In this article, I’m going to go against the idea that dividend stock investing is the ancient key to stock market performance. I know, I know, so provocative, right?
Whether you are an investment novice or a seasoned investor, you probably have heard one supposed pillar of stock market investing: dividends are sacred, important, and necessary.
Yet, here I am, throwing some crazy idea at you; the idea that dividend stock investing does not matter for millennials.
In this article, I’m basically going to destroy your reality and leave you second guessing your entire existence. Whoah. Ok, you are probably not as crazy into this stuff as I am, so you may not be THAT affected by this.
First, we will have a short intro about dividends. Then, you will be hearing about what Warren Buffett says concerning dividends. We will end with three problems associated with millennials using a dividend stock investing strategy.
Alright millennials, let’s talk dividends!
What are dividends?
Dividends are cash payments a company makes to their owners (shareholders) out of their profits. For example, if you purchase $10,000 worth of stock in a company that pays a dividend of 3%, you will receive $300 per year. ($10,000 x 3% = $300)
By paying a dividend to shareholders, a company is deciding not to retain that money to reinvest in the company. In our example, the $300 is now in your hands and no longer in the hands of the company. Many large blue-chip stocks pay dividends due to their sheer size and inability to use their entire profit to grow their operations.
It is important to realize, for the sake of understating my argument, that for every $1 paid to you as a shareholder through a dividend, the company no longer has that $1 to reinvest and grow the company operations.
Dividend reinvestment plan DRIP
A dividend reinvestment plan is a plan set up so that your dividends automatically purchase additional shares of company stock. For example, if you own stock in Apple (AAPL) and receive $150 in dividends, those dividends will go towards purchasing $150 worth of new shares of Apple.
The big question
Using our example above, you purchase $10,000 worth of stock in a company and receive a dividend of $300. The question is: can you reinvest that $300 at a better rate of return than if the company retained the money?
Why is this the big question you might ask? Think about if the company issuing the dividend can turn that $300 into $400 by retaining it in the company. Turning $300 into $400 is the equivalent of a 33.3% return.
Since the company did not retain the money and instead issued a dividend worth $300, you now have to find a place to invest that money.
If you invest the $300 in a bond paying 5%, you will likely have less money long term. This is because the company would have been able use the money to grow at a higher rate than 5%.
If you invest the dividend in a new stock, you should find a company producing equally impressive reinvestment returns.
Let’s take this concept, and use Warren Buffet as an example.
An example using the world’s greatest investor, Warren Buffett
If you had purchased $10,000 of Berkshire Hathaway when Warren Buffett acquired the company in 1964, guess how much that $10,000 would be worth today? The answer: about $130 million!
Berkshire Hathaway does NOT pay a dividend which has allowed Warren Buffett to reinvest 100% of the profits of Berkshire back into the company to continually grow the company for over 50 years.
Now, if you were sitting around in 1964 at the Berkshire Hathaway annual shareholder meeting, knowing what you know today, would you have wanted him to pay some of his profits to you as a shareholder via a dividend? Or, would you punch the person sitting next to you right straight in the mouth for even suggesting such a miraculously idiotic idea?
Physician on Fire gets this concept as you can see in this article he wrote regarding his Berkshire stock, “Selling Shares Beats Collecting Dividends”.
Think about it, if Buffett didn’t reinvest Berkshire Hathaway’s profits to grow operations, you would have been issued cash via a dividend. You would then pay taxes on that dividend income. Then, you have to do something with the cash dividend. What do you think the chances are of you finding a better place to put that dividend than back inside Berkshire Hathaway? I would say the chances are approximately, no bueno.
If you purchase the stock again over time, you will end up with a HIGHER average price. And in investing, you obviously want a lower average price, not a higher average price (you want to buy low, sell high).
Moreover, Buffett is left with less money to reinvest into the company, because he gave some of the profits to you in the form of cash. So now, Buffett doesn’t have the ability to grow Berkshire to the size it is today, and your $10,000 no longer grows to $130 million; it ends up being significantly less.
To recap:
- If Berkshire paid a dividend and didn’t reinvest 100% of its profits, it would be worth significantly less today.
- If you received a dividend from Berkshire, you would pay taxes on that money.
- You would then have to reinvest the money into Berkshire, and you would be left with a HIGHER average price over time.
- Buffet has less money to reinvest into Berkshire so it grows at a much slower rate of return.
None of this is good, so let’s just agree it is an incredible thing Buffett did not start paying a dividend all those years ago.
