While I like the concept of “mailbox money” and passive income from dividend-producing stocks, I don’t like being forced to accept cash back when I don’t need it and the tax consequences that go along with those dividends.
For a more complete explanation of my rationale for investing for total return and my preference for no-dividend stocks, see my previous posts on the topics:
Today, I’d like to share a rebuttal from someone who admittedly has significantly more experience in the world of investment management than I do. I’ve spent my career in anesthesia, whereas he’s spent his in private equity and investment banking.
Debunking the Myths of Dividend Investing
It was I was recently on the Reddit Financial Independence subreddit asking if anyone had been living solely off of dividends from building a dividend income portfolio… I recently wrote a piece about how I constructed a plan on how to live off dividends forever.
I was completely laughed out of the financial independence community room that I couldn’t possibly ever beat the trends of index investing nor are Dividend Aristocrats truly outperforming the markets due to selection bias.
Well, I wanted to write a piece that was near and dear to my heart… Something that I was passionate about and hoped you’d consider as well… Dividend investing, and the commonly viewed myths associated with it.
Background with investing
As a finance professional that formerly worked in investment banking and now works in private equity, I had to get to the bottom of this. I couldn’t let people disregard such an awesome opportunity to invest in businesses not bet on stocks.
I grew up reading a number of different financial books on investing, fundamental analysis and more. There has to be a better way for high incomers like me to invest solely on their own without paying large fees for managers to build a portfolio on their own.
Myths of Dividend Investing
Let’s get down to the myths regarding dividend investing. Here are the most important myths that are simply not true.
Myth #1: You Can Never Beat the Stock Market
Component A: You Are Investing in Businesses Not Betting on Stocks
Beating the stock market over the extreme long-term is difficult, but it is not out of the question. However, what if you didn’t have to beat the market for 20 years? You only need to beat it for a 10-year cycle. This is more likely than 20 years. But, what if you found the exact criteria for overperformance by screening for high quality dividend stocks at extremely attractive prices.
My formula for screening for dividend stocks is quite simple. My quantitative analysis includes using a stock screener by inputting the following criteria.
- Invest in stocks that have a dividend yield greater than 0%. We only want stocks that pay a dividend.
- Find companies with a market Capitalization of over $10bln. I only want companies with scale and a size advantage.
- Invest in stocks with a P/E ratio less than 20x.
- I want to invest in companies that are growing their Earnings Per Share (“EPS”), so screen for EPS growth next year of greater than 5%.
- Long-term growth is important, so filter companies that are growing their EPS over the long-term.
- Don’t overpay for growth, so screen for companies with a Price to Earnings Growth (“PEG”) of less than 1.
- Finally, I want dividend safety over the long-term. Screen for companies with a payout ratio of less than 50%. This gives us a margin of safety. If EPS doesn’t grow, there is still sufficient dividend coverage.
From there I have my list of dividend stocks that I’d like to screen further, which includes the following criteria:
- Is the company shareholder friendly?
- Does the Company have a modest dividend payout ratio? (Yes or No)
- Is the company known to hire internally? Has the team been there awhile?
- Do they have a track record of revenue and earnings growth? Has the company provided a long-term growth plan?
- Do you understand the business model and how they make money?
Institutional investors love dividend stocks, which in turn provides significant downside protections. Large institutional investors are always the first to invest in outstanding businesses at attractive valuations.
If the stock price decreases modestly without any significant news, institutional investors usually gobble up more shares quickly. This helps protect your downside too.
Component B: Not Every Stock In Your Portfolio Has to Beat the Market to Beat the Market!
Portfolio allocations is critical in dividend investing, which is why I built an infographic on how to build a dividend portfolio. In a portfolio of 10 stocks, you can actually do quite well if only 5 beat the market, 3 track or slight underperform the market and 2 underperform the market.
Follow the smart money. It doesn’t take a genius to find and understand a great business at attractive valuations.
Last time I checked there wasn’t lines of institutional capital looking to buy indices. Why?
