Investing for income is something that you hear a lot about these days. As the bulk of the baby boomer generation is at or near retirement, they understandably want to know how their retirement savings is going to translate into retirement 'income' for them. "How are we going to get our income?" is a very common question. Many investors believe that investing in high yielding investments is critical to their income success in retirement. This demographic tailwind has led to big time demand for all higher yielding investments including, high yield bonds, real estate investment trusts, utilities, and other high dividend yield equities. This demand for high yield has only been exacerbated by the low interest rate environment we currently find ourselves in (which is not a coincidence as lower interest rates are a direct result of the same demographic trends).
Could these investors be setting themselves up for trouble by focusing on yield as their main criteria for investing? In Chapter 19 of Ben Graham's seminal work, The Intelligent Investor, Graham discusses dividends in the context of evaluating company management. Graham identifies the question that any investor or manager should ask when considering to pay a dividend or not to pay a dividend. Can the company re-invest the retained earnings of the business in a way that will grow the business in a profitable way that provides a greater return for the shareholders than they could likely achieve on their own? If the company can, then shareholders will benefit more from retaining those earnings within the company rather than paying a dividend.
This is especially true when you consider the preferential tax treatment of capital gains over income from dividends. There are many examples of great companies growing their shareholders' per share value immensely by retaining all of the earnings of the business and re-investing it wisely. Recent examples include, Berkshire Hathaway, Alphabet, and Amazon. These companies have all had the ability to generate positive cashflows for a long time, but still choose not to pay any dividends and have retained all of their earnings for re-investment in the business on behalf of shareholders.
Despite the logic to retaining the earnings as noted above, there are many persuasive counter arguments to paying a dividend. These arguments include: The profits rightly belong to the shareholders and they are therefore entitled to have them paid out within the limits of prudent management. Many of the shareholders need their dividend income to live on. The earnings they receive in dividends are 'real money,' while those retained earnings may or may not ever show up in the market price of the stock in the future. These arguments are certainly compelling, but are they valid? Well let's address possible ways to address the concerns of the three arguments while still not paying a dividend.
The profits rightly belong to the shareholders and they are therefore entitled to have them paid out within the limits of prudent management. This argument is particularly persuasive when there are so many examples where management has used retained earnings to enrich themselves and expand their power, image, and prestige at the expense of shareholders. (For anyone who wants an education on management excesses, you should read about the career of Carl Icahn. Not only has he been one of the best activist shareholders in the world over the past 30 years, but he has made it his mission in business to exploit managements that don't put the shareholder's interest first)
There is no question, shareholders are entitled to the earnings of the business and they must ensure that management is acting in their best interests regardless of whether the management chooses to pay a dividend or not. However, this is more a reflection of whether or not you have good management or bad management running your company. If you have good management and they believe the correct thing to do is pay a dividend, then so much the better. But the fact that a company does not pay a dividend is certainly not evidence in and of itself that they are bad management who do not have shareholders' best interests at heart. In fact many managements have chosen to pay too high a dividend in the past which was detrimental to shareholders.
A good example of this was the performance of Crescent Point Energy Corp (CPG) in 2015. CPG is an oil and gas company which has consistently paid a high yield from its cash reserves. This high yield made the stock more attractive to investors and helped the company to finance acquisitions, operations, and the dividend itself through the persistent and continual issuance of new common stock, which diluted the existing shareholders equity in the company. For a time though, this didn't matter as the investors happily collected their high dividend yield, which is all they really wanted anyways.
Unfortunately the tide went out in mid-2015 with the drastic drop in oil prices, and many investors were caught swimming without any clothes on. CPG could no longer afford its high dividend and was forced to cut it. This compounded the earlier dilution of stock and resulted in punishing losses for investors as the stock dropped from over $47 a share in 2014 to less than $1.9 a share on market close Sept 17, 2020. There's no way to determine if paying a lower dividend would have saved investors from their losses on CPG, but I think it's safe to say that the unsustainable dividend payments were a big contributing factor in its rise and fall.
Many of the shareholders need their dividend income to live on. This is a common argument for paying dividends, but with proper retirement planning it is largely incorrect. While some investors may choose to live off of only the income their portfolio generates, this is not the only way to structure income payments for retirement. In a very simple strategy that we use with most of our retired clients, we section off at least 1 year's worth of monthly income in a risk-free investment like a savings account or a GIC. We use that money to pay the client's desired income out to them at the regular intervals they request.
For the rest of the portfolio it doesn't matter if the investments pay dividends or not, as their income doesn't rely on it. This strategy can be expanded for even longer periods of time if the investor wishes to protect even more against fluctuations in the market. In short, a need for income is not a rational argument for requiring dividends in your investments, as your income is not really dependent on the yield of your portfolio.
The earnings they receive in dividends are 'real money,' while those retained earnings may or may not ever show up in the market price of the stock in the future. This argument has more merit as market prices of stocks can fluctuate wildly, whereas dividend payments for a well-run company are consistent and are 'real money' in the shareholders hands. This is far more certain than the prospect that the stock price might rise in the future. While I agree with some aspects of this argument, I think this really comes down to how patient the investor is, and how well they've done their due diligence on a company they've invested in.
If they've done a thorough job of researching the company, and they believe the intrinsic value is higher than the market price, then that value will most likely show up in the market price, especially if the intrinsic value is increasing. Those gains in market value may come in lumps, rather than a consistent steady dividend payment, but the offsetting advantage will be that there will be no taxes to be paid until you choose to sell your investment, and even when you do sell, the taxes paid will be at the lower capital gains rate.
Ben Graham believed that companies should pay dividends, or in the alternative he believed that management should provide a clear-cut demonstration that the re-invested profits have produced a satisfactory increase in per-share earnings. He essentially put the onus on management to prove that they could do better with profits than the shareholders could do on their own. I think this is a prudent attitude for an investor to take when assessing management's decision to pay or not to pay a dividend. One thing that can be said about dividends is that a company's dividend track record can go a long way in assessing the quality of management and their dedication to putting the shareholders' interests first.
Companies with long track records of consistent and increasing dividends, without interruption, are usually indicative of a very well-run company that is doing their best for shareholders. Investors need to be cautious however as this is really only one factor among many that investors need to look at when assessing the quality of a company's management.
So is investors' obsession with dividends justified? As I've demonstrated, dividends or the absence thereof can be an important consideration in assessing the quality of management and of the underlying business itself. However, it is critical to remember that whether a dividend should be paid or not depends on the circumstances of the company itself, and whether or not it can re-invest those profits within the business in an advantageous way for shareholders. An investor should never make it a requirement that a company pay a dividend before they will invest in it. What's more, an over emphasis on dividends is leading many investors down the road to trouble.
The fallout from this is going to be a part of the story during the next market downturn and those that are unprepared for it are going to experience the pain of the dividend trap.
- Craig White, BA, LL.B., CIM
Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.
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