The Mystery of Dividend Preference

"But, if you plan to spend down retirement savings with a strategy based on preferring a dollar of dividends to a dollar of capital gains, you are betting against economic theory, portfolio theory, historical evidence, tax law, behavioral finance and the wisdom of Warren Buffett."

The Retirement Café: The Mystery Of Dividend Preference And The 'Spend Dividends Only' Strategy

 

I was looking at the Bogleheads thread on this issue this afternoon.

I found this response interesting -

The "dividend preference anomaly" - Bogleheads.org

 

The reference in the first link to Buffett on Dividends originates from the 2012 letter to shareholder and is as follows;


"And that brings us to dividends. Here we have to make a few assumptions and use some math. The numbers will require careful reading, but they are essential to understanding the case for and against dividends. So bear with me.

We’ll start by assuming that you and I are the equal owners of a business with $2 million of net worth. The business earns 12% on tangible net worth – $240,000 – and can reasonably expect to earn the same 12% on reinvested earnings. Furthermore, there are outsiders who always wish to buy into our business at 125% of net worth. Therefore, the value of what we each own is now $1.25 million.

You would like to have the two of us shareholders receive one-third of our company’s annual earnings and have two-thirds be reinvested. That plan, you feel, will nicely balance your needs for both current income and capital growth. So you suggest that we pay out $80,000 of current earnings and retain $160,000 to increase the future earnings of the business. In the first year, your dividend would be $40,000, and as earnings grew and the onethird payout was maintained, so too would your dividend. In total, dividends and stock value would increase 8% each year (12% earned on net worth less 4% of net worth paid out).

After ten years our company would have a net worth of $4,317,850 (the original $2 million compounded at 8%) and your dividend in the upcoming year would be $86,357. Each of us would have shares worth $2,698,656 (125% of our half of the company’s net worth). And we would live happily ever after – with dividends and the value of our stock continuing to grow at 8% annually.

There is an alternative approach, however, that would leave us even happier. Under this scenario, we would leave all earnings in the company and each sell 3.2% of our shares annually. Since the shares would be sold at 125% of book value, this approach would produce the same $40,000 of cash initially, a sum that would grow annually. Call this option the “sell-off” approach.

Under this “sell-off” scenario, the net worth of our company increases to $6,211,696 after ten years ($2 million compounded at 12%). Because we would be selling shares each year, our percentage ownership would have declined, and, after ten years, we would each own 36.12% of the business. Even so, your share of the net worth of the company at that time would be $2,243,540. And, remember, every dollar of net worth attributable to each of us can be sold for $1.25. Therefore, the market value of your remaining shares would be $2,804,425, about 4% greater than the value of your shares if we had followed the dividend approach.

Moreover, your annual cash receipts from the sell-off policy would now be running 4% more than you would have received under the dividend scenario. Voila! – you would have both more cash to spend annually and more capital value.

This calculation, of course, assumes that our hypothetical company can earn an average of 12% annually on net worth and that its shareholders can sell their shares for an average of 125% of book value. To that point, the S&P 500 earns considerably more than 12% on net worth and sells at a price far above 125% of that net worth. Both assumptions also seem reasonable for Berkshire, though certainly not assured.

Moreover, on the plus side, there also is a possibility that the assumptions will be exceeded. If they are, the argument for the sell-off policy becomes even stronger. Over Berkshire’s history – admittedly one that won’t come close to being repeated – the sell-off policy would have produced results for shareholders dramatically superior to the dividend policy.

Aside from the favorable math, there are two further – and important – arguments for a sell-off policy. First, dividends impose a specific cash-out policy upon all shareholders. If, say, 40% of earnings is the policy, those who wish 30% or 50% will be thwarted. Our 600,000 shareholders cover the waterfront in their desires for cash. It is safe to say, however, that a great many of them – perhaps even most of them – are in a net-savings mode and logically should prefer no payment at all.

The sell-off alternative, on the other hand, lets each shareholder make his own choice between cash receipts and capital build-up. One shareholder can elect to cash out, say, 60% of annual earnings while other shareholders elect 20% or nothing at all. Of course, a shareholder in our dividend-paying scenario could turn around and use his dividends to purchase more shares. But he would take a beating in doing so: He would both incur taxes and also pay a 25% premium to get his dividend reinvested. (Keep remembering, open-market purchases of the stock take place at 125% of book value.)