Dividends and High Returns on Invested Capital
If you are an investment novice, don’t let the title of this paragraph get you stressed; we are going to make this simple.
By the way, here is an article I wrote for the novices out there: Investing in Stocks for Beginners; 3 important ideas
As you can see, back in 1964, if you had forced Berkshire Hathaway to issue a dividend, you would have adversely affected your future investment in the company. Warren Buffett would not have been able to work his magic; his magic being the ability to reinvest the profits of the company at a high rate of return.
When we speak about reinvested capital, we are speaking about the rate a company is able reinvest their cash back into their business to grow their business operations and profit. As a shareholder, you want a company to efficiently grow its profits and operations, because your shares will increase in value.
For those interested in the technical aspects of ROIC: I use Joel Greenblatt’s formula when thinking about return on invested capital. Joel Greenblatt is a titan of investing in his own right and a Columbia University professor. He wrote: The Little Book That Still Beats the Market
At this point, you may be thinking to yourself, “Well, it’s Warren Buffett, and Warren Buffett is just an outlier”.
While Warren Buffett has an incredible track record, there are many fantastic companies not run by Warren Buffett making high returns on the money they retain to grow their businesses. The mere fact that you want a dividend is saying you don’t care about these fantastic companies’ ability to reinvest at high rates of return.
Buffett said this during a speech at the University of Florida
(Go to minute 58)
Here is a transcription of this very important idea:
The real question is whether we can retain dollar bills and turn them into more than one dollar at a decent rate… It [Berkshire] is run for its owners but it isn’t run to give them dividends because, so far, every dollar we have earned and could have paid out, we’ve turned into more than a dollar… Therefore, it would be silly to pay it out. Even if everybody was tax-free who owned it. It would have been a mistake to pay dividends at Berkshire because, so far, the dollar bills retained have become more than a dollar.
If you want to invest in companies having the potential to be compounders like Berkshire Hathaway, you don’t want them to issue dividends. You want them to grow their capital. As Warren says, “…retain dollar bills and turn them into more than one dollar at a decent rate.”
It is my view that compounders held over long periods of time will create positive stock returns. I believe it is perfect for millennials to own compounders due to their youth and long-term investing potential.
Dividends can reduce the amount of capital reinvested in a company and prevent the compounders from compounding.
Three millennial problems with dividend stock investing
Millennials are net buyers of stock. In other words, they will buy more stock over the years than they will sell. If you are a net buyer of stock, you should hold that stock for the long-term.
If your stock pays no dividends, you will have more favorable taxation and less fees.
If your stock pays dividends, you have the following problems:
Problem 1 – Taxes
Under the current tax structure, long term qualified dividends are taxed at 0-20%. (depending on your income)
The problem with dividend taxation when you are young is that you really don’t need the income. You will reinvest that income, but pay taxes along the way.
My Chipotle (CMG) stock I own outside of my IRA currently pays no dividend and I will only pay capital gains tax when I sell the stock (which will hopefully be a very long time from now).
By the way, you can see my portfolio here: My Stock Portfolio
It is my hope that Chipotle continues reinvesting its capital and does not pay a dividend; I do not need dividend income for a very long time.
*Some reading this will inevitably say you can own dividend stocks inside an IRA or qualified account. Yes, while you will have to pay income taxes when you distribute the investments, you will not pay taxes on those dividends. You are also limited to the amount you can allocate to those accounts each year. But the taxation may be minimized when inside an IRA. However, you still have the problem of brokerage fees and the average price over time (our next two points).
Problem 2 – Fees
For most brokerage companies, TD Ameritrade, Schwab etc…, if you have a dividend reinvestment plan DRIP and reinvest your money by purchasing additional shares, you will not be charged a commission.
The fees work in your favor if you desire to reinvest dividends and purchase more stock in the company issuing the dividend.
You may decide not to reinvest the dividends to purchase additional shares. You may, in turn, decide to invest the money into a different stock. If you do this you will then have to pay a commission for purchasing shares of a different stock.
For example, if you own shares of Apple, one day you may decide Apple is overvalued. Instead of using the dividend from Apple to purchase additional Apple shares, you may decide to take the cash and put it in your money market account. You will then purchase new stock but pay a commission. If you purchase Chipotle with the cash generated from the Apple dividend, you will pay your broker a commission for the purchase of your Chipotle stock.
This is an inefficient fee structure compared to simply allowing your money to grow inside a high return on capital stock issuing no dividends.
