Do dividends matter and should you cherry-pick high income shares?
"The only thing that gives me pleasure is to see my dividend coming in." are words attributed to J D Rockefeller, the world's first billionaire.
There are two possible ways of gaining from shares. A rise in price and the dividends paid once or twice a year.
In Rockefeller’s day there was far less information and compulsory disclosure. What a company paid in dividends was a key indicator of health.
Casual observers of the stock market can also know how much of the return from the UK’s top 100 companies (the FTSE 100) comes from dividends. There have been significant periods when the index hasn’t moved but the dividends kept being paid. Over the ten years to the end of 2019, the index grew 70% but an investor using their dividends to buy more shares would have made nearly 160%.
Dividends therefore seem important, but we should consider why dividends should not matter. If dividends were not paid the company would retain the capital and it would increase the asset value of the company. The fact that the markets likes or has a demand for dividends may have no more meaning than the high level of rice consumption in Bangladesh. The country’s diet consists of more rice per capita of any other nation. If we were in that bubble it would be easy to believe that rice was not a key component of human survival. Using this logic, anyone in Morocco, whose citizens eat the least rice (that’s a useless fact you can keep for a pub quiz) must be struggling. Of course, that would be ridiculous. Likewise, if dividends are not paid and they are substituted for capital growth there should not be a problem.
An example might be a company whose book value (the net value of all its assets) is equivalent to £1 per share. If it makes a post-tax profit of ten pence per share it could pay it all as a dividend. The book value of each share would still be £1. Alternatively, if its dividend was five pence, the book value would become £1.05. Whatever the split, the return is still ten pence per share. Many successful companies like Microsoft did not pay dividends for years. Other companies have paid too much and the share price has suffered.
Of course, the actual market price of a share is based on a lot besides book value. Stock prices follow sentiment whether it is caused by a
change in dividends or for more silly reasons, such as the son of one CEO spreading the Gangham Style dance craze. Over the long term though, the returns become more rational.
A good dividend policy should be a matter of suitability. Companies seeking growth are best keeping the money to invest but many multi-billion-dollar hogs are more likely to serve their shareholders by not holding cash like large piggy banks Ultimately though, investors should be most concerned about the TOTAL RETURN rather than the income yield of dividends.
Even income investors should not necessarily rank high dividends above quality stocks. Small amounts of shares can still be sold to meet an income. Fundamentally, the difference between obtaining cash though dividends or selling shares is that the one is the company shedding the assets and the other it’s the investor. It’s the same net amount of cash from the same pool of wealth, although the taxation may differ.
In conclusion, whether we like dividends or not, they are a poor tool to judge the quality of an investment.
February 2020 by David Cockling