Dividend Irrelevance Theory - The Irrelevance of Dividend Investing

Dividends are never 'irrelevant' per se, but they should not be the overiding factor when deciding what to invest in for a long term portfolio in retirement. Dividends are not relevant in determining which stocks may have good future returns. There is peer reviewed academic research and robust empirical evidence telling us that there is a right way for most people to invest. Which is low cost index funds. 

If your goal is a reliable long-term outcome, then there is no better approach. The basis for the irrelevance of dividends starts with the 1961 paper, Dividend Policy Growth and the Valuation of Shares by Merton Miller and Franco Modigliani. They explained in their paper that before frictions like trading costs and taxes, investors should be indifferent between $1 in the form of a dividend, which causes the stock price to drop by $1, and $1 received by selling some shares. This is a fact that must be true as long as $1 is worth $1. In support of this theory, we know empirically that stocks with the same exposure to factors like size, value, profitability, and investment, have the same average returns whether they pay dividends or not. Unless you believe that the market is irreparably broken, or that capital can be created out of thin air, there is no way to argue against the fact that the distribution of a dividend results in a reduction in share value. 

That must be true. There's no way around it. Dividend investors will tell you that theory does not extend to reality. And that dividend stocks do indeed do better than the market. I'm not denying that. On average dividend growth stocks beat the market. But dividends are not the reason. Dividend growth stocks on average have excess exposure to the value, profitability, and investment factors. That is what explains performance differences. This does not make picking individual dividend stocks a good idea. Dividend investors will tell you that the management of a dividend paying company is positively affected by their dividend policy which produces better long-term results for investors. There's no basis to believe this. For this idea to be true, the whole market would need to think that the company would not do well, while you believe otherwise. And then you would have to be right. Everything comes back to pricing. All else equal, for future returns to be higher, the current price would need to be too low meaning that the market is mispricing stocks with good dividend policy. There's no basis to believe that this is systematically happening across the stock market. With that in mind then let's walk through some math and start an example that we will come back to later in the video. 

Let us consider two companies, company one and company two. Company one is a dividend payer, while company two is not. To keep things simple, we will assume that both companies trade at the beginning book value of $10. Keep in mind that following valuation theory, the market price is based on the company's book value, plus the value of its discounted future profits discounted at some discount rate. This needs to be explicitly clear. If two companies have the same expected future profits and the market is discounting those profits at the same rate, the two companies would be expected to have the same price relative to their book value. Similarly, if two companies have the same profitability and the same relative price they must also have the same discount rate. The discount rate is the investor's expected return on a stock. This relationship holds true whether the company pays dividends or not. It is crucial to understand that we are assuming that company one and company two are the same size, have the same profitability, reinvest at the same rate, and trade at the same price relative to their book value. In this case, we are assuming that the price equals the book value to keep things simple. If all of this is true then these two companies must have the same expected return. The two companies have a starting book value of $10 per share. They each earn $2 per share. Company one pays a $1 dividend, and company two pays no dividend. You own 10,000 shares of company one and you receive $10,000 in dividends. Your shares now have a value of $11, $10 starting value plus $2 in earnings minus the $1 dividend. Your total portfolio consists of $110,000 in company one stock, and $10,000 in cash before taxes. I own 10,000 shares of company two. It is now worth $120,000. If I needed some cash, I could sell some of my shares. Maybe I would create my own dividend equal to yours but I don't have to. I could sell more or less shares as needed. I'm not allowing the company's dividend policy to dictate my spending. All of this is true whether the stock market is up or down. If the market is down and the dividend is paid, the value of the company still falls by the amount of the dividend. It has to. This is not up for discussion unless you don't believe in mathematics. Receiving a dividend in a down market is exactly, and I mean exactly the same as selling off some shares in a downmarket. 

