Project Nayuki


I dislike dividends

I invest in the stock market to grow my wealth to meet future financial goals. Along the way, I had to learn many terms and concepts about how financial products (securities) work, and make choices about which ideas to put into practice.

A couple of commonly held beliefs, especially among beginner investors, are that receiving a dividend is essentially “free money” and that dividend-paying stocks are better than non-dividend stocks.

I disagree with this popular preference for dividends. I mainly care about total return (dividends + capital gains), and see major downsides involving dividends. I will discuss this in terms of Canadian regulations, but many concepts apply to the USA and other countries. Note that I treat the term dividend to be synonymous with distribution, interest, and coupon; for example, I consider a bond coupon payout to be a dividend.

Disadvantages

Poor diversification

Dividend-paying stocks are a small portion of the entire stock market, whether in terms of the number of companies or market capitalization. Limiting yourself to or strongly preferring dividend stocks will decrease your portfolio’s diversification. Focusing on dividend stocks is not a compensated risk – in other words, you don’t get higher expected returns despite taking on more risk.

Annual taxation

Whenever a dividend is paid out in a non-registered (taxable) account, an income tax liability is generated in the year the payment was received. By contrast, capital gains are taxed at the time when you choose to sell the security. You might receive dividends in a high-income year and thus have a high marginal tax rate, whereas you can choose to wait until a low-income year to trigger capital gains.

Also, taxing an investment’s growth every year instead of just once at the end harms the power of compounding. For example, starting with $1000, growing by 8% each year but taxing 20% of the growth each year, after 40 years we end up with $11958. Whereas starting with $1000, growing by 8% each year for 40 years, and taxing 20% of the growth at the very end, we end up with $17580.

Unrecoverable foreign taxes

Dividends from foreign companies (whether held directly in one’s account, through a domestically based fund, or through a foreign fund) usually have taxes withheld by the source country, with an amount somewhere around 15%. In an RRSP, US dividends are untaxed as the only exception. In a non-registered account, most foreign taxes translate into tax credits for your Canadian personal income tax return. However, not all layers of taxes can be recovered – e.g. a Canadian person holding a US-based fund that holds a European company. All foreign taxes in a TFSA are unrecoverable.

(More info: Dimensional Fund Advisors: Foreign Withholding Taxes, Canadian Couch Potato: Foreign Withholding Tax Explained, Canadian Couch Potato: Foreign Withholding Tax: Which Fund Goes Where?)

Gross-up and credits

Eligible dividends from Canadian companies are handled in a confusing way for income tax purposes. When you receive $100 of eligible dividends, you need to report $138 in income because of a 38% gross-up. However, you also receive non-refundable tax credits along with those eligible dividends. A consequence of these rules is that you can receive up to about $40k of eligible dividends before needing to pay income taxes.

These rules exist to almost perfectly integrate corporate taxes with personal taxes. The idea is that a doctor earning $100k a year should pay essentially the same amount of tax whether he takes the income directly or he takes dividends through a one-man corporation. The idea is that the dividend is paid after the corporate tax is subtracted, so the personal credit represents the corporate tax paid, and the grossed-up amount represents the pre-tax income that the corporation received.

(More info: The Loonie Doctor: Investment Income & Taxation: Intelligent Design or Jurassic Park?)

Higher marginal rate

At high income levels, earning $1 through dividends incurs a higher marginal tax rate than earning $1 via capital gains. The complication is that for dividends coming from Canadian companies, the dividend tax credit makes it hard to compare the two scenarios without detailed information about one’s income and deductions. Also, the dividend gross-up can lead to surprising clawbacks in government welfare programs like Old Age Security (OAS).

Income categories

When you receive dividends in a non-registered account, you will receive a T3 or T5 slip after the end of the year, explaining the amounts you received. Dividends are not a monolithic number; instead they are partitioned into amounts like eligible Canadian dividends, foreign non-business income, return of capital, and a couple others. This is more work and more things to understand than capital gains.

Pay lag

Generally speaking, a dividend payout works like this:

  1. The company announces the schedule of one or more payouts, days to months in advance, at its discretion.

  2. There is a record date, which means you need to own the stock (settled) at the end of that day to be entitled to receive a particular dividend payout.

  3. There is a pay date a week or two later, which is when the cash arrives in your account.

In theory, the stock price drops by the dividend-per-share amount immediately after the record date. Ideally, you would be able to take the cash and reinvest it into the same stock or use it to buy other things. But because there is a noticeable delay between the record date and the pay date, you would either miss out on market opportunities or need to pay a bit of interest to borrow cash.

Stock price history

Most stock price charts don’t factor in the effect of dividends. For example, a company starting at $100 and growing in price by 5% per year would look better than another company starting at $100 and giving a 5% dividend per year.

With access to the necessary data and some effort in programming, it’s possible to correct for this and produce a total return price history. However, due to the lag between the dividend record date and pay date, there is ambiguity about which date to use when adjusting the dividend into the stock price.

Uninvested cash

A portfolio containing entirely non-dividend companies would see its cash balance never change. A portfolio containing dividend companies would see cash steadily build up over time. This uninvested cash is a drag on returns due to inflation and opportunity cost, so it should be periodically reinvested into something. Manual reinvestment takes time, effort, and possibly trading fees (such as $10 per trade regardless of the value/shares traded). One solution to this is a dividend reinvestment plan (DRIP).

