Dividends: frenemy status achieved

A bit of a rambling post from one of the authors incoming. You may have seen – and hopefully celebrated with us – the other author’s recent success overcoming the $0 net worth mark and powering ever further up the mountain. Godspeed, friend!

On the other hand, this author collects a few dozen dollars in dividends every single night. One of my favorite Buffettisms is, “If you don’t find a way to make money while you sleep, you will work until you die.” Counting sheep is for the sheepdogs; count dividends instead and tell Ambien to take a hike.

I love dividends. While many DGI investors set up DRIP’s, my preference is to pool dividends and diversify based on which businesses represent the best opportunity at the time the pool is big enough to justify a brokerage commission fee. This only makes sense in accounts where that watershed moment happens at least once per year. For smaller accounts, which I have a few, DRIP’ing is simpler and puts afterburners on the compounding engine. Dividends are easy to love as they come into my account, but what about how it affects the businesses writing the checks?

Proof is in the dividend pudding

If you’ve been through the tech bubble bursting or the Great Recession – and I won’t date myself by saying whether or not I observed both – then you’re a bit weary of stocks.

You’d be stupid to not cast a keen eye at the Dow. Fortunately, I used knowledge to overcome fear and spent a lot of time learning about investing before walking into the casino. It doesn’t look like Vegas now (scammy POS stink of a city), more like a green-thumb nursery holding some delicious fruit hidden amongst long dead undergrowth and a few sneaky poison ivy vines.

One of my key takeaways from all the investing reading I’ve done is that you cannot fake a dividend. No matter how much you cook your books, if you have to write a multi-billion dollar check quarterly, the cash is either there or it is not. That knowledge helps separate the balm from the toxins and makes investing a bit more palatable.

Taxation of dividends

Dividends are double-taxed, once as net income for the business and again when the deposit lands in my account. For IRA’s and their ilk, this is fine – no tax on the personal side. But for taxable brokerage accounts, this can be a major pain in the ass depending on your income. I’m pursuing a low-bracket early retirement, but until I gather the nuts to overcome FIRECalc’s  lowest limbo line and my own OneMoreYearitis, that 15% haircut by Uncle Sam cuts a little close for comfort.

Not only does the tax code put a little bitterness into the sweetness of dividends, but I have some philosophical qualms about the practice as well.

Dividends as a business model

Companies that pursue ever-increasing dividends at all cost have spawned a massive Dividend Growth Investor (DGI) movement. It’s a great way to invest, and I don’t have many bones to pick with the approach at a personal level.

However, I do believe that corporations may be selling themselves short by focusing on sending checks out the door. In some cases, repurchase programs are the best approach. In others, opening new sales channels or investing in R&D would be more appropriate. All told, a lot of cash is allocated one way or another in any profitable business, and I do not believe that sending shareholders ever-larger checks is always the best approach.

I’m also curious if we’ll look back in a decade or two and rename DGI’ers to yield-chasers, blaming them – rightly or wrongly – for a blue-chip wipeout after driving up all the good DGI names to bubbly heights. But I digress. I hate to see businesses try to scrape out a 2% raise to stay on some arbitrary “Royalty” list of precious DGI stocks (our own cheeky metaphor of a name notwithstanding) when the core earnings suffer from a lack of investment in the business itself.

Dividend cuts are so disdained by the investing community that buying a stock after a dividend cut has been shown to be an academically wise maneuver. Ask Grandma and Grandpa what they thought of GE’s decision in the depths of the Great Recession. Still, sometimes, it’s the best course for the business. And I don’t mind a bit if one of my holdings must make that call in the midst of a challenging environment. After it slashed its dividend to almost nil, I didn’t sell one of my major oil investments after I gobbled up several names during the oil price collapse, and the business has begun to reward me handsomely for my patience after others fled.

What about growth?

I’m not a big fan of the “Growth” vs “Value” or “Growth” vs “Income” simplifications. It’s all investing. There’s just something that makes running a business ever-easier when next year’s profits end up 8%, 10%, or even 15% higher than this year’s: year after year, 10K after 10K. The cash just keeps on coming. And even though some of these big-growth names sport high P/E ratios—eliminating them from conventional “Value” approaches—or they don’t pay a juicy yield—falling off the screeners used by DGI’ers and pure-income plays—they do soar like Jordan after perpetual eye-popping earnings reports.

Every year that net income increases by 10%, the P/E ratio drops so quickly. A 29X earnings number quickly becomes 16X cost-to-earnings ratio after you make a purchase, and you see capital appreciation along the way, maybe with a small divvy check in the mail. I’m thinking of Visa and Nike here, and those two businesses ought to be in everyone’s portfolio, no matter his/her investing style.

Disclosure: long V, long NKE. The book linked to Amazon is an affiliate link, and we earn a pittance if you purchase it; you earn a tremendous amount of investing knowledge if you read it.