The Irrelevance of Dividends - YouTube

- Whenever I make a video or write an article

about the irrelevance of dividends,

the dividend crowd is quick to respond

and defend their love of dividends.

The problem for dividend investors in this dialogue

is that there is no basis at all, whatsoever

to have a preference for dividends.

Showing me dividends stocks

with great past returns is not basis.

Most of the arguments from dividend lovers end up

being focused on the ability to select individual stocks.

Which is not something that most people can do consistently.

Even in a stock picking environment,

there is no reason to believe that dividends,

or the growth of dividends would be an indication

of a good stock to own.

I'm Ben Felix, portfolio manager at PWL Capital.

In this episode of Common Sense Investing,

I'm going to tell you, again, why dividends are irrelevant.

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I need to get one thing out of the way before I start,

when I say that dividends are irrelevant,

I do not mean that they are not an important component

of total returns, they are.

What I mean is that dividends are not relevant

in determining which stocks may have good future returns.

And one more thing,

one of the comments I've heard

from a few dividend investors online

is that we should all be nice to each other.

People should invest however they feel comfortable.

Dividend investing is not wrong,

and neither is index investing.

We can all exist together.

Nope, that's not what I'm here for.

I'm trying to hurt anyone's feelings.

But there is peer reviewed academic research

and robust empirical evidence telling us

that there is a right way for most people to invest.

Which is low cost index funds.

If your goal is a reliable long-term outcome,

then there is no better approach.

The basis for the irrelevance of dividends

starts with the 1961 paper, Dividend Policy Growth

and the Valuation of Shares by Merton Miller

and Franco Modigliani.

They explained in their paper

that 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.

This is a fact that must be true as long as $1 is worth $1.

In support of this theory,

we know empirically that stocks with the same exposure

to factors like size, value, profitability, and investment,

have the same average returns

whether they pay dividends or not.

Unless you believe that the market is irreparably broken,

or that capital can be created out of thin air,

there is no way to argue against the fact

that the distribution of a dividend

results in a reduction in share value.

That must be true.

There's no way around it.

Dividend investors will tell you

that theory does not extend to reality.

And that dividend stocks do indeed do better

than the market.

I'm not denying that.

On average dividend growth stocks beat the market.

But dividends are not the reason.

Dividend growth stocks on average have excess exposure

to the value, profitability, and investment factors.

That is what explains performance differences.

This does not make picking individual dividend stocks

a good idea.

Dividend investors will tell you that the management

of a dividend paying company is positively affected

by their dividend policy

which produces better long-term results for investors.

There's no basis to believe this.

For this idea to be true, the whole market

would need to think that the company would not do well,

while you believe otherwise.

And then you would have to be right.

Everything comes back to pricing.

All else equal, for future returns to be higher,

the current price would need to be too low

meaning that the market is mispricing stocks

with good dividend policy.

There's no basis to believe that this is

systematically happening across the stock market.

With that in mind then let's walk through some math

and start an example that we will come back

to later in the video.

Let us consider two companies,

company one and company two.

Company one is a dividend payer, while company two is not.

To keep things simple,

we will assume that both companies trade

at the beginning book value of $10.

Keep in mind that following valuation theory,

the market price is based on the company's book value,

plus the value of its discounted future profits

discounted at some discount rate.

This needs to be explicitly clear.

If two companies have the same expected future profits

and the market is discounting those profits

at the same rate, the two companies would be expected

to have the same price relative to their book value.

Similarly, if two companies have the same profitability

and the same relative price

they must also have the same discount rate.

The discount rate is the investor's expected return

on a stock.

This relationship holds true

whether the company pays dividends or not.

It is crucial to understand that we are assuming

that company one and company two are the same size,

have the same profitability, reinvest at the same rate,

and trade at the same price relative to their book value.

In this case, we are assuming

that the price equals the book value to keep things simple.

If all of this is true

then these two companies must have the same expected return.

The two companies have a starting book value

of $10 per share.

They each earn $2 per share.

Company one pays a $1 dividend,

and company two pays no dividend.

You own 10,000 shares of company one

and you receive $10,000 in dividends.

Your shares now have a value of $11,

$10 starting value plus $2 in earnings

minus the $1 dividend.

Your total portfolio consists of $110,000

in company one stock, and $10,000 in cash before taxes.

I own 10,000 shares of company two.

It is now worth $120,000.

If I needed some cash, I could sell some of my shares.

Maybe I would create my own dividend equal to yours

but I don't have to.

I could sell more or less shares as needed.

I'm not allowing the company's dividend policy

to dictate my spending.

All of this is true whether the stock market is up or down.

If the market is down and the dividend is paid,

the value of the company still falls

by the amount of the dividend.

It has to.

This is not up for discussion

unless you don't believe in mathematics.

Receiving a dividend in a down market is exactly,

and I mean exactly the same as selling off some shares

in a downmarket.