Problem 3 – Reinvestment Returns
Your stock may become expensive and hurt your average price
If you own a stock for the long term, your stock price will fluctuate over time. There may be periods when you believe your stock price is too expensive, and hence, you do not believe it is the most efficient place to purchase additional shares.
To use Chipotle and Apple again, if you believe Apple is overvalued, and continue to have the dividend purchase additional shares, you are increasing your average price over time.
If you own a company like Chipotle instead, and you believe Chipotle is overvalued, you are not purchasing additional shares (the profits are being retained to grow the company not being paid as dividends). Since you are not purchasing additional shares in Chipotle, your average price will stay lower.
As you can see, this ends up being a lose lose situation: you will one day have dividends purchase additional shares at high prices, or, you will pay additional commissions for having dividends purchase shares of a different stock. And, of course, there’s the taxes.
In summary:
- You receive cash in the form of a dividend and pay tax on that income (outside a qualified retirement account).
- You do not use the income for living expenses because you are young.
- Since you do not use the income for living expenses, you will reinvest the dividend income.
- If you reinvest the divided income you will likely one day purchase additional shares of an overvalued stock.
- If you do not reinvest the dividend income, you will pay additional fees to your broker for reinvesting the dividend in a different stock.
The Example of Apple
You may not remember, but Apple did not pay a dividend until 2012. If you were a young investor in the year 2000 and only employed a dividend stock buying strategy, Apple (AAPLl) wouldn’t have been on your list of companies to purchase because it did not pay a dividend.
Subsequently, If you did NOT employ a dividend stock buying strategy, you may very well have invested in Apple in the early 2000’s.
If you purchased Apple, you are very happy they did not pay a dividend; their lack of a dividend allowed them to reinvest their profits in the company.
If Apple started paying a dividend in the year 2000 equal to $150 million for example, it is not just $150 million dollars Apple is giving to shareholders. It is also the lost opportunity cost of the $150 million reinvested into the company at a high return over many years.
Guess what, Apple has had high returns on the capital it reinvests. This has allowed the company to become the largest corporation in terms of capitalization in the world; currently worth over $700 billion.
Today, Apple’s sheer size has driven it to issue a dividend. This dividend is necessary because Apple is too large, has too much cash, and makes too much of a profit, to reinvest 100% of its profits for growth. So, owning stock in Apple isn’t a bad thing just because it pays a dividend. Just do not buy Apple for the sole purpose of generating income from its dividend if you a young investor.
In closing, I want to make one thing very clear. The idea of investing in a stock that pays a dividend is NOT a bad thing. What IS a bad thing when you are a young investor, is investing in a stock BECAUSE it pays a dividend.
I’m not saying everyone should go out and only purchase high return on capital companies paying no dividends. You may find a company that has favorable economics and high barriers to entry. If that company is selling at a good price, you should buy that company’s stock regardless of whether it issues dividends. This article from Modest Money is well done and makes a different argument about a dividend grower approach.
While I search for companies making high returns on invested capital, it doesn’t mean you need to use the same strategy. Just be mindful that a company earning high returns on its capital can be adversely affected by dividends.
When it comes to taxation, fees and reinvestment returns, millennials have a better chance by not solely using a dividend investing strategy. But, buying stocks that issue dividends is completely fine for the right reasons.
Just don’t purchase stocks for the sole purpose of dividends if you are a millennial.
Thanks for reading and I hope you learned something. If you disagree with me, I would love to know why. Collegial debate and an invigorating discussion is encouraged!
Photo Credit: Flickr – DonkeyHotey- Warren Buffett Caricature
Disclaimer: These are the opinions of the author. Every person has their own unique situation; this article is not written to solve the situations of the readers. This post also has affiliate links. You can read my affiliate link disclaimer here: Disclaimer
I never knew that about Berkshire. That’s interesting that BH never paid a dividend, but not surprising. Chalk it up to another brilliant Buffett-ism. I’m of the school of thought that the younger you are, the more risk tolerant you should be. So, I would throw another strategy into your pool. How about if you invest blue chip for the dividend, but while you are young, use that dividend to invest in high-growth, relatively higher risk stocks or funds? The principle appreciation should balance out the commission fees you warn of, while the potential downside risk is balanced out by the fact that you are young, the dividend is more or less “free”, and you can easily make up any significant loss over the long term (especially if you hold on to those blue chips!)
Tommy Copeland! Nice hearing from you and good thoughts. If a blue chip is undervalued, has great economics, management, and happens to pay a dividend, I’d be all for it. And as for reinvesting the divided, I would personally just want to reinvest it in my next best idea. I wouldn’t do it just for the risk aspect. But that could be a viable way to go for some. And I would probably only reinvest in something else if I thought the blue chip paying the dividend was overvalued at the time.
