How do you live with yourself? – Well-known fund manager

The snarky comment above was allegedly made by well-known fund manager to another fund manager because he specializes in dividend income strategies.

Investing for dividends is actually controversial in the asset management world. This may be somewhat surprising given that dividends are foundational to our current understanding of why stocks have value.  

In 1937, John Burr Williams, a Harvard Ph.D. candidate in Economics, submitted a doctoral dissertation on the topic of the “intrinsic value” of a business. The choice of this topic, interestingly, was prompted by the legendary economist and Harvard professor Joseph Schumpeter, who popularized the idea of “creative destruction” to describe how capitalism fuels innovation through disruption.  

A year later, John Burr Williams published The Theory of Investment Value. Within this investment classic, Williams laid out the basic framework for understanding the true or intrinsic value of any security. Referring to Williams, Warren Buffett summarized his ideas in Berkshire Hathaway’s 1992 Annual Report.

The value of any stock, bond, or business today is determined by the cash inflows and outflows—discounted at an appropriate interest rate—that can be expected to occur during the remaining life of the asset. - Warren Buffett

Williams pioneered discounted cash flow analysis and proposed the “dividend discount model,” which is still used today. The basic premise of the dividend discount model is relatively straightforward.

If we think about the value of a bond as being a function of all the future cash flows it will send back to the owner, a company is no different. A rational person would pay a price for a company (or a portion of a company, i.e. a share of stock) that appropriately reflects the future cash flows that are expected to be received.

Valuation in the dividend discount model is based on the idea of cash distributions that are literally going to be sent to shareholders. Discounted cash flow (DCF) analysis, the primary tool for business and asset valuation today, is a little more abstract.

Rather than dividends, DCF valuation relies on the concept of “free cash flow.” Free cash flow has a few variations, but in essence it is the cash generated by a business after taking into account expenses and other drags to the cash flow of a business (such as working capital increases and capital expenditures). Free cash flow represents the funds generated during a given period that are theoretically available to distribute as dividends without increasing the company’s debt load.  

Conceptually, dividends and free cash flow are very similar. Dividends are the actual distributions a company makes, whereas free cash flow measures the potential of a business to support dividends without incurring additional debt.

So, given the central role of dividends in corporate valuation, why is dividend investing at all controversial? Critics of dividend funds and dividend strategies usually make the following points.

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5 Common Criticisms of Dividend Investing

"What actually matters is total return (income received plus capital appreciation). It doesn’t matter what form it takes. In fact, receiving dividends is often bad because you may have to pay taxes on them whereas unrealized capital gains are untaxed."

"Companies that give money back to you are doing so because they have no good way of investing it for you. You want to invest in businesses that can take the cash they generate and reinvest it for higher returns, not just return it to you. Dividends are in fact a sign of weakness, not strength."  

"The board obviously doesn’t think its shares are a good value. Otherwise, they would buy back stock with their extra cash instead of paying dividends."

"You don’t need the companies to give you the cash. If you want to monetize some of your investment, you can sell down your position and 'synthetically' create income."

"Investors who are chasing dividends are behaving irrationally and just responding psychologically to the positive feeling associated with receiving a dividend check."

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In our view, there are elements of truth in these criticisms but also flaws. We address these below as we explain why it may make sense for investors to prioritize stocks that offer steady and rising dividends as they assemble a long-term portfolio.

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5 Reasons to Follow a Dividend Strategy

Actual income versus paper profits‍

As contributors to total return, income and capital appreciation are the same in theory, but we invest in reality. Successful investors tend to have long holding periods, if only to defer realizing capital gains. A stream of dividends as a component of total return alleviates some of the pressure on exit timing as a driver of actual cash on cash investment performance.

Many investors operate with some degree of personal leverage (even if indirectly, by having a home mortgage, for example). Many investors also rely (or want to be able to rely in the future) on investment returns as a source of personal income. In practice, consistent dividend streams represent a valuable source of cash flow that is either needed or potentially needed. By providing actual cash flow, dividend stocks give an investor leeway to have more capital allocated to higher growth equities as opposed to fixed income investments.

Dividends signal capital discipline

Rather than indicate an inability to deploy capital effectively, companies that operate with a clear and meaningful dividend policy demonstrate a disciplined attitude towards capital allocation. Profits are not horded but rather partially returned to shareholders, while only the most promising growth investments (capital projects or acquisitions) are authorized.  