The second disadvantage of the dividend approach is of equal importance: The tax consequences for all taxpaying shareholders are inferior – usually far inferior – to those under the sell-off program. Under the dividend program, all of the cash received by shareholders each year is taxed whereas the sell-off program results in tax on only the gain portion of the cash receipts."

http://www.berkshirehathaway.com/letters/2012ltr.pdf

 

I’d also add:
1. laziness
2. knowing that whether I’m ill / incapable of making selling decisions the money keeps flowing into the account. This happened to me at one stage.
3. if I’m not around the wife need never worry about where the money is coming from. It just magically keeps appearing in the account.
4. peace of mind ...

I find it interesting why others have so much difficulty understanding why dividend focused investors are unconcerned that they may not be maximising performance. If we all thought that way then every investor would be 100% S&P 500 / global equities. Or perhaps lets dial down the risk and take Buffet’s advice of 90% S&P 500 index fund and 10% short term bonds. Gotta be right, it came from Warren.

Then again it’s not uncommon for some retirees to be totally invested in Term Deposits. My parents despite not being wealthy were and still had sufficient funds up until they died. Maximum performance was the furthest thing from their mind. It was peace of mind.

According to the following from the above link to Retirement Cafe site It would appear that a number of us here who have been following the “spend the dividends only approach” for decades have been successful purely due to luck:

It would be interesting to hear the views of others here living off share income such as @SatayKing and @troung and if they feel it was all due to luck.

Funny in that Bogleheads worship recently deceased Jack Bogle who has done more for the average investor than Buffet ever will. Bogle must also be one of these lucky investors with totally screwed up investing mentality about shares for their income. Here’s some quotes from Bogle:

Legends Of Indexing: John Bogle | ETF.com

Here’s to good luck.

 

On top of that, I just don’t get the beef with it.

Even using index funds and accepting dividend flows as income appears to be derided. Just the word dividend seems to bring the pitchforks out for some lol.

They really don’t think much of dividend investors do they? Apparently we think it’s free guaranteed money.

It’s simply cash coming from the earnings of the underlying companies/assets. Bit like rent from real estate. What’s the big deal?

It’s generally accepted that dividends are more reliable than capital gains. So is that not an attractive feature? If it is then it’s rational for that to be preferable as an income source for some people in retirement.

I don’t get the Buffett argument either. You won’t be cashing out your shares at the precise growing book value. Big assumption.

Also the tax argument is US focused and nonsense for living on dividends in Australia. Dividends are hardly penalised. Almost $200k per couple of dividends can be earned before out of pocket tax is payable.

 

I actually think “living off capital” mentality is the new kid on the block and perhaps due to financial repression post GFC. That is given the low yields on offer it all seems too hard to accumulate enough capital to live off the natural yield of the portfolio.

Traditionally passive income was all about replacing your employment income with income from investments. That is, rent from property, dividends from shares, interest from cash / bonds. The thought of selling assets was never considered unless one had no choice.

This is what I think Bogle was emphasising that in times gone by one invested in assets for their income. Over time this thinking has changed where nowadays the greater fool theory of chasing capital gains is more the norm. Investors seem to have lost sight of the true meaning of passive income. As per Bogle’s previous quote:

 

There is nothing new about "living of capital" I consider it living off a Buisiness , nothing new. It is just a concept of people who think you need to" work for the man to earn a living" What you don't understand is that a dividend is capital. It is just a transfer of capital. Living of dividends is living off capital or a business. Reinvesting earnings and increasing revenue increases capital You can take those reinvested earnings from your account any time you want by making a withdrawal. No different than taking capital in the form of interest from a bank account . It is not hard to accumulate enough capital to live off if you are prepared to open your mind I did that between the ages of 15 and 30 starting with 1k Admittedly I was only living on $100 a week in the Philippines. I recall we had this conversation a few years ago and I gave you about 10 companies to illustrate the folly of dividend investing a lot of them have gone up 500-700% That portfolio has increased 75% since July 17 when I last done the tax it was up about 40% the year before that.

 

I understand the intellectual basis for this assertion, but the capital vs income distinction is fundamental under our common law , equity (which governs the law of trusts) and our taxation system.

 

I think it’s also important to keep in mind the different characteristics of the US stock market -

Dividends Don’t Matter As Much As They Used To

I have no data to back it up, but I’d expect the psychology of dividend investing to be more prevalent amongst Australian investors, simply because dividends make up such a big chunk of the returns, and also have the benefits of imputation credits.

 

Big subject. I don’t have the mental bandwidth to deal with this at the moment! Answer is in part tax environment which shapes company capital allocation decisions, individual tax situations and significant behavioral aspects. This is also historical going back to pre index fund times. I think I would deadset need a day to map all this out.

