From time to time we get questions about dividends at Telarray. Dividends seem to make logical sense as a chance to receive the mythical “passive income” of popular investing culture from an investment portfolio. Several funds even market the idea of “dividend aristocrats” as superior investments because they consistently raise their payout over time. Those funds have gotten good traction in recent years.
There’s nothing wrong with dividends! In fact, stock funds in Telarray portfolios pay dividends of anywhere from 0.5% to over 2% currently, and we look to both dividends and price appreciation as components of equity returns. However, we don’t expressly target investment in dividend paying securities or favor high dividend payers in our funds.
Here are a few reasons we welcome but don’t obsess about dividends:
- As far back as 1961, a famous paper by Modigliani and Miller demonstrated that investors should be indifferent to receiving dividends vs. selling shares of the company to generate cash. In other words, regardless of the company’s election, you can generate your own dividends as necessary by selling small fractions of your holdings (and ensure capital gains treatment on the proceeds).
- We believe that tilts towards certain factors like small cap, value, and profitability are likely to result in long-term outperformance compared to the market. Some claim that high dividends themselves are a factor that drives outperformance, but most experts tend to agree that the dividend factor is actually so closely correlated with value and other factors that it’s not a meaningful driver of outperformance by itself. We agree.
- Dividends tend to come during a specific time in a company’s lifecycle. Young companies with strong prospects tend to use the money to reinvest in their business, so dividends typically aren’t established until companies mature. Focusing on dividends essentially focuses on mature companies — or even overripe companies beginning to decline — which unnecessarily narrows the diversity of a given portfolio.
- Dividends suffer from what’s known as double taxation. Dividends are paid from after-tax corporate profits, but then immediately taxed as ordinary or qualified dividends to the individual investor. Paying dividends can be appropriate, but investing money back into the company avoids or at least defers this phenomenon.
- Share buybacks have become a prominent shareholder-friendly use of cash by corporations. Rather than paying the money to shareholders as dividends, cash is used to buy shares of the company on the open market, which reduces the number of shares outstanding and tends to raise the price slightly. This has a similar effect to paying dividends, except that the tax on the buyback “dividend” is deferred until your shares are sold. A focus on dividends excludes a widening array of shareholder-friendly companies using this approach.
- For lack of a better term, dividends have gotten weird lately. In a quest for yield, investors have aggressively bought stock of companies paying dividends, driving the dividends ever lower. Boards of directors are ever conscious of the stigma of cutting payouts, even when economics would indicate otherwise. During the pandemic of 2020, companies paid dividends far in excess of corporate profits, which is clearly not sustainable and can lead to unusual distortions not expected by traditional models. These are not your grandparents’ dividends we’re seeing distributed today.
In a world of low nominal bond yields, investors are being increasingly drawn to the siren song of high-dividend-paying stocks. Some investors believe they might provide better income than bonds along with the price appreciation potential of stocks. We believe taking money from bonds to buy stocks will end badly, as historically even dividend stocks can be volatile, and there seems to be no better way to dampen inevitable equity market volatility than an allocation to good old-fashioned bonds. Stocks are still stocks, and the idea of replacing bonds with dividend paying stocks (no matter how high the yield) upsets the entire time-tested approach to risk management in your portfolio.
We look forward to reinvesting the dividends you do receive in your Telarray portfolios, and believe you should take comfort in your current level of exposure to dividend-paying stocks in your diversified Telarray portfolio.