The truth about dividends
Have you ever heard that investors should seek dividends? It’s free money, right? Right?
This is the second article of the series « Popular but wrong beliefs about investing »
Here is part 1: The stock market is like a casino.
Today, I would like to explore another false belief:
Investors should seek dividends
What is a dividend?
If you hold at least 1 share of a company, for instance Apple, you’re a part owner of the company. And as such, you’re entitled to get a part of its profits. The dividend is the part of the profit that goes to the shareholders. It’s usually expressed as a percentage of the share price. But it’s better to think of it as a fixed yearly cash yield.
What do I mean by that? Imagine that I’m offering to you a 10% investment. So, you give me 100 francs, and in return, I’m giving you 10 francs every year until you decide to sell that investment. Now imagine that over the course of first year, the 100 francs turn into 200 francs. How much are you getting for the second year? 10 or 20 francs? If you think like me, you would expect 20 francs because I did sell you a 10% investment. But in the case of dividends, you’d still be getting the 10 francs, not 20.
So the dividend yield is just a figure of speech: you’re not getting a 10% dividend; you’re getting a 10 francs dividend.
Dividends are like free money, right?
Imagine that there is a jar of coins sitting on a table and your job is to estimate how much money is in there. You can’t empty the jar to count the money. But the jar is see-through so you know what kind of coins are in there. Now let’s say that you have written down your estimate on a piece of paper. And let’s say that your estimate is 500 francs. Now, a judge arrives, opens the jar and removes 10 francs from the jar and gives it to you, just because you’re playing the game. What is your new estimate of the value of the jar? If you’re consistent, you should update it to 490 francs.
That’s exactly what happens with dividends: the minute the company commits to paying a dividend, its value decreases. So any dividend you receive is value taken away from the share price.
Companies paying dividends are better though, right?
Not really. It turns out that established companies who have existed for a long time, like Coca-Cola, Philip Morris, or Johnson & Johnson, are providing dividends to their shareholders. And one could argue that those companies are « better » because they have been providing and will continue to provide a product people want. They are usually giving a dividend because they’re already investing enough money into their business so that it grows at a sustainable rate.
But a company giving away a dividend is guaranteed to grow at a lower rate than a similar company not paying a dividend, because growth is dependent on how much money can be re-invested in a business. The company that has less money to reinvest will grow slower.
High dividends can actually be a trap
Rookie investors usually fall for the high dividend yield. For instance, they see a company paying a 20% dividend yield and they think: Hey, I’m getting a 20% return!
But here we go back to my first remarks about how dividends are best seen as a fix cash yield instead of a percentage. If the yield is so high, it usually means that the share price has collapsed. And why do share prices collapse? Usually because the underlying business isn’t doing so well.
And what do struggling business do? They save money and the best way to save money is… to cut the dividend. Yes, dividends are not guaranteed. And the most efficient way for a company to strengthen its balance sheet.
Imagine that you’re currently donating to charity (here is a selfish reason for donating to charity) but suddenly, you lose your job. What are you going to do? Most people will tighten the belt: no more fancy vacations, no more expensive nights out and… no more donations. Because all the money must go toward paying for essentials: rent, food, insurances, etc.
Using this analogy, you, as a shareholder, are the charity the company is donating to. It’s nice and good until difficult times come.
There are countless of examples of companies which have cut dividends over the years but the latest example on my mind is the American phone operator AT&T: they cut their dividend nearly in half at the beginning of 2022.
And what happens when a company cuts dividends? Well, all the investors who owned the company because it was paying a dividend sell. And when lots of people sell, the price decreases. So, not only you lose the dividend but the share price is also lower. Double punishment.
Seeking dividends is particularly silly as a Swiss resident
The one great tax feature of Switzerland is that there is no tax on capital gains here. That means: if you buy at 100 and sell at 150, you pay 0 taxes on those 50 profits. That’s simply amazing.
But what about dividends? Well, dividends are taxed as income. Which means that you’ll pay your marginal tax rate on any dividend you might get. Plus, some countries like the US have a withholding tax on dividends. You might get some or all of it back with you fill the right forms but it’s a hassle.
So, seeking dividends as a Swiss resident is silly because you are voluntarily paying more taxes.
By choosing companies which don’t pay a dividend, you’re (legally) avoiding that tax.
Remember the example of the coin jar: share price and dividends paid are connected, so any money not paid out in dividends will stay in the business and increase its value. And because of that amazing feature of the Swiss tax code, you won’t pay any taxes on that increased value.
Does it mean that you should exclude dividend paying companies from your portfolio?
Not necessarily. It depends on what you need. Some people need income. Maybe because they’re retired. Although, even in that case it might be better to just sell a few shares to simulate an income stream.
Another reason to choose companies paying dividends is that they are just too good to pass on. For instance, most of my portfolio is invested in companies which don’t pay a dividend. But when LVMH was trading at 250 euros a share in 2018, I bought in, even though they pay a dividend.
Would I prefer if LVMH didn’t pay a dividend? Yes. But I would rather own a share of the the business than not own it despite the dividend.
What doesn’t make sense is to buy share of a company for the sole and only reason that they pay a dividend.