I disagree completely…As a millenial you have a huge advantage which is called time. Investing in (high) dividend stocks or ETF’s (even better) will create a passive income at young age. The sooner you start the better. Buffett earns 6750$ per minute because he started at young age and he could re-invest his money in more growth companies.
The snowball effect becomes exponential over time and accelerates time and time again. Just look up the graphs…
You always need to investigate whether the cash flow is safe from a company. if you reinvest the dividend income, you should NOT reinvest it in the overvalued stock but do it in another one that is still undervalued. That is a basic mistake you shouldn’t make at all times ! The fees of your broker are marginal impact if you use the lowest cost broker compared to the high dividends. Just limit your number of your transactions and accumulate cash to certain amounts. Keep it simple.
There’s an easy solution for each of your problems so I don’t follow your arguments to arrive at your end conclusion to NOT take dividend in the decision making of your purchase of stocks. What is your strategy then for creating another passive income? There are many very successful bloggers building nice portfolios based on dividend income which will lead to financial freedom.
Patrick, thanks so much for stopping by and I appreciate the comment. As this is written for millennials, 99.999% of the millennials you refer to will not need passive income via dividends for a very long time. Hence, they are not “living” off the income.
I would agree that if you are a millennial who is living off the income as you were lucky enough to have retired early, or if you are a millennial who is planning on retiring in the short term, then dividend investing may be an ok route. If you are like the vast majority of millennial investors, you will not be retiring anytime soon and you do not need passive income.
In the long run, as you can read in the article, it is my view that companies able to reinvest at high returns will outperform over the long term. If we are talking long term, it is not smart to invest in a company “solely” for a dividend. If there is a fantastic company at a good price and it pays a dividend, that is a great thing to buy.
As for ETf’s, I would argue that that millennials investing in ETF’s don’t care much about dividends. This is due to the same reason above; they don’t need passive dividend income for a very long time.
To answer your question: What is your strategy then for creating another passive income?
I don’t plan on retiring in the short term because I am a millennial. There are two scenarios in my view:
1. Invest in companies paying high returns on invested capital selling at fair prices (those companies may pay dividends, but its not THE reason to invest in the company)
2. Invest ONLY in companies paying dividends to create a passive income stream.
3. Invest in an ETF/Index
For me, I believe that scenario 1 extrapolated until I need passive income many years from today, I will net a much larger nest egg than if I started investing in dividend stocks many years before I needed passive income. I believe that scenario 3 will also likely result in a larger nest egg than scenario 2.
Once you net a larger amount of money years from today, you then turn it into a passive income stream
While we may disagree on this one, I hope you continue to come around and comment. I appreciate it!
You are correct that BRK-A pays no dividend but it owns stocks that pay dividends. BRK-A itself is a major shareholder in IBM, Wells Fargo, Apple, American Express, Coca Cola and many more, all of which pay a healthy dividend.
You use Berkshire as an example of why you should not invest in dividend stocks. However, BRK-A is directly involved in buying stock and companies that pay dividends, which is the activity you are arguing against.
I appreciate you commenting and hope keep coming by and sharing your thoughts.
Chris, I apprecaite the comment! Yes, Buffett invests in companies paying dividends. A few reasons Buffett is more likely to purchase companies with dividends is because Berkshire Hathaway makes over $24 billion in profits annually. Many companies which will move the needle for Berkshire are very large corporations which pay dividends. Buffett has a problem in that he cannot purchase a fractional share in a small or even medium business. In many cases, the only way for him to move the needle would be to purchase an entire business. He does this often, but great businesses are rarely for sale. So he doesn’t have as large a stock universe as someone like us does.
Buffett also does not personally own these shares. Bueffett owns shares in Berkshire which owns shares of dividend paying companies. Berkshire as a corporation can deduct dividends which people like you and I cannot. So Berkshire also has a much lower tax bill due on dividend income than individuals who own the same stock.
But, doesn’t Berkshire Hathaway have most of its holdings in dividend paying stocks? That’s like one of the main ways they have been so successful. Warren Buffet, one of the greatest financial minds of all time, is all about buying up dividend paying stocks. I mean I guess I get it if you were banking on a small company that you thought was going to grow over time, but for a well-established company that is simply going to increase at or slightly above the inflation rate and matching the market, I believe dividends would be an extremely valuable part of your portfolio. I don’t know, it seems like you’re missing out on a huge opportunity for growth that is well tested and proven.