If dividends are irrelevant, and it is only exposure to the common risk factors that explain differences in returns, we would have expect two funds with similar exposure to the factors to have similar returns regardless of their level of focus on dividends. To prove this, we will compare VIG, the Vanguard Dividend Appreciation ETF, to two funds from Dimensional Fund Advisors that together create comparable factor exposure to VIG. Dimensional funds are total market funds that seek exposure to the known risk factors. They're blind to dividends. I'm using it US funds so that I can use the Match Factor Exposure tool @portfoliovisualizer.com to run the analysis. For the period from January, 2013, through May, 2019, which is when the data for the newest of these funds starts, the annualized return for VIG was 12.98%. While the annualized return for the portfolio of dimensional funds was 14.67%. The risk adjusted returns were also higher for the dimensional portfolio. The R squared for VIG and the factor regression was 94.3%. Meaning that exposure to the factors explains almost all of its returns. The R squared for the portfolio of dimensional funds was 99%. The point here is not the dimensional funds beat VIG. The point is that two portfolios with similar factor exposure will produce similar results. I don't know what else to say. Dividends do not explain future returns, and limiting your opportunity set to the stocks that pay dividends cuts your opportunity set roughly in half because roughly half of global stocks do not pay dividends. Less diversification means more dispersion which reduces the reliability of your outcome. 

I think that dividend investors should just admit that they're nothing more than stock pickers. Picking dividend paying companies does not make picking stocks any smarter or safer. I will concede that dividend growers will tend to be large cap value stocks with robust profitability that invest conservatively. So picking them is probably better than picking penny stocks, but there's still a ton of security specific risks that you cannot get away from. To be completely clear, I have nothing against dividends. They are an important component of returns. I think I just think that the idea that you can use dividends to pick winning stocks is egregious. And again, please do not tell me the names of individual dividend growers with great past returns as evidence that dividends matter. It would be just as relevant to tell me the names of stocks starting with the letter A with great past returns. In both cases the information is meaningless. That's actually a pretty good comparison. I do have something else to add. 

In Canada for exmaple, Canadian dividends are taxed more favorably than any other type of income when you have a low income. This is often used as an argument to invest in Canadian dividend paying stocks as a Canadian resident. I believe the situation is similar in other countries as well. Let's look at an example, say you already had $47,630 of taxable income in Ontario in 2019. From there you're marginal tax rate on capital gains would be 14.83%, and marginal tax rate on eligible dividends would be 6.39%. It seems obvious that the dividends are way more tax efficient, but hold on. Let's bring back our example from earlier. You received $10,000 in dividends from company one. You would owe $639 in tax. I received $10,000 in capital gains from company two. I will not pay any tax on those capital gains until I sell. If I need some income, I will sell some of my shares. Here's where people get really confused, when I sell $10,000 worth of my shares, I am not paying tax on the full $10,000 capital gain. I'm only paying tax on a proportional amount of the gain. Let me explain. I paid $100,000 for my shares. They're now worth $120,000. When I sell $10,000 of my position to cover my living expenses, the capital gain is only going to be $1,666. The proportional amount of my total gains on 10,000. The tax owing would only be $247. The amount of tax will increase over time as I crew more unrealized capital gains, but the crossover for dividends being more tax efficient will not happen for many years, and I may be able to offset future gains with losses. I'm also in control of triggering the gains. 

What if we didn't need the full $10,000 of income this year? You're still paying tax on the dividend. Lastly, I know I'm repeating something that I already said in a past video here, but I can't leave it out. Dividend investors will tell you to look at how much Warren Buffett loves dividends. And they will tell you that this is a reason for you to love them too. Warren Buffet is happy to collect dividends. But he is also happy to not collect dividends. He explicitly wrote about this to help you, the average investor understand why. It takes up a whole section of his 2012 letter to shareholders. Please go and read this before following Buffet into dividend stocks. He has made it so clear that this is not a criteria on that he uses to help identify good companies. 

Buffett likes low prices, he is a value investor. Low priced stocks will often have high dividend yields. That does not mean that Buffet loves dividends. Using dividends to pick stocks simply does not make sense. It has no basis in financial theory and this can be proven empirically by comparing dividend focused index funds and factor index funds with similar factor exposures as we have done. If you want to pick dividend stocks, if that is where you most comfortable, that is fine. But you have to understand that you were still nothing more than a stock picker. There is no pedestal for dividend investors to stand on.