Dividends: not always a welcome source of income
Many investors follow dividend strategies. However, tax and market pricing can make them costly to implement.
Investing in companies that pay dividends has long been a popular investment strategy, with many investors happy to spend dividends, while fearing spending down their capital.
We’ve illustrated before in the growth vs value debate that dividend paying stocks have been out of fashion, so a return to form should not be ruled out if some of the more highly valued tech stocks are de-rated by the market. Yet there remain fundamental reasons why businesses paying and you receiving dividends may not be an entirely optimal strategy in which to place too much of your wealth.
A dividend strategy is one style of investing that, by its nature, excludes other parts of the investment universe. Relying wholly on dividends risks tilting your portfolio to parts of the market which might not perform well. A September 2018 paper by Hendrik Bessembinder showed that just 43% of US equities have outperformed US treasuries on a total return basis since they went public, illustrating the dangers of being in the wrong investments.
Why do businesses pay dividends?
There are good reasons for businesses to pay dividends; a mature business may foresee lower rates of overall profitability by over investing and expanding their footprint if there is not a large enough market for their services. For example, many fund management firms generate a lot of cash, but buying smaller fund managers and hiring more staff may be a poor use of resources if their revenue is from a handful of blockbuster funds.
Shareholders also like to receive dividends as they (generally) come from profitable businesses that have an element of predictability to their future earnings, and there is a chance that those dividends could grow over time. This represents an attractive alternative to owning bonds. A business that pays a progressive dividend will naturally attract income investors, possibly seeing their shares trade at a premium to others.
Re-investing a dividend is not always an efficient way to compound wealth
Fund Manager Terry Smith, a well-respected growth investor, is an advocate for companies not paying dividends, arguing that if a business is trading on multiple of its book value, e.g. 3.5x price-to-book, it makes no sense for a company to pay out profits for you to re-invest them at 3.5x price-to-book, when the business could re-invest them at book value and generate a higher return on your behalf. Selling a small proportion of your shares every year can generate an artificial ‘dividend’, which is sustainable if your investments grow over time.
While conceptually true, this only works if the business trades at a ratio greater than 1.0x – many financials, such as banks, currently trade at less than book value, implying that the market does not have faith in that value being realised if the business was broken up.
Dividends can be inefficient if not held within an ISA
It’s surprising how many people still buy individual stocks, purely because they have a good yield. Dividends are not ‘free’ money. When an investment pays a dividend its capital value falls by the amount of the dividend paid, which is the same concept as transferring money from your left pocket to your right pocket. Assuming no taxes or frictional costs, your total wealth should stay the same.
Regrettably, taxes get in the way.
Let’s say a 40% marginal rate income tax payer wanted to boost their pre-tax income by £1000 from holding dividend paying stocks.
The dividend attracts tax of 32.5%, resulting in net income of £675. The simple fact the stock has paid a dividend results in an immediate loss of value to your overall wealth of £325.
If instead you sold a position with (we will be generous) a 100% capital gain, half of your investment is the initial stake and the other half the gain. Selling £1000 of it would attract an overall tax rate of 10% - zero tax on the initial investment and 20% on the capital gain element. You would receive £900 net and have a tax bill of £100, a difference of +£225 overall.
Higher capital gains allowances put dividends at even more of a tax disadvantage, which means many investors try and hold dividend payers in their ISA while looking to get capital growth outside the wrapper.
There is no magic bullet for beating the stock market in the long run. What has worked in the past may not work in the future, and thus for those who look for a more diversified investment approach, owning index funds and exchange traded funds (ETFs) will guarantee the broadest investment approach.
IG Smart Portfolios are designed to act as the core of an investment portfolio, while IG’s share dealing services can allow investors to tilt their portfolios to different parts of the market. Our list of Top 50 ETFs can also offer assistance in helping you navigate the increasingly busy ETF market – just recently the Index Industry Association calculated that there were 3.7 million investment indices being marketed in June 2018, greatly outnumbering the number of globally listed companies.