Hi Adam. Thanks for stopping by! As I mentioned below to the comment made by Chris, Buffett does have investments in stocks paying dividends. A large advantage Berkshire has a corporation is the ability to deduct dividend income. Us individuals cannot do that. Also, Buffett has a disadvantage that we do not have. He has to allocate capital into large corporations to move the needle at Berkshire. Many large corporations pay dividends because they are too large to efficiently reinvest 100 percent of capital at high rates or return.
Also, the article does not say you should NOT invest in dividend stocks. It says you should not ONLY invest in dividend stocks. If you find a stock paying high returns on capital at a nice price and it pays a dividends, the article refers to that as a great opportunity.
Thanks for stopping by and I hope you keep reading and commenting. I appreciate the discussion.
I am a millennial who graduated college with no debt, and has been invested in dividend growth stocks over the past decade. I will be financially independent by next year – this is when my dividend income will exceed my expenses.
If I hadn’t found dividend growth investing, I would not be close to being financially independent. I would not have bought stock during the 2007 – 2009 financial crisis when everyone was scared about stocks, nor would I have kept buying during the 2009 – 2017 bull market, when everyone was telling me stocks were “high”.
I only buy stock in companies that have paid dividends – these are proven companies that have worked very well for me. I sometimes “cheat” and buy index funds in my 401K – and those pay dividends too.
There are no fees if you buy a dividend stock and hold for years or decades ( there are commission free brokers). There are no taxes if you hold stock in a Roth IRA. As for reinvestment, you have flexibility to reinvest in the same company that paid dividends or elsewhere. If an overvalued company buys back stock, regardless of valuation, you are stuck and without option.
As for Warren Buffett – he is a genius capital allocator. This is a very rare skill. It is impossible to determine who the next Buffett will be. Unfortunately, most CEO’s are terrible allocators of excess cash. You may want to research the performance of companies by reinvestment of capital. Buffett does invest in businesses that pay him a boatload of dividends that he then allocates elsewhere. Look at his investments like Coca-Cola, Geico, American Express – these are all dividend paying companies.
Hey Dividend Growth Investor! Thanks for the comment. I always appreciate being able to have a discussion on the blog.
First I would say congratulations! That is great that you are at the point you can pay your expenses.
I would argue a few counter points. While it really is fantastic that you did so well only investing in dividend stocks, that is not to say you would have done worse investing in stocks paying no dividends. It is my view that finding great companies paying high returns on invested capital at favorable prices will compound at high returns over long periods of time. If those companies DO pay dividends, that is great. If they do not pay dividends, I personally don’t care.
I would take a great company with high ROIC with no dividend and a favorable price, over an OK company paying an OK ROIC but with a favorable dividend.
I believe there is a risk of lost opportunity cost for those investing ONLY in dividends and disregard other potential fantastic companies. I believe investors would NET a a larger account balance over time which could be turned into dividend income at the right time in the future. I also don’t believe the vast majority of millennials will be passive income anytime soon. Hence, I believe they will trade a lower account balance in the future for dividends in the present by only focusing on dividends.
We disagree on this one, but I hope you keep coming by and commenting. I do enjoy different perspectives on my articles so readers can make more informed decisions and hear two sides of the story.
I don’t really invest in individual stocks, but I think like everything else diversification is the key. In my emergency fund ( which is allocated 25% Bonds, 25% cash and the other 50% is in a high dividend yield fund because the the stability of cash flows most high dividend yielding stocks have. I want less volatility in my equities as part of my emergency fund so it makes sense there.
However, anything I’m long in I totally agree. There is a useful financial tool for every circumstance.
Thanks for the comment, Matt! Definitely don’t want to have all of your money in one basket. I agree that short-term you want minimal volatility. Thanks for reading and hope you come back and comment soon!
Hello,
I like this article. I thought many times about different investing strategies. I came to the same conclusion, it is better to invest in companies which have high possibility to grow, for the same reasons. I came from Germany where taxes are a big issue.
For all comments mentioned that Berkshire invest in dividend paying stocks too, I like to say: That is right, but it was never its strategy. If you look in the past Berkshire buy companies with low prices but great growing potentials. Today a lot of this companies have reached a certain level of capitalization. Now it is better paying dividends to making more than a dollar from a dollar than trying to grow.
But the time horizon to hold a company for Berkshire is ever and so they get a lot of dividends. But it is not it’s strategy and that’s the intention of this article.
Buffets credo is buying bargains and that’s the way you should always buying.