Instead I’ll rely on the something simple ; total return is the name of the game. Dividends are an important component of total return. Dividend focused investing is just a packaging issue. If you want to favor yield over total return, then at least understand what you are doing - your reasons (behavioral) may be very valid . It’s your money. Whatever helps stay the course I reckon.

 

I have a few problems with the "no dividend, growth is king" mantra. Admittedly, I'm no expert and I'm probably being irrational but here goes....

1: From the Buffet article...."This calculation, of course, assumes that our hypothetical company can earn an average of 12% annually on net worth and that its shareholders can sell their shares for an average of 125% of book value. To that point, the S&P 500 earns considerably more than 12% on net worth and sells at a price far above 125% of that net worth. Both assumptions also seem reasonable for Berkshire, though certainly not assured."

I'd argue that they may seem reasonable when times are good but certainly not assured. When times are bad those assumptions are far from reasonable. So really what it comes down to is if you are lucky enough to be accumulating and then de-accumulating during favourable cycles you will get lucky and win. If you are unfortunate to be doing the opposite you are **** out of luck.

2: The mantra is based on the idea that the company can always generate a better return on reinvested profits than the individual can. History has shown this to be false in many cases.

3: From what I understand the comment from the linked article...."When $10,000 of stock pays out $300 in dividends, the value of the remaining stock immediately drops to $9,700 at payout." is wrong quite often. Market participants, whether dividend or growth focused, are equally irrational most of the time. It is not uncommon for a share price to barely move or drop significantly less than the dividend payment amount.

4: Lastly, I can only sell a stock once. I can receive dividends for as long as the company exists. As mentioned above, if I'm unlucky enough to be hit with a poor SOR scenario I'm **** out of luck if I'm forced to sell all or most of my shares during a bear market.

 

That's me on any given day

Its interesting to read some of the Bogleheads threads and then also articles like the below which give a slightly different point of view than most on that forum, also bearing in mind both are US centric and we're living in Aus, with a whole different set of rules of the game when it comes to tax etc

John Bogle Likes Dividends

"Bogle: You're right, and that's why I'm on this pretty much one-man, I think, crusade to have people, particularly retired people, look not at the value of their portfolio, but at the income stream they get. They're going to go out to the mailbox and they're going to open, let's say, the middle of every month when the fund or group of funds pays their dividends. They're going to get a certain dividend. Dividends are what matter to these people. The stream of income is what matters, and dividends [tend to increase] in history. There have only been a couple of serious drops in the dividends in the Standard & Poor's 500.

Benz: 2008 was one.

Bogle: 2008 was one, and you could argue it's going to happen again and again. But that was when basically the financial system eliminated its dividends, and we're back at the higher level right now. You took like a probably 20% drop in you income--I think, is about the right number--and we're back above that level now.

Look at the dividend and try to ignore the market. As I've often said--nothing like quoting oneself, Christine--the stock market is a giant distraction to the business of indexing, and in particular for the business of retirement investor. It’s the income flow from Social Security, pensions, whatever it might be, and dividend income, and that's what’s important. It's amazing how this dividend line [tends to increase over time] and the market [goes up and down over time], but they track each other in the long run."

Some of his quotes are listed below:

" what is truly remarkable is that the record of dividend payments by US corporations heavily favors rising dividends over declining dividends, almost irrespective of prevailing business conditions. "

"Between 1926-1992, annual dividends increased in 57 years, declined moderately (less than 10%) in 4, and declined by more than 10% in another 5."

“Dividends nicely exceeded inflation at a rate of 1.4%/year.”

"Even when a company does not pay a dividend, investors implicitly value the firms stock based on the presumption of future dividends"

Another Bogle quote on dividends:

“If you really need the dividend income, I see nothing wrong with over-weighting high-dividend stocks, knowing you’re taking a small risk of falling significantly behind the total market.

But you can own blue chip stocks, and you’re going to get a higher dividend, a situation I think would be attractive to an awful lot of investors. But once you depart from the market portfolio, you’re taking on extra risk.”

 

great stuff

Once difference in Australia is that interest on loans used to purchase shares will not be deductible unless the shares are expected to pay a dividend.

 

Berkshire Hathaway: And where do you think the company gets some of it's revenues from? Insurance premiums, leases, sales for services, revenues from railways, dividends. They are not kindly, elderly gentleman who don't understand the concept of revenue streams, including dividends, yet give none of that to shareholders. Hope any odd dude who has one Berkshire Hathaway share has another source of income. They may view themselves as "wealthy" but will die of dehydration as they cannot afford to buy water.

