Challenging Media Assumptions
The financial media constantly emphasizes two reasons for favouring dividend paying stocks: 1) they offer certainty/higher returns, and 2) they provide for income needs. Let’s examine these assumptions.
Do dividends produce higher returns?
Dividend payments are not created out of thin air, rather they come from the company’s earnings or assets. When a company pays out a dividend, the value of the company is reduced by the corresponding amount. The company has to take cash out of the bank in order to pay shareholders a dividend, with the result that this cash is no longer available to the company for expansion, for technology improvements, for marketing, or for research and development. In effect, the company is choosing to return available cash to investors rather than using it to grow the company. Please note that I did not say that the company is giving profits back to investors, which is not necessarily the case.
It’s the company’s investment policy rather than their dividend policy that is likely to affect the value of your portfolio. Dividends in and of themselves do not drive the total returns of stocks; in fact, the total return of high dividend paying stocks may not be any greater than those of low dividend paying stocks.1We caution readers to consider this research in light of the media’s focus on yield in our current environment of stock market volatility as a panacea on which to build a portfolio.
It is possible that higher dividends—resulting in lower company values—may also result in higher risk. A test of this consideration is as follows: When a company strips away cash in order to pay out dividends, is it taking risk away from its balance sheet or adding risk? In some cases a viable argument could be made that it is adding risk by giving up available cash.
Do dividends produce higher returns…not necessarily. Consider two companies with a $10 stock value each. Company A pays out a $1 dividend and company B does not pay a dividend. The day after the dividend company A stock is worth $9 and the investor now has $1 in cash for a total value of $10. Company B, which did not pay a dividend, is still worth $10!
Do dividends provide for income needs?
The second reason dividend paying stocks appear attractive to investors, particularly in retirement, is the portfolio income they produce.
It is preferable for a taxable investor not to have dividend income from a portfolio, because the tax advantage in compounding, pre-tax growth is in itself exceptionally compelling. Retired business owners are often defined as investors in search of income.
Arguably, you could say that these investors need cash flow, not income!
As an alternative to meeting income needs with dividend payments, you can create a dividend-like payment stream by selling securities in the portfolio—so-called synthetic dividends*. There is often resistance to this idea because of the perception that the investor is encroaching on capital to produce cash flow and possibly locking in a loss if the stock or bond price has dropped. However, research shows that the value of a company is determined solely by ‘real’ considerations, like the earning power of the firm’s assets and its investment policy, and not by how the fruits of the earning power are packaged for distribution.2
Because the dividend payment is simply ‘packaging’, it does not necessarily change the underlying (pre-tax) value of the portfolio. In reality the tax impact of synthetic versus regular dividends could produce a positive outcome, as taxes on capital gains are moderately preferable to taxes on dividends in the highest marginal tax rates in provinces across Canada.
Synthetic dividends also allow for a much more specific and controllable distribution of an investment portfolio. The synthetic dividend is based on the long term planning and income needs of the portfolio holder and not solely on the dividend policies of the underlying stocks.
The use of synthetic dividends also allows to the portfolio to be rebalanced. Generating cash flow from securities sales not only results in more efficient tax management but also in the opportunistic selling of assets that are overweight relative to the strategic portfolio target.
Do dividends provide for income needs? They certainly do, but a thorough examination of alternatives is important before implementing any strategy. Let me clarify that I am not advocating the avoidance of dividend paying stocks. Rather, I am stressing that the focus of the portfolio building process should be on those issues that are personalized for each investor. The overall asset allocation decision needs to be made on the basis of risk tolerance and returns requirements.
Key Points to Remember
- Dividend policy does not determine the long-term returns of a stock/stock portfolio.
- Taxable, pre-retired investors will achieve higher after-tax returns by reducing the number of dividend-paying stocks in favor of compounding capital growth.
- A synthetic dividend may be more tax efficient, more accurate and more flexible than a regular dividend when planning for cash flow needs.
* Synthetic dividends may have tax implications or trigger commission charges. Please consult a professional before utilizing this strategy.
- Nobel Laureates Merton Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of Business 34, no. 4 (October 1961)
- Merton Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of Business 34, no. 4 (October 1961)
Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada. The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above. The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd. Rates are not guaranteed and are subject to change at any time without notice.