Best regards Sebastian
Nice comments, Sebastian. I agree with you that Buffett’s strategy has not been to only buy companies paying dividends. I’m glad you got the point about Buffett. He doesn’t invest in companies BECAUSE they pay a dividend, he invests in companies he believes are fantastic and selling at a favorable prices. If that company issues dividends, that is great. But it doesn’t matter to him if a company doesn’t pay a dividend.
Ask people who invested 10K in Enron at the beginning of that company and see how much its worth now about non dividend paying stocks. You think they would do that again. You cannot fake valuations and cash flow when you have to pay a dividend. There are just as may companies you can point too to prove your point as there is to disprove your point. Also Qualcomm, and all those dotcom start ups back before they crashed.
Thanks for commenting, Jeff! I will give you a counterargument about Enron.
Basically, you should only invest in companies you research and understand. One look at Enron’s financials and you wouldn’t have understood Enron. As long as you live by this mantra, after researching Enron, you would simply move onto the next company to research. If you invested when Enron started, you should have done the same thing; you should have sold Enron as soon as their financials became impossible to understand.
I am slightly confused by the argument that, “You cannot fake valuations and cash flow when you have to pay a dividend”. Enron paid a dividend so I’m not sure why you say you cannot fake cashflow when you pay a dividend?
Either way, thanks for the comment and I hope you continue to visit the site and comment!
I’m in agreement. A company should only pay a dividend if they cannot achieve a greater return by investing the funds in their business then you as the investor can make by reinvesting the income. As someone early in the game you do not require that income to live so ultimately all you really want is the optimal return until you need the cash. That is determined by the yield you expect from those funds minus any expected tax. Given less liquidity should mean higher returns, investing in non passive income providing stocks should be superior for those just starting investing, similar to long term bonds versus short. Of course it’s not always the case, but the point remains dividends are not by itself the optimal strategy.
Hey FullTimeFinance! Thanks for commenting. I have read some of your articles before so it is nice to hear from you.
You hit the nail on the head. It is all about the ability for your money to reach optimal returns wherever it is placed. Long term, active investors, should seek the highest returns, but not in a speculative manner. Investing in fantastic companies should create more wealth long term, and if those companies can reinvest at high returns, you should receive high returns down the road.
I hope you continue to come by and comment. I appreciate it!
Eh.
If in two alternate universes, the same company exists. In one universe it gives dividends, and in the other universe it doesn’t. If you invest the dividends received you would get the exact same end result, if you hold the stock in a tax-advantaged account. If it’s in a taxable, that highly depends on where you live and your tax bracket. Where I live dividends are taxed less than capital gains.
Using your example: If you were to buy $10,000 worth of shares with a 3% dividends, you would indeed get $300 a year. But what if that company is a dividend grower? What if they grow their dividends by 10% a year?
By the time you retire, let’s say 35 years later, that initial $10,000 would be giving you $7,664 per year in dividends. You’re almost being given your initial investment every year without the need to sell any stocks.
This is what Warren Buffet did with Coca Cola.
“What gets less attention are the dividend payouts which are sent to Berkshire’s headquarters as cold, hard cash. Every 90 days, Warren Buffett receives 10% of his initial purchase price back when he gets sent a check for $140,000,000.”
Hi Jon!
I love the example. Thanks for commenting.
The way you approach this is likely the way many people would approach it. However, there are some major problems. If it the two alternative universes you mention, two companies make the exact same profit, it is impossible for them both to APPRECIATE at the same rate of return. This is because one company is paying a portion of its profits to you. If it pays a portion of its profits to you, it cannot reinvest those profits into itself to increase it’s profit and operations.
If I own a dry cleaner that can make a 20% return on each dollar reinvested and it retains ALL profits. And I own another dry cleaner that can increase each dollar reinvested by 20%, put distributes 20% of profits. My first dry cleaner if it made an annual profit of $100,000 would reinvest $100,000 at 20% annual rate of return. The other dry cleaner would only reinvest $70,000 ($30,000 were paid in dividends). Even if you purchased additional shares, the 20% compounding being lost on dividends is a drastic problem for the dividend paying dry cleaner comparatively.
There will be a large opportunity cost for this if the company makes high returns on the money it reinvests into itself. This is even true if a company increases it’s dividend each year.
The other problem will be that your average price paid (cost basis) for the company that appreciates at a higher rate will be the same price you purchased the stock for in the “non-dividend” scenario.
