On Dividend Paying Stocks

On Twitter, there is a raging debate on whether you should buy stocks for their dividends. On one side are those who argue that buying dividend paying stocks is the best way to ensure a cash flow without having to liquidate investments to generate a regular income and on the other side we have those who argue that is simply makes no sense to buy dividend paying stocks especially considering the low yields most of them provide one with. It’s akin to buying real estate for the rental income vs buying real estate for the growth opportunity if offered. So, what is true and what is not?

To better understand the truth, let’s start at the beginning of why dividends were paid to shareholders in the first place. Going back in history, you will notice that the first companies were not of the kind that exists today but were joint stock companies formed for pooling of risk capital for a certain venture. Because the ventures of those days meant a binary result – the venture either succeeded beyond imagination or failed miserably, the pooling of resources reduced risk for all players and when the rewards came – everyone wanted a cut and this cut is what today we shall call as Dividends.

Paying out large dividends in the past meant the stock was seen as a great investment – In the early years of Dutch East India Company’s existence, the company paid out as much as 75% of its income as dividends. By doing this, the company was able to make a case for higher stock prices and which in turn enabled it to draw upon higher risk capital. 

Today, companies pay out dividends for a host of reasons but more than the share price, its paid to shareholders to retain their loyalty towards the stock. In the United States for example, historically the small shareholder bought companies that provided them with a regular income in form of the dividend and this meant that companies that paid out a steady stream of dividends.

In fact such stocks even have a moniker – Widow-and-orphan stocks. These stocks are seen as stocks that often pay a high dividend and are generally considered low risk. The dividend paying attribute is not limited to stocks either – even today we have Equity funds that pay out dividends.

Dividends are not free money the company is distributing to its shareholders. Rather, it distributes a part of the income it has earned in the previous year after keeping aside what it believes is required for either future investments or just hoard it for a rainy day.

When a company pays out a hefty part of its income as dividend, what it suggests is that it has no avenues to invest and feels better off paying back a large part of the said income back to its shareholders. One high dividend distribution company (and not making waves on Twitter) is Castrol. It has paid on an average 80% of its net income in the last 12 years. The stock CAGR over the last 10 years (12 years currently would fall right at the bottom of the 2008 crash) is a piddly 0.50%. I am not saying that this could have been better if the company had used the money instead to grow, but am saying that a high dividend payout ratio has a cost.

Coal India, another great company with a high dividend payout (to please its principal shareholder – Government of India) has seen its shareholders lose a cumulative 11.25% per year for the last 9 years.

Not all companies are believers in paying dividends even when they have substantial cash profits / reserves either. The biggest name in the Industry – Warren Buffett loves getting paid dividends by the companies he owns but hates paying out dividends for the shareholders of Berkshire Hathaway. In his 2012 letter he laid out his rationale for not paying dividends and instead says that shareholders who want such income are better off by having a sell-off policy. I would urge you to go through it  (Link) 

This year, has seen a spate of companies announcing mega-dividends. The rationale for the same is the fact that the government has changed its policy when it comes to how dividends are taxed. Until 1997, dividends were taxed at the hands of the shareholder. But those were the days of physical shares and very few tax payers I would assume would maintain let alone pay a tax on the dividends received. To eliminate this, the government of that time shifted the burden of paying taxes on the dividend paid out to the company. Thus came out about the Dividend Distribution Tax.  In 2020, this has been reversed with dividends once again being taxed at the hands of the Individual taxpayer.

This change has meant that a shareholder who falls into the higher tax bracket is better off selling a part of the share equivalent to the dividend he would receive for he pays a lower tax vs getting paid the same by the company. But the change is also a bonanza for multinational companies who can now payout a higher dividend for the parent may own shares in a lower tax rate country and hence end up paying a much lower tax on its income than what would have been deducted via the dividend distribution tax.

Given the immense opportunities in the market, I feel that investors would be short changing themselves if they went after dividends rather than growth. If you want a regular income, you are any day better of with products like Post Office Monthly Scheme than buy stocks based on their past dividend activity for the risk is that you may end up with a gain on dividends (that are then taxed) while losing not just opportunity but taking a cut in the capital itself. 

Want to read more. Do check out – 

The Evolution of Dividend Policy in the Corporation and in Academic Theory.