There are many arguments for and against investing in companies who pay a dividend. Even legend Warren Buffett believes against paying a dividend with his company Berkshire Hathaway. I respectfully disagree with this thinking and let me explain why. Now there are 2 common arguments against investing in companies who pay a dividend. Read the dividend argument and then my response below.
1. The company shouldn’t pay a dividend back to its shareholders because it could use that cash to invest in the business, grow profits, etc.
I hear this argument pretty frequently from anti-dividend supporters. They always mention Warren Buffett, and because he did it then it should be a model for all companies. I vehemently disagree with this thinking. Firstly, taking the cash from the shareholders and giving it to the company instead means you are taking away all the power from the shareholders. In essence, you are asking the shareholders to put all their trust in the CEO and Board of Directors that the money will be spent efficiently.
Don’t Give All the Power Away
While it’s true that most of this money may be spent wisely, the fact is the shareholder is giving up control. I’d rather receive the dividend and make the decision for myself if this money should be reinvested in the company. It should not be the company’s decision to make. I always recommend reinvesting your dividends, and consequently if it no longer looks profitable to do this for a company, then sell and find a new investment. At least in the meantime you have collected dividends from a company and you can take your compounded interest elsewhere. If you never received dividends from a company, then when you sell because you no longer believe in that story then you have nothing to show for your investment (especially if the share price has dropped since).
Think about it again for a second. So you want money that is supposed to be returned to the shareholders to instead be given back to the big corporations we are financing? How much of this excess cash will be reinvested in the business, and how much of it will slip through the cracks and end up in lavish vacations, luxury hotels, and exquisite dining for the CEO and his pals? You really don’t know. And while I’m being a little extreme, I don’t believe it is far fetched to think that this sort of thing happens all the time at big, profitable companies that actually are good investments. I’m sure there’s plenty of cash to go around at a lot of these companies, but I’d prefer that some of it was coming back to be in the form of a dividend.
You also hear the argument that share appreciation is more important than dividends because the gains are real and more than a dividend, while a dividend is not “real income.” This is very wrong as well. The fact is that share appreciation is not a real return, unless you are selling at that time. Stock prices fluctuate daily, but you aren’t losing and gaining money every day unless you are selling everyday. When you buy a stock, you have to be comfortable with the fact that the share price could crash down or scream up. At the end of the day, if you bought 400 shares then a week later you still own 40 shares. If the stock prices shoots up from $8 to $10, you don’t have $4,000, you have 400 shares. Only when you sell do you have $4,000. Buying and selling frequently to lock up little gains like this will erode your investing power from transaction costs and tax implications. When you invest like this, you try timing the market to maximize your gains, which is a fool’s game.
With the 400 share example again, let’s say the share price went from $8 to $6 but you got paid a dividend. You don’t only have $2,400, you have 400 shares plus the reinvested dividend. Let’s say you got 10 additional shares from this. So now you have 410 shares instead of 400. The next year you may have 420 shares, then 430, and so on. At the end of the day, it doesn’t matter what the stock price did on a daily basis from year to year because you are long term investing and collecting dividends. Let’s say after 4 years the stock price is now $14 and because of reinvested dividends you have 450 shares instead of 400. Suddenly you are rewarded for your patience and have been earning compounded interest on your dividends.
This compounding interest phenomenon doesn’t happen naturally with companies who don’t pay a dividend unless you are buying and selling frequently. I don’t pretend to know what the future stock price might be tomorrow or next week, but I do know that the tortoise always beats the hare in the long run. A long term investment plan with compounded dividends will always beat a short term focused and greedy plan.
Miss Out on Gains to Also Miss Out On Catastrophic Losses
One last point with this first argument. I hear this frequently as well. “Oh you missed out on so many gains from growth companies by only investing in companies that pay a dividend.” This is true, BUT I also avoid so many losses. Have you ever heard of the greater fool theory? Basically investors will pile into a growth stock no matter how high the P/E ratio gets because they assume that they can sell that stock at a later time to some greater fool. The problem with this is that the bubble eventually pops, and so many people lose a great percentage of their investment.
Plus, you’ve heard me before argue about being careful with investing in growth stocks. With a majority of the market focused on earnings growth, even a half a percent slowdown in growth can cause a major sell off and really burn investors. Why would you want to be subject to such extreme volatility? I’d rather avoid these choppy waters and gravitate to the calmer seas, where I can watch my dividends compound and not have to worry about a bubble popping. There is such a serene calm in such an investing strategy, and I’d advise you to try it. It may not be sexy, but investing in big established companies that pay healthy dividends AT REASONABLE VALUATIONS pays off in the long term.
2. A company may pay too much cash towards the dividend, putting the business in jeopardy.
This is true and can actually be a much bigger problem than most people realize. Too much cash to shareholders can be a problem for companies who can’t afford it and can really hurt big time. But I teach to always stay away from these companies, and it’s not hard to identify which ones have cash problems.
Like I explained in my free eBook guide, 7 Steps to Understanding the Stock Market, dividend payout ratio can be easily calculated from the annual report and you should not be investing in these companies! To learn more about this, subscribe to the free newsletter and get your free download of my book. How do you feel about the dividend argument? Leave a comment below and let me know what you think.
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**The Dividend Argument: Here’s What I Think**
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