The Dividend Investors Achilles Heel

What Is An Achilles Heel?

If you haven’t read Homer’s Iliad, you may not know who Achilles was or the meaning behind an “achilles’ heel“. Let me give you a brief history lesson before we get to the subject at hand. Achilles was an ancient Greek warrior that achieved the status of a hero for his feats in the Trojan War. The story goes that Thetis, Achilles’ mother, wanted to make her son immortal by dipping him in the river Styx, however, while dipping him in the river she held him by his left heel, in turn causing it to be the sole vulnerable part of his body. Before the end of the Trojan War, Achilles was shot with an arrow by Paris, a Trojan prince, in his left heel, which ultimately led to his death. In present day the term ‘achilles heel’ refers to a vulnerable point.

So what is the “achilles heel” for dividend investors? Let’s touch on a few I can think of.

*Trigger Warning* I will be critical of dividend investing in the next few sections. But fear not, I am a dividend investor, and there is a point to this critique that will be clear once you finish reading.

1. Limiting One’s Options

When you make the decision to solely pursue a dividend focused strategy you in turn cut your investable universe roughly by half. Approximately 79% (3,582) of the companies listed on the New York Stock Exchange (4,527) currently pay a dividend. Of these companies, less than half (~48%) currently have a dividend yield of at least 3%, and even fewer have reasonable dividend growth histories. Looking at the NASDAQ the percentages are even lower. Only 32% (1,316) of companies trading on the exchange (4,035) currently pay a dividend, and roughly 44% of these companies have a dividend yield of at least 3%.

Limiting an investable universe can be both a good and bad thing, depending on the criterion used. The sole fact of whether a given company pays a dividend or doesn’t, isn’t necessarily a good criterion. There are plenty of great companies that do not pay dividends, and plenty that do. But the same can be said of awful companies that make for poor investments. A good way to visualize this is to picture shooting an arrow at a target. The arrows are your investing decisions while the target is your investable universe. When you focus solely on dividend stocks you are not only shrinking your target (investable universe), you also shrink the bullseye (number of best companies).

For context, during the past year, out of the top 20 performing stocks on the NYSE, only 5 were stocks that paid a dividend. This means that as a strict dividend investor you would have not even considered 15 of these top 20 performers.

2. Focusing on Dividend Data

New dividend investors may place a great deal of emphasis on dividend data to drive their investment decisions. Inherently, this can make a lot of sense especially if the driving factor that lead a person to adopt a dividend strategy was the appeal of receiving dividends. This however is not the best strategy to pursue. An excellent track record of paying and increasing dividends is not the driving force of a stocks success, it is rather the growth of the underlying business that drives great dividend track records.

While focusing on dividend yields, dividend growth and payout ratios is good, it is much more prudent to focus on the financial growth of the company. Analyzing dividend data can be easier and more appealing than reviewing financial statements. Perhaps that is why newer dividend investors build their strategies primarily around dividend oriented metrics. But this can lead to poor investment decisions and missed opportunities.

3. Tax Inefficiency

Dividends are inherently tax inefficient, at least as it applies to U.S. investors. Barring a few exceptions, all dividends are subject to taxation. The exceptions being, holding dividend stocks in a tax free or tax deferred account, or having ordinary income below specific thresholds where the tax code does not impose taxes on dividends. However, the majority of dividend investors will likely pay some tax on their dividends, either now or in the future. And not all dividends are taxed favorably.

While capital gains are also subject to taxation, the individual investor has more control over the tax liability they incur subject to capital gains versus dividends. Many investors consider this to be a handicap of owning dividend paying stocks as the “tax drag” on your portfolio may compound into material missed opportunities.

4. Irrelevance of Dividends

The dividend irrelevance theory implies that dividends have no effect on a company’s profitably nor its stock price, hence making them irrelevant. Since the share price of a company is proportionally adjusted by the paid out dividend, the investor gains nothing from the dividends they receive. Furthermore, the dividend can create a tax event for the investor leaving them worse off had the dividend not been paid at all.

This theory was proposed by Modigliani and Miller as part of their famous capital structure theories. They argued that in a perfect world investors could create the same “cash flow” of dividends by simply selling shares of the stock. A company’s dividend policy and payout schedule dictate the decision of how much or how frequently to create “cash flow”. This leaves dividend investors worse off, by limiting their control of “cash flow” and forcing them to incur unnecessary tax obligations. Of course we do not live in a perfect world and there are many factors that support or refute this theory.

