There are great reasons to invest in dividend stocks. And most are not taught in business school.
Anyone who went to school for finance learned that – all things equal – a company’s dividend policy should theoretically have no impact on your investment decision-making.
Since transaction costs are minimal and taxes a wash, you should be indifferent as to whether you are paid a dividend or manufacture a dividend (by selling shares). In theory, a dividend simply takes something that is already yours (cash on the corporate balance sheet) and places it in your personal bank account.
Reality is quite different – there are great reasons to invest in dividend stocks.
Note: not all dividend stocks are equal. Personally, when looking at dividend stocks I prefer to invest in companies with sizable moats, growing revenues and easy dividend coverage. You shouldn’t chase yields for the sake of it. Some companies have high dividend yields because they are in dying industries and/or the market is anticipating a dividend cut.
At the corporate level, there are a number of arguments as to why some companies should pay dividends. Perhaps the biggest is that dividends enforce discipline on company management by restricting cash flow. This forces managers to limit projects to those with a higher IRR (Internal Rate of Return).
Note: Fast-growing companies with massive opportunities (e.g. Shopify) inherently have a lot of high IRR projects to invest in. For this reason, it makes more sense for these companies not to return capital to shareholders.
In contrast, cash-rich companies that don’t give cash back to shareholders are more likely to waste money on low IRR projects or acquisitions that only serve to bolster executive pay. Instead, these companies should be giving cash back to shareholders who can then re-allocate to companies with higher return projects.
Dividend policy can also signal insiders’ confidence in the future. The current economic crisis is a perfect example. While some companies have recently cut their dividend (e.g. Wells Fargo) to free up cash in a collapsing environment, others have actually raised dividends. A company that raises its dividend during an economic depression signals to the market the resilience of its cash flows. In today’s environment, I’m much more comfortable giving my hard-earned cash to companies that are still raising dividends.
At a more personal level, I like dividends because they help me stay disciplined. A stock with a 5% dividend yield at the time of purchase provides me a 5% return regardless of the stock price. Knowing this, I’m less likely to make emotional buy and sell decisions. It’s purely psychological, but a known cash return that accumulates in my account beats an unknown potential return that sits in a company’s account (or is tied up in other corporate assets).
While I can manufacture those cash dividend returns by selling shares as they increase in value, this requires more intervention on my part. Do I systematically sell each quarter? Or only sell when share prices rise to crystallize some of my gains? Do I sell a fixed percentage or dollar amount? Do I stop selling when prices fall?
While these questions can be answered and a systematic process created, the emotional gyrations of the market could make me change the process at the worst time. In contrast, if a stock declines but I know I’ll continue to receive my 5% dividend I’ll be more inclined to hold on.
If you’re like me, activity is detrimental to your investing returns. The more I sit tight, the better I do. So any investing strategy that helps me avoid unnecessary activity is helpful.