Myth #2: Index Investing is Completely Worry Free
So, why don’t true investors just invest in indices? One could argue that they are being paid to invest and their investors wouldn’t like that… Yes, true! That is a part of it, but it is not the most important point. The most important part is…
Allocation of capital. By choosing an approach of building your own portfolio, you can allocate your capital to industries that have sounds businesses but are just not valued properly. For example, the Amazon craze has opened up doors of opportunity for investing in strong, proven retail stocks that meet my above criteria. I invested in Target when everyone thought the retail world is ending. I recently went to Target and they look to be doing just fine to me now. Retail-apocalypse? I think not.
Another example includes right after the Great Recession, financial stocks were priced below book value (balance sheet equity) meaning you could invest at a price below the value of the business in a liquidation scenario. You are literally buying $1 for $0.50!
What about index investing then? Well, you have zero discretion on where your capital is allocated in terms of sectors. Currently, the S&P 500 is heavily weighted towards technology (i.e., Facebook, Netflix, Amazon, etc.). Those valuations are lofty and I expect valuations to correct, which doesn’t bode well for your overall asset allocation. How is that heavy allocation of technology stocks going to look in 5 years from now? I’ll let you be the judge.
With index investing, you don’t have the discretion to allocate your capital to opportunistic industries.
With the explosion of Exchange Traded Funds (ETFs) and robo-advisors, there is legitimate concern regarding stock market valuations and overvalued considerations for key components of the indexes. The rise of ETFs and robo-advisors has bid up the prices of some of the largest components of the indices…
Most retail investors have been enamored with the fact that they continue to throw money into these vehicles completely worry free. By being worry free within the approach of index investing, investors will be caught in a vicious cycle once the market turns.
Myth #3: Dividends Are Completely Tax Inefficient!
Yes, that might be true for those on this site. However, what about when you retire? Your retirement income becomes your dividend income. Your future effective tax rate is now substantially lower than your current tax rate.With dividend investing, our goal is to invest in outstanding businesses at attractive valuations. Therefore, we should never have to sell shares and we are locked into long-term capital gains. We only want to continue buying shares in these businesses over time.
Consider my dividend calculator to help you develop a plan on what it will take for you to live completely off dividends forever.
Myth #4: Dividend Investing Takes Significant Time
Within my dividend investing approach, I invest in core businesses that simply have limited risk at further downside due to the attractive nature of the valuations, management teams and balance sheet. To find these outstanding businesses, it simply isn’t that difficult to do anymore. Why?
We live in the information age. We can have any piece of information pushed to us in real-time. I use several different resources
What is your excuse?
Conclusion on Dividend Investing
PoF stated in his prior post about Selling Shares Beats Collecting Dividends that in his portfolio, he sees a tax drag of about 0.6% of the portfolio annually with taxes on dividends of about 30% on a 2% dividend. However, I’d like to consider in my above points that the small tax drag is drastically trumped by the following considerations:
- The constant reinvesting of dividend income enables outstanding compound interest that add up dramatically over time. Even the smallest of dips in a stock will result in massive gains down the road when you are reinvesting all dividend income back into your portfolio.
- Investing in sectors or companies at attractive valuations can extract abnormal returns. This trumps a 6-7% average annual return over time by a wide margin.
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[PoF: We could go back and forth all day on some of the finer points (kind of like I did with DGI in the comments of the selling shares post, but in reality, we’d be arguing over whether or not 50 or 60 basis points of tax drag on a portion of your portfolio is going to make or break your investing plan. Hint: it’s not.
Like my argument that the backdoor Roth gives you marginal gains for what might be a lot of effort, what you do with dividends (or whether or not you backdoor Roth) isn’t going to determine whether or not you’re successful. Saving diligently, investing sensibly, and remaining consistent are keys to an investing plan.
I’ll push back against point #1 just above — constantly reinvesting dividends isn’t going to make you any wealthier than not receiving a dividend. If a $100 stock gives me a $2 dividend, I’ll have a $98 stock and $2. Reinvesting the dividend gets me back to $100 or exactly where I would have been if I hadn’t received the dividend.
Yes, day-to-day fluctuations in stock prices make my example not precisely how things work, but that is essentially what happens when you receive a dividend. The share price is adjusted downward, reflecting the company giving up some cash to the shareholders.]
Do you invest for dividends? What criteria do you use? Or are you like me and focused on the total return with a preference for a low dividend yield? Let’s discuss in the comments below!