Wednesday, October 24, 2012

Dividends versus Homemade Dividends

Some investors question whether dividends offer any real value to investors. One of their main arguments against dividends is that on the ex-dividend date, the stock price decreases exactly by the amount of the dividend.

The argument goes on further to mention that it should not matter to investors whether they buy a stock yielding 4%, or sell 4% of their portfolio. I am using four percent after the famous four percent rule for retirement. Using both scenarios, the investor will have the same amount of cash. Selling off a portion of one’s portfolio in order to generate cash is regarded as “homemade dividend”. There are several issues with this flawed reasoning.

First, when someone sells a portion of their portfolio, they end up with less shares. If the stock price stays flat, the investor is essentially depleting their asset base. The only way that this strategy would work without depleting your nest egg will be if the share price keeps increasing. Sometimes share prices fall or stay flat for extended periods of time, which could spell trouble for these investors. For example, retirees who relied on the traditional 4% withdrawal rule since 2000 and invested in S&P 500 index funds would have less than 7 years worth of expenses covered. If you are a male, and retired at the age of 62 in 2000, you have approximately 12 more years to live according to the Social Security Administration Longevity Calculator. To summarize, selling a portion of your portfolio to generate cash for living expenses is the same type of advice that people followed when refinancing their homes in order to obtain more cash from their home equity. On the other hand, investors who receive a dividend have cash in hand and the same number of shares. The only difference is that the company has less cash on hand, while the present value of the earnings stream is the same in both situations.

Second, just because a stock  price supposedly decreases by the amount of the dividend on the ex-dividend date, doesn’t mean that dividends and homemade dividends are the same thing. Dividends come from earnings that the company paying them has generated. As a result, the dividend is directly connected to the company’s fundamentals. The stock price on the other hand is something completely separate from the underlying business in the short run. In the long run, a stock price is determined by profitability and expectations of profitability. A company which sells for $10/share, but distributed a $10 special cash dividend will not trade at $0 if it is still in business and earning money.

If we make an analogy with bonds, one would note that the prices for both bonds and dividend stocks are decreased by the distribution amount on the ex-dividend date. With bonds however, interest is accrued daily and when you sell the security before the distribution date, you still get a prorated portion of the distribution. For example, let us assume that an investor purchases a 6% bond that pays every 6 months. The bond investor would then receive $30 on a $1000 bond on June 30 and $30 on December 31. By Mar 31, the bond has accumulated an accrued interest amount of 1.50%. If the investor manages to sell the bond at some random price, say 100%, the investor would actually receive the proceeds from the price and the accumulated interest for a total gain of 1.50%. It is interesting to note that dividend haters always focus on the ex-dividend date when discussing their opinions that dividends and homemade dividends are the same thing. In fact, dividend stocks probably also accrue the dividend amount over time. As a result, investors do not really “lose” anything when ex-dividend date comes. In fact, this is mostly a cosmetic change, since stock prices are not directly tied to fundamentals but to other factors. Because stock prices fluctuate all the time, what truly affects stock prices is earnings, economic expectations, inflation interest rates, investor sentiment, the fact that stock prices are trading “ex-dividend” doesn’t really show on stock prices, unless a large special dividend is being paid out. As a result, stock dividends are already “calculated” by the marketplace and added to the stock’s valuation.

For my retirement plan, I am exclusively relying on dividend growth stocks. I might receive Social Security one day, and I do have a 401(k) plan which I have enrolled simply for my employer match. I invest any funds I save and any dividends I receive into more income securities. I recently purchased the following stocks over the past month:

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. The company has managed to boost distributions for 25 years in a row. Over the past decade, Chevron has raised dividends by 8.80%/year on average. Yield: 3.20% (analysis)

Aflac Incorporated (AFL), through its subsidiary, American Family Life Assurance Company of Columbus, provides supplemental health and life insurance. The company has managed to boost distributions for 29 years in a row. Over the past decade, Aflac has raised dividends by 20.40%/year on average. Yield: 2.70% (analysis)

Unilever PLC (UL) operates as a fast-moving consumer goods company in Asia, Africa, Europe, and the Americas. The company has managed to boost distributions for 12 years in a row. Over the past decade, Unilever has raised dividends by 9.90%/year on average. Yield: 3.20% (analysis)

Air Products and Chemicals, Inc. (APD) provides atmospheric gases, process and specialty gases, performance materials, equipment, and services worldwide. The company has managed to boost distributions for 30 years in a row. Over the past decade, Air Products and Chemicals has raised dividends by 11.10%/year on average. Yield: 3.10% (analysis)

Abbott Laboratories (ABT) engages in the discovery, development, manufacture, and sale of health care products worldwide. The company has managed to boost distributions for 40 years in a row. Over the past decade, Abbott Laboratories has raised dividends by 8.70%/year on average. Yield: 3.20% (analysis)

Update: Dave Van Knapp wrote an excellent article on Why Selling A Few Shares Is Not The Same As Getting A Dividend

Check the comments on Seeking Alpha for this article as well: Dividends Versus Homemade Dividends

Full Disclosure: Long CVX, AFL, UL, APD, ABT

Relevant Articles:

Why I am a dividend growth investor?
Why should companies pay out dividends?
How to avoid being a dividend loser
How to be a Dividend Winner

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