But other situations will benefit from focusing on a growth strategy and staying away from dividend-paying stocks. Regardless of your choice of investment strategy, it is imperative to be aware of dividend yield traps and how dividend-paying companies may not be as stable as commonly regarded.

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