Are Dividend Investors Foolish?
“Howard, I couldn’t figure out how to turn it off. All I got was menu after menu. But there’s no off switch.”
Today’s beef is with today’s world. It is a world of so many labor-saving devices that we must work night and day to keep up with them.
They must be bought. Then serviced. Then repaired. Then replaced with something more up-to-date, which is to say, something that is an even bigger nuisance.
It is true in almost all aspects of life. Finance as well as car maintenance. Things become more sophisticated and more complex. Risk goes up. And costs. And fragility. Is it worth it?
The answer is usually no.
For instance, just recently my son Will, who now runs our new publishing business, Bonner & Partners, came to me with an idea for a new investment advisory. It’s based on the idea that you can successfully compound wealth over time through investing in the right kind of dividend stocks.
We’re skeptical. But you can decide for yourself. You can follow the debate we had with a young analyst in today’s Market Insight column (below).
Most of these innovations tend to be dead ends. But not all.
Now, back to today’s real beef…
A Complex World
It is a complex world. There is a solution to every problem (even problems that don’t really exist). And every solution comes with more new problems.
Joseph Tainter was right. Society becomes more and more complex. Complexity sucks up resources. Eventually society goes broke.
In today’s installment, your editor returns to his farmhouse in rural Maryland, only a couple of miles from where he was born. His house has just been remodeled. It is so completely improved that it is almost unbearable.
Howard, the builder, attempts to explain. Here’s how our conversation went:
“Yes, it is a little more sophisticated than what you had before.”
“I don’t understand why the AC system can’t have a simple off switch.”
“Well, you should never turn it off.”
“Because, this house has a lot of fine woodwork and carpeting and so forth. You can’t let it get too humid or the wood will swell up and crack and you’ll get mold.”
“Can’t we just open the windows?”
“You don’t have to open the windows any more.”
“Because this is an energy efficient house. It’s state-of-the-art. We replaced all the insulation with foam. The windows are super tight. And the temperature and humidity are automatically regulated.”
“But if it is so energy efficient, why is the AC system on all the time?”
“That’s probably not the AC you hear.”
“Then, what is it?”
“It’s the air-exchanger.”
“Air exchanger? What’s that?”
“Well, the house is so tight that it doesn’t get enough fresh air. So, we have an air-exchanger to bring in air from the outside.”
“Then why go to the trouble of insulating so much? Why not just leave the leaky windows?”
“Well, the air exchanger doesn’t use much energy.”
“How about the humidifier?”
“No, that doesn’t use much either.”
“And the de-humidifier?”
“Same thing. Very low energy use. All of this uses less energy than standard AC.”
“Sounds like they will use a lot more of my energy… more bother… more machines… another control system… another thing I have to figure out… more manuals and service contracts that I have to keep… another thing that will break down.”
“Hold on. These are very efficient and reliable systems. They shouldn’t need too much maintenance.”
“I just want to turn them off and open the window. But I can’t open the window, not with the AC running.”
“You don’t need to open the window. This system allows you to control the flow of air.”
“But that’s just the point. I can’t control anything. It’s all automatic. I can’t even turn it off.”
“Well, your air temperature and humidity are controlled for you. And you also get fresh air when you need it. It’s all state-of-the-art in home interior climate control.
“When it’s too cold outside, the system keeps you warm. When it’s hot outside, it keeps you cool. When your humidity rises above 60%, the dehumidifier comes into service. When the humidity falls below 40%, the humidifier activates. And when the air gets stale, the air-exchanger turns on.”
“Why not just open the window?”
“Mr. Bonner, I’m afraid you’re out of touch with modern home technology.”
Dividends or Capital Gains?
From the desk of Chris Hunter
As Bill mentioned, there’s an interesting discussion going on behind the scenes at Bonner & Partners.
You see, one of our new analysts, Jim Nelson, is convinced that investing for income is the single best way to make money in the markets.
Jim has an impressive track record to back him up. Over the four years he edited the popular income investing newsletter Lifetime Income Report (2009 to 2012), his recommended portfolio had an average gain (including returns from dividends) of 34.3%.
But you know Bill. He’s a skeptic.
Here’s what he wrote in an email when Will suggested the idea of an income newsletter to him:
Sounds like the strategy in question would be good for producing income a family might live on…
Less ideal for maintaining or expanding capital.
It’s a fair point.
Bill’s argument is simple. If a company is paying out cash in the form of dividends, it is not reinvesting that cash back into the business.
Apple is a good example. It didn’t pay any dividends until recently. Warren Buffett’s Berkshire Hathaway is another good example. It doesn’t pay dividends at all.
Few people would say these are bad businesses. They are just more focused on reinvesting cash back into their businesses than paying it out to shareholders. That reinvestment helps grow future profits. Shareholders still benefit… they just do so through higher capital gains over time.
But Jim doesn’t buy this line of thinking… Here’s what he emailed back to Bill:
The argument about whether a company should reinvest its capital back into its business or pay it out to shareholders just doesn’t make sense to me. It never did. A company – unless under specific conditions – should never do one and not the other.
Reinvesting its earnings through R&D spending, strategic acquisitions and expanding its business or markets is a good thing. But I can’t think of many cases for established companies where they have enough reinvestment opportunities to spend all their money. Take Apple as a good example. Despite Apple’s big spending, the company is still flush with cash.
Apple is always trying to grow its market share. And it has competitors to race against. Surely, it should have no problem finding places to reinvest its earnings. But as we all know, that’s not the case.
That’s a case where a higher payout ratio – the amount of earnings paid out in dividends to shareholders – is definitely warranted. In other words, I think Apple should pay an even bigger dividend to attract more shareholders. It’ll still have plenty of cash left over for R&D, etc…
That’s what I look for. Put simply, companies that have a track record of finding the right balance between reinvesting cash and paying it out to shareholders.
Besides, returning cash to shareholders in the form of dividends supports a company’s share price and keeps its cost of equity low.
Isn’t that better than having a company you’re invested in spend all of its earnings on investments it isn’t sure will grow its business? We all know that management often does dumb things with cash… especially spending it on ill-advised or over-priced acquisitions.
You may recall what happened when Quaker Oats bought out Snapple, back in the 1990s. Snapple was a hot brand. But it couldn’t compete in the same large-scale grocery store environment Quaker Oats participates in.
After paying $1.7 billion for Snapple in 1994, Quaker Oats sold Snapple for just $300 million three years later.
I’d rather a company pay me a share of its earnings in the form of dividends than take big gambles which, let’s face it, a lot of acquisitions are.
After all, shareholders are company owners. They should get paid like owners.
Jim certainly got Bill’s attention. But Bill’s still not convinced.
I wouldn’t go as far as saying income strategies “don’t work.” But they’re best for people who actually want an income to spend (for example, retirees).
Another problem with dividend income is it’s taxed at a higher rate than capital gains.
Surely, this is a big problem for dividend investors?
Another good point…
We’ll be continuing this conversation in these pages over the coming days.
Stay tuned! And if you want to pitch in on this conversation, just shoot an email to email@example.com.