Dividend Investing
We now interrupt your regularly scheduled innovation investing to bring you some "other thoughts" on other ways to think about investing.

Yesterday, someone asked in my general direction: "What dividend stocks do you recommend?"

And, well, I have thoughts.

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My personal take is that dividends are irrelevant. Thats a tad savage, but let me explain:

When I say that dividends are irrelevant, I don’t mean that they are not an important component of total returns. They are. What I mean is that dividends are not relevant in determining which stocks may have good future returns.

We have to talk about what dividends are to unpack that a little more:

A dividend of $1 is the same thing as $1 received by selling some shares of a company. This is because the distribution of a dividend results in a reduction in share value.

The important point is that a company’s value falls by the amount of the dividend when they pay it out. This is true whether the stock is up or down.

Dividends do not explain future returns, and limiting your opportunity-set to the companies that pay dividends arbitrarily cuts your investable universe in half because roughly half of global stocks do not pay dividends.

Also, you are in control of paying taxes on the gains. When you take a dividend, you have to pay taxes on it (if you don’t reinvest it). And if you always reinvest it… why do you care that there is a dividend in the first place?

Dividend growing companies do tend to be large cap value stocks with robust profitability that invest conservatively, so that can possibly be a reason for outperformance as a group if there is any… but its important to understand that the performance is coming from those factors and not the dividend itself.

There is no reason to believe that dividends, or the growth of dividends, is an indication of a good stock to own. If that is your strategy, its probably a better use of your time to look at other approaches to analyze good companies that will actually affect the stock performance.
Nate Pabrai's avatar
I see dividends as a signal that a company is generating more free cash flow than it can effectively reinvest. Basically they're saying that if we reinvest that cash the return on equity (ROE) rate would be smaller, so they are offloading the cash to increase the ROE by decreasing the divisor.
Nathan Worden's avatar
@nate Yep, thats a good way to look at it. Dividends aren't bad- like you point out they may be the most responsible use of the cash.

But I'm curious, would you agree or disagree that picking companies solely off of their dividend policy is a bad idea?
Nate Pabrai's avatar
Filtering based on dividends selects for companies that are more in a maintenance mode as opposed to growing. Depending on valuations that can be good or bad. For example if you believe that we are at the end of a market cycle and growth stocks are at too much of a premium then a dividend filter might help you find companies that haven’t had their prices bid to as high levels. A slow growth dividend stock may be a great buy at the right price and a high growth company can be a bad buy at a price too high!
Nathan Worden's avatar
@nate I like the way you put that, thanks for your insight!
Does this mean that if a company's dividend yield is 30%, then the stock value drops 30% after a dividend distribution?
Nathan Worden's avatar
@bdakter theoretically yes; Share prices often drop by the amount the dividends are paid. When the company pays out the dividend, the value of the company is reduced by the amount of the total payout.

However, the market decides the price of shares, not the dividend, so you will not reliably see this happen every time.
Got it! Can you please explain (or point me to a resource that explains) what this means: "the market decides the price of shares, not the dividend" ?
Nathan Worden's avatar
Yes- so any time you have an asset, the value of that asset is just what someone else is willing to pay for it. Saying "the market" refers to all the potential buyers and sellers out there who are willing to transact at a certain price. What those market participants decide that price should be is the price.

They may be looking at fundamental analysis of the company, they may be looking at the dividend, they may be doing a discounted cash flow, they may be speculating that favorable regulation may occur, they may believe in management- the point is, there are a lot of subjective as well as objective ways to value a company, and all those data points are being reflected in the willingness of a buyer to buy and a seller to sell.

"The market decides the price of shares, not the dividend" means that just because theoretically the price of a company should drop because the company paid out a dividend, does not mean that it will. There are many other factors that could matter more to someone, and they may make their buying decision prioritizing that over dividends.
I get it! It's just one factor of many, and there's not a linear, causal relationship between the two.
According to this explanation, this plan of mine won't work: Buy a bunch of stock (eg 100 shares at $5 a share, with a dividend amount of $0.50) right before the Ex-dividend date, then sell them all right after the record date for $500 (or more) and collect $50 in dividends?
Nathan Worden's avatar
Right, what would likely happen is that because the dividend schedule and amount is public knowledge, the market would "price in" the knowledge of the ex-dividend date. So someone probably won't buy the shares from you at the higher price after the ex-divided date, because they know as well as you do that they won't be entitled to the upcoming divided.

If they do buy from you at the higher price, they are probably doing so because they are looking at some other way to value the shares that they are prioritizing over the dividends.
This is very interesting to me. From your comment, I'm understanding that when I click "Sell" on the stock in my account, the only way it gets sold, is if someone else clicks "Buy" on his account. And if there are more sellers than buyers, the stock will remain unsold at the end of the day. In other words, it doesn't get sold to back to the company or to some other nebulous "thing". There needs to be an actual buyer buying from me (like any other marketplace, eg ebay). Did I get that correctly?
Nathan Worden's avatar
So, when you click "Sell" on the stock in your account, the immediate buyer is usually going to be a high-frequency trading shop / market maker / institution. What these entities do is provide "liquidity", meaning, they allow you to sell what you want when you want. If you were to click "Sell" in your account, and at that exact moment there wasn't anyone else buying, you'd be stuck holding your asset. Market makers help solve this problem.

It can be a huge problem for you if you really need the money from your asset now. Stocks are supposed to be very "liquid" assets. Meaning you should be able to sell them right now if you want to and get their current market value. Thats why institutions can buy your asset so quickly, because they can act as middle men between you and the ultimate buyer.

The market makers make their money by buying from you and selling to someone else at a very very small markup. For them, they make their money by doing a huge amount of volume.

If there are more sellers than buyers, then the sellers will start to lower their price they are willing to accept, because the buyers will eventually become interested in the asset if it is seen as "A good deal". If the seller isn't willing to sell at a lower price, then yes, they are stuck holding on to the asset.

Stock does not get sold back to the company. (Unless, the company independently decides to do a "stock buy-back" but that is a separate topic)
This is all very interesting to me - thank you! I'm refining my mental model, in LS-speak LOL
Nathan Worden's avatar
Haha yeah that is a good way to think about it- building up your "mental model" :D