However, in the dividend scenario, you will have to reinvest your dividend over time. As the price of the stock appreciates, you will be purchasing more shares at higher prices. The average price you paid for your stock will increase comparitively.
So in one scenario you have a lower price (cost basis) and in the other scenario you have a higher cost basis.
I appreciate you commenting and I hope you keep coming back and adding to the discussion.
Well I’m glad to see everyone in the comments are calling you out for being stupid.
Let me just add you do not understand drip investing. Yes when you DRIP and AAPL is overvalued your cost goes up, but no company stays over valued forever. When the shares of AAPL are undervalued you will end up purchasing more shares so overall your cost stays low. Please do your research before you spew lies to us young people. If we want to be lied to we’ll just turn on the news.
P.s. I triple dog dare you to post this analysis on seeking Alpha.
Hey Josh! Well, thanks for the spicy comment.
So, basically when it comes to DRIP investing you are saying I am correct that eventually it will be overvalued. I did comment that stocks fluctuate and will sometimes be over valued and sometimes undervalued.
Your comment, “When the shares of AAPL are undervalued you will end up purchasing more shares so overall your cost stays low”. Sure if it is undervalued it will stay low, then when it is overvalued it will increase your price, then you may or may not end up somewhere in the middle.
I guess the point you are missing about the article is that in the case of Apple, if you only invested in stocks paying dividends, you WOULDN’T EVEN HAVE OWNED IT it prior to 2012. You would have missed years of price appreciation because you were hunting for dividends.
The thesis is not that you should NOT buy dividend stocks. It is that you should not ONLY buy dividend stocks. If you buy a great company at a fair price and it pays a divided, that’s no problemo.
I’m happy to have you back to comment another time!
I don’t mind the argument, there are several ways to reach a comfortable retirement. I really think you could’ve found some better support for your argument though. Choosing the most successful investor of our lifetimes does not really paint a run of the mill example, that’s an outlier. Also, you mention, Berkshire, but fail to mention that Buffet’s investment criteria himself (the way he made all his money) is dividend investing based. You’ll find that if you look into the S&P 500, a huge portion of the index return is from dividend paying stocks. Much of the history in the market is against your idea, you may have a couple “hits” investing in non-dividend payers, but you’ll have far more misses, they are an indicator of the health of a business. You’re acting as if the Dow 30 companies are not reinvesting their profits into their businesses, simply is not the case.
Good luck to you in your journey though.
Hey Dividend Stacker! Thank you for reading and I love the comment. Always like the back and forth so readers can weigh different arguments.
I will argue with your following comments:
1. You said “Also, you mention, Berkshire, but fail to mention that Buffet’s investment criteria himself (the way he made all his money) is dividend investing based.”
This is false. I believe you are suggesting Buffett only invested in dividend producing companies because he used a dividend investing strategy to build his massive wealth. This is completely false. For example, Buffet bought See’s candy in the 1970’s. To my knowledge, See’s did not pay a dividend. And, even if it did, Buffet’s NUMBER ONE goal is to own a business outright. He wants to reinvest the profits of a business into Berkshire Hathaway. Only wanting companies which pay dividends makes not sense for that style of investing. If See’s paid a dividend he would have less money to reinvest into Berkshire. It is true that he has invested in companies which have paid dividends, for example his most famous Coca-Cola investment. But he didn’t invest in it BECAUSE it paid a dividend. The company had an incredible franchise, barriers to entry, nice returns on capital, and favorable management. The dividend is added into his calculation of intrinsic value of course, but whether Coca-Cola paid a dividend or not he probably could have cared less given those few points.
2. You said, “You’ll find that if you look into the S&P 500, a huge portion of the index return is from dividend paying stocks.”
Of course the S&p 500 has historically had a huge portion of its profits from dividends. Over 80% of companies pay dividends in the s&p. If you assume they average a payout ratio of 40%, and then you do an analysis where you remove the dividends from the index, the index will look abysmal. Dividends are profits of a company, so of course it is accurate that a high amount of growth of the index came from dividends, because dividends are profits. I am not arguing that you shouldn’t invest in those companies. I am arguing that you shouldn’t ONLY invest in the companies paying dividends in the index. If you think about it, the companies featured in the index years from now, are likely not currently paying a dividend. They are reinvesting their profits in themselves, so they can grow into a company large enough to be in the s&p. Once they are so large they cannot reinvest 100% of profits back inside themselves at high rates of return, of course they should release those to profits to shareholders.
I really do appreciate you reading and I hope you come back and comment in the future! Like I said, I love great comments so readers can make a decision with less bias.