Synthetic DRIP

At some brokerages, you can elect to immediately use dividends to buy more shares of the company it came from. As most brokerages only allow owning whole shares, a dividend payout would lead to some shares being bought and some leftover cash. Additionally, if you have DRIP enabled and you choose to sell all of a stock right after a dividend payout record date, a week later on the dividend pay date you may be surprised to receive more shares of that stock. You might need to pay a commission fee to sell those shares.

Short selling

When you short-sell a stock and hold the short position on a dividend record date, you have to pay back the dividend amount. This is made worse if you already used the cash from the short sale to buy something else, and/or the dividend is not in your preferred currency (e.g. you have lots of CAD but need to pay out in USD) – which means possibly paying foreign exchange fees (1~2% at some brokerages).

This probably impacts the use of dividend-paying stocks in Norbert’s gambit. You would go long on the stock in one account and short the same number of shares in another account. If there is a dividend record date near the time you perform the gambit, you might end up receiving a dividend in one account and paying a dividend in another account, and these would theoretically cancel out except for foreign exchange fees and maybe income taxes. So it is best to plan ahead and strictly avoid dividend dates when doing Norbert’s gambit.

Neutral

Survivorship bias

A company that has a history of paying out a steady dividend is usually a sign of success. All the companies today that pay a dividend are probably, on average, more successful than non-dividend companies in terms of their total return for the past years or decades. However, this does not mean that investing in today’s dividend companies will produce better outcomes for the future than otherwise – some companies will stop their dividends and some will start paying dividends.

Likewise, looking at the set of dividend companies that have never decreased their periodic payouts over the years (e.g. the S&P 500 Dividend Aristocrats), these companies have been successful in the past, but it’s no guarantee they will continue to grow or survive in the future.

Mental accounting

Dividends feel like free cash that you can go out and spend immediately. Meanwhile, selling shares of a stock whose price rose feels like losing the principal or capital. But for the most part, both actions are financially the same. Also worth considering:

  • A DRIP takes your dividend cash and immediately buys more shares, which means you are not obliged to receive cash in your hands.

  • Even though selling shares means that you will own a smaller fraction of the company, this can still happen in other ways. A company can issue new shares (dilution) at its discretion, especially if it needs to take a big investment round to try to grow the company. A company can even liquidate all your shares and hand you cash.

  • A company can choose to forego distributing a dividend and instead use the cash to buy back shares on the open market, thus raising the price of the other outstanding shares that weren’t bought back.

  • When a company issues a dividend, there is no guarantee that the stock price will hold steady. It is entirely possible for a company to keep issuing dividends until its price goes to zero.

  • Dividends can’t be taken away from you after the fact, but neither can the cash proceeds of selling shares. Conversely, a company can cancel future dividends anytime it wants, and its stock price could go to zero at any point in the future.

At the end of the day, a dollar is a dollar. You want to maximize the total dollar value of your stocks and cash, not the number of shares of a company or the percentage of a company owned. Although mental accounting doesn’t equate to losing money, the psychological bias can lead to poor choices that lose money (e.g. spending money instead of compounding).

Stability

Most companies strive to keep a steady dividend payout schedule over a period of years, say $0.03 per share per quarter. This produces a steady income for shareholders and inspires confidence in the company’s long-term prospects. However, this stability is fragile because the company has no legal obligation to pay any dividend at all. Indeed, during downturns of the company in question or the market as a whole, some companies quickly reduce or eliminate their dividends. This contrasts with bond payments, where a company is in serious trouble and at risk of bankruptcy if it misses a full payment.

Total return

I mainly care about the total return of a stock, not solely its dividend yield. As a first approximation, that means I care about dividends plus capital gains. The second approximation is to factor in the effect of various taxes – e.g. foreign withholding tax, Canadian dividend tax credit, capital gains tax rate.

Swap conversions

Horizons is a Canadian asset manager whose funds effectively convert dividends into capital gains. For example, HXT is an ETF that pays no dividends and whose price fluctuates according to both the prices and the dividends of the companies in the S&P/TSX 60 Index. If you hold one of these funds, you can get better compounding of your money over decades, and you can avoid paying dividend taxes during high-income years at the peak of your career.

Price decrease

If a company kept reinvesting in itself and not paying dividends, its stock price could grow to terrifying heights. Tech companies like Amazon and Tesla rose to thousands of dollars per share as a result. But the most famous example is Berkshire Hathaway’s original share class (BRK.A), which rose to hundreds of thousands of dollars per share. However, this problem can be solved with stock splits, so it’s not a strong motivation to start issuing dividends.

Advantages

Steady companies

Let’s suppose that we created a small company to buy a single house and collect rent. If the rent monies stayed within the company, the company’s value would rise. But we (the owner) might find this behavior nonsensical, because instead of collecting a rent dividend every month, we would only be able to capture the total value of the company when we sell the company years later.

Suppose a longtime profitable company just kept piling up cash without distributing it as dividends. The book value of the company would certainly grow, and the market cap probably would too. But cash has no nominal return, and even has a negative real return when considering inflation. Better uses of the cash would be to buy useful assets for the company, acquire other companies, or give the cash to shareholders so they can make their own choices. If dividends didn’t exist, it would remove one important outlet for a company’s cash.

Personal corporations

If you sell your labor services through a fully self-owned corporation, you need that corporation to pay out to you personally in some way, and a dividend is the most straightforward way to do so.

More info