Share buybacks are often mistimed

Over the course of our careers, we have observed a tendency for boards of directors to authorize share buyback programs when the outlook seems sunny (and share prices are high) rather than when the company is experiencing turbulence (and share prices are depressed). There is abundant academic research that suggests corporate boards add no discernible value when repurchasing shares versus the alternative of returning cash to shareholders, who can decide for themselves whether to reinvest in the company or the shares of other companies.

Risks with “synthetic income”

Selling down securities to manufacture an income stream introduces a variety of execution risks and implementation burdens. Mechanically selling down positions exposes investors to the possibility of reducing exposure in periods of market stress when holdings are substantially undervalued.  

Dividends give us staying power  

It may be theoretically correct to equate paper profits to real cash distributions, since one can always sell a liquid security, but receiving a steady stream of cash flow potentially reinforces our psychological commitment to an investment, especially in periods of stress. A supposedly irrational psychological attachment to dividends might offset other irrational temptations, like abandoning investments after a period of disappointing performance. Dividends not only support our actual financial cash flow needs but also sustain a long-term investment mindset and can help avoid short-term trading temptations.

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While investors have many valid reasons to emphasize dividends in their investment program, dividend investing, like all forms of investing, needs to be done very carefully. We have significant experience navigating the universe of income investments and have learned a number of things (sometimes the hard way) that are specifically relevant to dividend-paying stocks. When building a portfolio of dividend stocks, investors should be highly aware of the following risks.

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5 Pitfalls of Dividend Investing

Conflating dividends with profits 

Dividend yield is not really a valuation metric and doesn’t directly signal whether or not a stock is “cheap.” A dividend is for the most part a voluntary cash distribution, determined by a board of directors. The same exact business could have wildly different dividends, or no dividend at all, based on the decisions of the board.  

Concepts like free cash flow or cash earnings are more indicative of business value. A company with a high dividend yield may simply be over-distributing cash relative to what it can sustainably support. To make an assessment of value, one has to take a close look at the specific cash flow dynamics of the company.

Over-reaching for yield

Everyone wants high dividends, but the best dividend opportunities are often not the ones offering the highest yields, which may be unsustainable or lack growth potential. Dividend investing should be done in the context of finding good businesses with attractive valuations that also have attractive dividend potential.

Leverage  

One way to goose a dividend is by amplifying the cash flow generation of a business with low interest rate debt (which is naturally more common in low interest rate environments). But the more debt a company has, the riskier the equity becomes. REITs, in particular mortgage REITs, are sometimes highly levered yield plays; proceed with extreme caution.

Dividend cuts  

Dividend-hungry investors are often lured into seemingly high yields only to watch the dividend get slashed or even eliminated in short order. A dramatic deterioration in the fundamentals of a business could lead to a false perception that a stock trades at a rich dividend yield. In these scenarios, investors look at the most recently declared dividend in relation to a reduced share price. But when a business is threatened financially, boards have a tendency to cut dividends sharply, especially when they are out of whack with peers.  

Missing out on growth  

Dividend stocks are often clustered in a few industry sectors. Low multiple value stocks are also typically overrepresented within the dividend universe, as opposed to higher multiple growth stocks. Investors should be mindful of diversification when constructing a dividend-oriented portfolio but also look for exposure to good stocks that may lack dividend attributes. Passive approaches that emphasize growth or low dividend sectors (such as technology) are a good complement to a dividend portfolio.

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Conclusion

Prioritizing stocks with an attractive dividend profile is a rational stance for many investors. Like any focused investment strategy, investing with a preference for dividends need to be executed carefully and thoughtfully.

With many of years of experience in income-oriented investing, we believe the key to successful dividend investing is to develop a solid understanding of the underlying business fundamentals. Dividend investors should first and foremost consider buying a stock because they believe the business is strong and the valuation is attractive — and not because the yield is high.  

The 76research Income Builder Model Portfolio is intended for income-oriented investors and managed to generate an overall yield that is materially higher than broad equity indices. The portfolio primarily includes stocks with above average dividend yields from a cross section of industries and may also include ETFs that offer exposure to fixed income instruments. While investments are screened for their income and income growth characteristics, specific holdings are chosen based on valuation and general business quality, growth and risk considerations.

Disclaimer