And Mr W via BH is no certainly stranger to dividends. Buy $5B of Goldman Sach preference at a price we peons couldn't get in a fit, have Goldman Sach buy them back at $5.6B two years later and also collect over $1B in dividends at a 10% yield. Doesn't know about the value of dividends? Give me a break.

As for my situation. Put it down to what has been termed a strong financial discipline which I still have to a large extent. A wife of the same mind set. An ability to live off less than one income with the rest invested. An general indifference to having the latest thing - only ever owned five cars and all them bought used with current being a 2011 model. Modest three-bedroom home for years. Did it's job of keeping the rain off our heads. A fear of debt knowing what can happen when it goes against you. Using what I now view as extremely generous tax concessions for plonking money in superannuation which I have previously discussed.

And finally knowing myself and my competence level. Admitting I do not have any skills in selecting any particular share or shares with a view to reaping capital gains. Some may view that as a defeatist attitude but I see it as pragmatic.

And where has it placed me. Only once have I indicated where I sit and I shan't do that again. Suffice to say I am above the third quintile in terms of income.

Can everybody do it? Yes although I believe it's harder now given the changes in the past and probably those in the near future.

Will everybody achieve it? Nup.

I look at those in their 50's working in supermarkets and other places. Doing it for pin money or to make ends meet? Highly likely the latter.

Wizened person behind food counters. Yeah sure their doing it because they have reached FIRE!

And the courier driver does it because they love driving around all day delivering your packages. Living the dream.

It's one of those days, folks

 

You can also use your dividends to grow your capital by utilising the reinvestment option if you choose to do so.
Marg

 

But you will be taxed each year, making less capital to compound.

 

I don’t have the stats to prove it but it seems to be younger investors who are most supportive of the total return approach vs aging retirees.

Take younger investors it’s hard for them to know how an older retiree would feel when earning employment income. Even if one partner is retired the other partner is still earning an income, that removes a lot of stress. The retired partner also has the comfort of knowing if need be they still have plentiful human capital left to return to the workforce. Even if both are retired young there is double the human capital remaining to return to work if needed.

Now take aging retirees. No remaining human capital, a finite amount of assets, not knowing how long their capital needs to last, increased fear of risk / change. These feeling are real regardless of how much they might know about investing. It’s why so many retirees value “income” so highly.

Of course there will be the usual outcry of but but dividends are NOT free money. No they aren’t but at least they’re in the “investors” hands. For every Buffet / Berkshire Hathaway there are countless company CEOs / Boards that chose to retain most of the company profits only to then destroy shareholder capital through poor acquisitions and misuse of capital. A great company one day can the **** the next. Take Woolworths Masters disaster.

Which is why I, even when younger, have generally paid greater attention to successful older investors as they understand and know these emotions / issues which I knew I would be faced with as I aged. I’ve learnt tremendous technical knowledge from younger investors but retirement can be a very different ballgame. That’s why I so value the wisdom / philosophy of successful older investors and life experience that comes with it.

Hence why I think Bogle’s quotes in previous posts are so powerful as they are particularly directed at RETIREES by a retiree.

It’s also why stupid politicians and others can’t understand why retirees are so fearful of spending their retirement “capital”. It’s not all about leaving an inheretence. It’s more about knowing / hoping you don’t die in poverty. These aging retirees throughout their lives have seen how one’s wealth can near disappear overnight given their timeframe (it’ll be ok in the long term is of little comfort) if taking on too much risk or spending capital too early on.

Anyhow a few thoughts.

 

He he. Mostly companies are run by humans who, although ruthless, have the same foibles as others. Give them a wad of money in the kitty and hubris can take over.

BHP didn't just shovel cash into Magna Copper. It backed up a Double B semi and bulldozed the funds in. Did the same with the hot briquette fiasco. As for Wesfarmers and it's attempt to replicate Bunnings in the UK.

Give the money to me if you don't mind

 

That was one of those great events that came out of the GFC. Gotta love Warren Buffet, he comes across as this loveable old chap spruiking value investing in consumer staples like Coke and Gillete, then along comes the GFC, he's sitting on a pile of cash while everyone else is jumping out of the windows and he just royally bends over one of the most ruthless investment banks out there. Compete legend.

 

The Oracle of Omaha hates paying a dividend but loves collecting one