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?
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 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.
- 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 techincal 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. For those who what a more technical understanding you can click here: Joel Greenblatt ROIC
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 millenial 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. For example 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.
- 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 beacause 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.
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