If dividends are irrelevant,

and it is only exposure to the common risk factors

that explain differences in returns,

we would have expect two funds with similar exposure

to the factors to have similar returns

regardless of their level of focus on dividends.

To prove this, we will compare VIG,

the Vanguard Dividend Appreciation ETF,

to two funds from Dimensional Fund Advisors

that together create comparable factor exposure to VIG.

Dimensional funds are total market funds that seek exposure

to the known risk factors.

They're blind to dividends.

I'm using it US funds so that I can use

the Match Factor Exposure tool @portfoliovisualizer.com

to run the analysis.

For the period from January, 2013, through May, 2019,

which is when the data for the newest of these funds starts,

the annualized return for VIG was 12.98%.

While the annualized return

for the portfolio of dimensional funds was 14.67%.

The risk adjusted returns were also higher

for the dimensional portfolio.

The R squared for VIG and the factor regression was 94.3%.

Meaning that exposure to the factors

explains almost all of its returns.

The R squared for the portfolio

of dimensional funds was 99%.

The point here is not the dimensional funds beat VIG.

The point is that two portfolios

with similar factor exposure will produce similar results.

I don't know what else to say.

Dividends do not explain future returns,

and limiting your opportunity set to the stocks

that pay dividends cuts your opportunity set

roughly in half because roughly half of global stocks

do not pay dividends.

Less diversification means more dispersion

which reduces the reliability of your outcome.

I think that dividend investors should just admit

that they're nothing more than stock pickers.

Picking dividend paying companies

does not make picking stocks any smarter or safer.

I will concede that dividend growers

will tend to be large cap value stocks

with robust profitability that invest conservatively.

So picking them is probably better

than picking penny stocks, but there's still

a ton of security specific risks

that you cannot get away from.

To be completely clear,

I have nothing against dividends.

They are an important component of returns.

I think I just think that the idea

that you can use dividends to pick winning stocks

is egregious.

And again, please do not tell me the names

of individual dividend growers with great past returns

as evidence that dividends matter.

It would be just as relevant to tell me the names

of stocks starting with the letter A

with great past returns.

In both cases the information is meaningless.

That's actually a pretty good comparison.

I do have something else to add.

In Canada, Canadian dividends are taxed more favorably

than any other type of income when you have a low income.

This is often used as an argument

to invest in Canadian dividend paying stocks

as a Canadian resident.

I believe the situation is similar

in other countries as well.

Let's look at an example, say you already had $47,630

of taxable income in Ontario in 2019.

From there you're marginal tax rate

on capital gains would be 14.83%,

and marginal tax rate on eligible dividends would be 6.39%.

It seems obvious that the dividends

are way more tax efficient, but hold on.

Let's bring back our example from earlier.

You received $10,000 in dividends from company one.

You would owe $639 in tax.

I received $10,000 in capital gains from company two.

I will not pay any tax on those capital gains until I sell.

If I need some income, I will sell some of my shares.

Here's where people get really confused,

when I sell $10,000 worth of my shares,

I am not paying tax on the full $10,000 capital gain.

I'm only paying tax on a proportional amount of the gain.

Let me explain.

I paid $100,000 for my shares.

They're now worth $120,000.

When I sell $10,000 of my position

to cover my living expenses,

the capital gain is only going to be $1,666.

The proportional amount of my total gains on 10,000.

The tax owing would only be $247.

The amount of tax will increase over time

as I crew more unrealized capital gains,

but the crossover for dividends being more tax efficient

will not happen for many years,

and I may be able to offset future gains with losses.

I'm also in control of triggering the gains.

What if we didn't need the full $10,000 of income this year?

You're still paying tax on the dividend.

Lastly, I know I'm repeating something

that I already said in a past video here,

but I can't leave it out.

Dividend investors will tell you to look

at how much Warren Buffett loves dividends.

And they will tell you

that this is a reason for you to love them too.

Warren Buffet is happy to collect dividends.

But he is also happy to not collect dividends.

He explicitly wrote about this to help you,

the average investor understand why.

It takes up a whole section

of his 2012 letter to shareholders.

Please go and read this before following Buffet

into dividend stocks.

He has made it so clear that this is not a criteria

on that he uses to help identify good companies.

Buffett likes low prices, he is a value investor.

Low priced stocks will often have high dividend yields.

That does not mean that Buffet loves dividends.

Using dividends to pick stocks simply does not make sense.

It has no basis in financial theory

and this can be proven empirically

by comparing dividend focused index funds

and factor index funds

with similar factor exposures as we have done.

If you want to pick dividend stocks,

if that is where you most comfortable, that is fine.

But you have to understand

that you were still nothing more than a stock picker.

There is no pedestal for dividend investors to stand on.

Thanks for watching,

my name is Ben Felix of PWL Capital

and this is Common Sense Investing.

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