I see these as more poor examples. Warren Buffett bought Sees Candy, which means he bought all the profits, which means he bought ALL the dividends. He has 100% of the profits back in his pocket yearly to reallocate how he chooses, whether it be back into the company or elsewhere, he gets all the dividends from that company. If you’re suggesting that millennials should focus on owning companies so that they can control the profits, sure great idea, but you’re talking to different millennials than I know.
I chose the S&P 500 as an example because Warren says, to basically anyone but himself, that an investor should allocate 90% to an index fund tracking the market and 10% to safer plays. Meaning he recommends your strategy (according to you) should be 72% dividend paying stocks.
Hi Dividend Stacker. Thanks for replying to my reply, I believe you are the first to do so on this article. I love the back and forth, so thanks for continuing the conversation.
I think the first point would be to make sure we’re on the same page about Buffet; he does not use a dividend investing strategy. He does invest in companies paying dividends, but his strategy is not to purchase companies for the sole purpose of dividends. He will purchase companies not paying dividends just as easily as those who do pay dividends.
To the other point, my suggestion is to find companies paying high rates of return on the capital reinvested inside their own company. If I receive a dividend, I then have to turn around and find a new company (adding to my frictional costs and increasing my price longterm). If I have a company making high returns on the capital it reinvests inside itself, there is no way I can allocate the capital from the dividend to make as high a rate of return as the company can. So, I would prefer the company keep the profits so I can enjoy capital appreciation long term.
If you click on the My Portfolio tab above, you will see I also have a nice chunk in an S&P 500 index fund. I agree with his view of owning an index fund. I don’t care what percentage of the companies dividends, because I am completely fine with averaging an index for passive investing. However, if I am trying to beat an index, I want to find the companies paying high rates on reinvested capital so they can increase their profits at at higher rate than their peers. My strategy is to do lots of research and, as I find those companies, sell out of my index and purchase said companies.
Remember, the article does not state you should not invest in companies paying dividends. It states you should not invest in companies ONLY because they pay dividends.
Thanks for reading and I hope you continue to stop by!
Hello
I know I am a little late to this party but just found the article and enjoyed it greatly!
There have been a lot of great comments and points made on both sides of this debate on dividends vs no dividends.
Before I make my comment, I want to clarify that I understand that you are not AGAINST dividend paying stocks but you think people should not buy a stock JUST because of the dividend.
With that being said, I respectfully have two comments that I would like to make about the article and would love to hear your thoughts about them in return.
I do not believe either of these points were addressed:
(If they were and I missed them, please forgive me.)
The first point I would like to make is similar to one made by another commentor in that Berkshire Hathaway is a bit of an exception. Warren Buffet is one of the most successful investors of all time.
It hardly seems fair to compare all stocks in general to his as it is indeed an outlier.
The other issue that I have with this is his business model is very different from many other companies out there such as Apple (who sell physical products) or Netflix (who provide a service)
Point being that perhaps not all companies are going to be as successful as BH by NOT offering dividends. I would love to see some examples of other companies that NEVER offered dividends escalate their stock price the amount BH has in the amount of time they have. Not many I would wager. Bottom line on this point is that I agree that I think BH is an outlier and not a typical business model (or typical success record for that matter)
My second question I believe has been overlooked entirely. I am going to use the example of two individuals who both compile a $1M portfolio over 40 years.
Individual #1 has a portfolio made up of only NON dividend paying stocks.
Individual #2 has a portfolio made up of ONLY dividend stocks.
Let’s say both these people retire at age 65 in the year 2005.
For the first 3-4 years, both individuals would be enjoying life and both getting passive income.
However, enter 2008-2009 recession:
The person with dividend stocks picked their portfolio wisely of stocks like walmart, mcdonalds, J&J, P&G and other dividend stocks that actually thrive during recessions.
the price of their stock may go down but their monthly income will honestly not change that much.
The person who has a $1M portfolio of non dividend paying stocks follows the 4% rule and sells off 4% of their portfolio every year to live off of. Now all of the sudden, that 4% take a HUGE bite out of their capitol for those two years because the value of the stocks themselves have fallen so much.
By the time the market comes back, they are left with far less capitol than they had in 2007.
Now, they run a much higher risk of running out of money in retirement.
One other bonus point I would bring up is great quality growth stocks like coaca cola now pay BH 20% each year because their dividends have grown consistently.
Are non dividend stocks going to be giving you 20% every year in 4 decades? Probably not.
Again, this comment is made with all due respect but would love to hear your input on it.
Thanks again.
Dan Watson