So Why Should You Be a Dividend Investor?

Just because an investment strategy has vulnerabilities does not imply it can’t be profitable or the ideal path for certain individual investors. All investing strategies have their achilles heel. I believe that it’s important to know the vulnerabilities of your investing strategy, because an informed investor can be a smarter investor.

Let’s break down each of the 4 vulnerabilities and examine why dividend investing can still make perfect sense.

Limiting one’s options. It’s true, focusing solely on dividends stocks does eliminate the option of investing in many great businesses that do not pay a dividend. However, when we consider the sheer number of stocks available to retail investors, it is highly unlikely that an individual investor would be able to consider the full spectrum of the market as a viable investable universe. Through one way or another an individual investor has to focus on small chunks of the market at a time and further trim this universe down to a handful of stocks they can properly review. The inverse approach is investing in index funds or ETFs by which you are buying the good companies along with the bad ones, betting on the fact that the stock market as a whole expands over time.

I believe there are enough great companies within the “dividend paying” universe of stocks for individual investors to earn respectable total returns all the while achieving other dividend specific investment objectives.

Focusing on dividend data. This vulnerability is a consequence of beginner level dividend information available online. For novice investors, it is far easier to comprehend basic concepts and therefore it is easier to apply these metrics in the decision process. As novice investors acquire more knowledge they become more informed investors and they tend to make smarter decisions. Fortunately, newer investors typically have small portfolios and many of the novice mistakes are learned with fewer lost dollars.

Tax inefficiency. Again this is a vulnerability that can be overcome with a basic education about the tax code and how to use it to your advantage. All of the necessary information is readily available online, all that is required is to seek it out. Taking advantage of tax free or tax deferred accounts and learning which dividends are more tax advantageous can greatly improve your long term results. While dividends can be tax inefficient there are plenty of ways to mitigate or defer the tax drag on your portfolio.

Irrelevance of dividends theory. While the theory is certainly true and does hold some merit, the world of investing is not perfect and therefore dividends are not irrelevant. Not all investing objectives are focused around maximizing total return. There are plenty of advantages that dividend focused strategies can provide with generating “cash flow” that are not easily replicated by selling shares of non-dividend stocks. Liquidating portions of your portfolio to generate cash flow in some instances can be equally or more burdensome than a simple dividend strategy. Also the theory in itself does not imply that dividend stocks should be completely avoided because dividends are irrelevant, it simply implies that individual investors should not pay more attention to dividend stocks opposed to non dividend stocks.

I for one enjoy being a dividend focused investor. I like the passive cash flow dividends offer and I like watching this cash flow grow over time. I realize that there are vulnerabilities to this type of investing strategy, but thus far it has worked very well for me. If I can meet or exceed my expectations with a dividend focused strategy, it is irrelevant to me that I am limiting myself by solely focusing on this segment of the market.

Investing is not a zero sum game, at least the basic form of investing in which you purchase shares of stocks or funds. What this means is that for me to “win” someone else doesn’t have to “lose”. Figure out what “winning” means to you and then follow the investing strategy that helps you reach that goal.

It’s good to know the vulnerabilities of your investing strategy, because then you can find ways to limit their impact on your portfolio.

Data Driven Dividend Growth Portfolio Update

Hence forth this portfolio will be abbreviated as 3DGR. I’m writing this update on Tuesday May 7th, which marks the one week point since the launch of this portfolio.

The portfolio is off to a decent start, it’s one week return is +3.54% relative to +3.03% for the investable universe and +3.02% for SPY the S&P 500 Trust ETF.

The chart below shows the one week (price only) return for all 93 stocks in the investable universe. The red bars are the chosen 20 stocks included in the 3DGR portfolio. As you can see they are spread out across the full spectrum of the chart. But we were able to select 2 of the 4 best stocks thus far. A single week’s return is silly to analyze, I’m sharing it just to show you how I plan on providing updates on the portfolio in the coming months.

I foresee that during this initial launch year I will make several observations on this data set that may lead to certain optimizations that can be applied to this strategy during its second year. I look forward to analyzing and sharing this data with you.

It’s nice to get off to a good start but I’m more focused on where we finish, opposed to how we get there.