What's the Deal With Dividends?
Plus Elon Musk becomes the President? (For Now)
I shudder at the idea of talking about anything related to finance sitting around the table for Thanksgiving dinner, but if I had to talk about something with my family, I’d bring up one of the areas in personal finance that irks me the most: the obsession with dividend investing.
Dividend investing is all over social media. I meet with people in their 30’s who only want high dividend paying stocks. I meet with people in their 70’s who only want high dividend paying stocks. THE PEOPLE WANT THEM AND THEY ARE LOUD AND PASSIONATE ABOUT IT.
But…why?
What are dividends, exactly? They are one of five options CEO’s have at their disposal to use their companies’ extra cash: Reinvest in the business, acquire other businesses, pay down company debt, buy back company shares, and/or distribute cash back to shareholders, aka pay a cash dividend.
Some people claim that dividends are “income” and “free money”. The income claim is certainly true. For “ordinary dividends”, as you will be taxed at your ordinary income rate. If you meet certain requirements, your dividends might be “qualified dividends” and taxed at your capital gains rate (assuming you are holding the investments in a taxable account).
People need income to live. We get it. Despite dividends clearly being income, they are slightly different than receiving income as you would from a W-2 job and they most certainly not “free money” in any sense.
When a company pays a dividend, the share price is reduced by the amount of that dividend.
If you are valuing a company today and they return a bunch of money to shareholders tomorrow, the company will be worth less tomorrow than it is today. If your stock price is $100 per share and they issue a $2 dividend, you now have $2 cash in your pocket and a stock worth $98.
Maybe people get this concept confused with interest from bank accounts and bonds, where you do receive interest payments that do not lower your principal value.
I read a fascinating book last week titled, “Shareholder Yield: A Better Approach to Dividend Investing” by Meb Faber1. It was a short, to-the-point read about the “culture” of dividend investing and why dividends are only part of the investment puzzle, not the WHOLE puzzle as many investors make them.
Faber makes the argument that investors can outperform if they focus on how CEO’s make use of all five of their options to deploy capital (he really focuses on just three: stock buybacks, debt pay-down, and dividend policy).
In the book, Faber describes an environment that incentivizes stock buybacks as a better deal for companies AND for shareholders than dividends. Stock buybacks essentially allow companies to buy company shares on the open market and cancel/retire them, reducing the amount of shares in the company and thereby increasing each shareholders stake. It’s a way to increase shareholder value without forcing shareholders to pay income taxes, like a dividend does2.
Share buybacks are also more flexible than dividends. Investors look for companies that have a policy of consistently paying dividends. Investors want stability. Or even better, growing dividends. What happens to dividend-paying companies when the economy turns and their free cash flow dries up? Do they keep paying dividends? Do they lower the payment or suspend the payment? Do they take out debt just to continue paying the dividends? Two cases of continuing to issue dividends despite financial trouble are Chesapeake Energy (taking out too much debt to finance dividends) and General Motors (weakened financial strength, not enough cash flow). Both companies filed for bankruptcy. Investors tend to flee when dividends are cut drastically.
Investors don’t yet punish companies in a similar way for not buying back shares on a consistent basis. CEOs have a lot more flexibility with the timing and quantity of buybacks. Faber argues that top CEOs understand this and are masters at deciding between the five choices they have to deploy capital.
The best thing about dividends for most of their proponents (whether they know it or not) is purely psychological. If they need $20k income from a portfolio to live off of in retirement, it is convenient and nice to know that they could have a $1 million dollar portfolio in a taxable account that has a 3% dividend yield and they’ll get $30k in dividend income (more than $20k because you gotta factor paying taxes!).
There are other, potentially more tax-efficient ways for someone to get the $20k in income, such as selling appreciated shares. But that tends to be more difficult for people to do, even if using a total return approach vs. income/yield approach to portfolio management might lead to better long-term outcomes!3 There is something magical about receiving the cash in your account without having to “sell” any shares. It’s probably why proponents of dividend investing argue about it with such a religious fervor.
On second thought, I’d rather enjoy family time and some turkey, mashed potatoes and stuffing and leave the dividend talk for another day.
My question from the previous Mound Visits about Elon Musk was answered quickly so I thought I would follow up on it.
Elon Musk will be the (Co) Head of the Department of Governmental Efficiency (DOGE). But no, it will not be an actual government agency. Musk will not face the ethical dilemma of selling his personal assets to reduce conflicts of interest (so he won’t be getting a massive tax break).
I made the joke that Musk bought the Presidency, and based on his activity since the election, that joke is very much not a joke. Musk has been Trump’s best buddy, hanging out with him at Mar-a-Lago and being involved in meetings and phone calls.
In news that should surprise no one:
“The sources said Musk’s near-constant presence at Mar-a-Lago in the week since Election Day had begun to wear on people who’ve been in Trump’s inner circle longer than he has and who see him as overstepping his role in the transition. The sources spoke on condition of anonymity because they’re not authorized to speak publicly.
“He’s behaving as if he’s a co-president and making sure everyone knows it,” one of the people said.
“And he’s sure taking lots of credit for the president’s victory. Bragging about America PAC and X to anyone who will listen. He’s trying to make President Trump feel indebted to him. And the president is indebted to no one,” this person added.
Musk didn’t immediately respond to a request for comment Tuesday.”
Musk and Trump were also joined-at-the-hip at Madison Square Garden on a Saturday night to watch UFC. And the next Monday, Tesla stock was up big after Trump’s team announced they are planning a framework to ease regulations on self-driving cars.
This is all hilarious to me and I’m sure it will end well.
If you want your personal finance questions answered in a future Mound Visits, comment below or send me an email at nick@nineinningfinance.com with your question/scenario.
Also please share this post with anyone you think might find it helpful.
Nothing in this email is intended to serve as financial advice. I don’t know your personal circumstances and would never provide financial advice through this medium. This newsletter is intended to be educational and entertaining. Please consult a financial professional and do your own research before making any changes to your portfolio.
Full transparency: Faber wrote this book because his company, Cambria Investments, has several investment funds that utilize this shareholder yield strategy. It is a marketing book, but he makes a compelling case.
There’s a reason Warren Buffett doesn’t allow Berkshire Hathaway to issue dividends. He’s also a big proponent of share buybacks, used appropriately.
Sound like a great topic for a future post!