Should You Only Invest In Companies That Pay Dividends?

A common belief among retired investors is that to provide income for their retirement that they should only invest in companies that pay dividends. This obsession over dividend-paying companies has grown in recent years, exacerbated by the fact that other income-paying investments pay barely enough to keep pace with inflation. Long gone are the days retired investors could dump money into GICs paying double-digit returns.  But should retired investors place so much emphasis on dividends?

Dividends Can Be a Trap

Many mature and stable companies pay good consistent dividends to their shareholders.  Oftentimes this is due to fact that the company has exhausted most of the opportunities for their business to reinvest profits.  When a company can't reinvest its profits at a good rate of return, the best thing they can do is return that money to their shareholders.  Think of businesses like Coca Cola who dominate in all global markets alongside another competitor.  Coca Cola has fewer opportunities to reinvest profits back into the business and instead pays some of these profits back out to shareholders.

But sometimes, companies that are suffering choose to also pay large dividends in hopes of retaining and attracting investors who seek yield. Investors need to be careful because a high dividend yield from a company that's slowly dying is no recipe for retirement success and can lead to permanent loss of capital down the road.

Dividends Are Not Bonds

Part of the bias towards investments that pay dividends may be attributable to the fact many investors feel like dividends are like a guarantee.  Investors focused on dividends need to understand that  dividends are not like bonds and there is no contractual obligation or guarantee that companies have to pay them.  During times of economic turmoil, it's not uncommon for businesses to decide to cut or suspend their dividend.  

Just look at the COVID crisis. Many companies had to suspend or cut dividends to free up cash to stay afloat. This is especially true for companies who pay out a large percentage of their profits via dividends (measured by their payout ratio).  In these cases, not only is income either halted or reduced, but there is a good chance many of the investors who also own the stock for its dividend alone will choose to sell, pushing the stock price down 40%, 50%, 60% or more!  

For investors who bought these companies based on their dividends alone, this becomes a tough spot to be in and could mean a permanent loss of capital.  It's worth noting that it doesn't take a pandemic or economic crisis for companies to have to cut or suspend dividends.  Just ask the shareholders of a company like Sears.

Stretching for Yield

As mentioned, retired investors often focus on dividends alone with the idea that this will help ensure they have an adequate income in retirement.  What many retail investors are unaware of is that in today's low-interest-rate environment, many investors are also trying to do the exact same thing, leading to what we call 'stretching for yield.' Stretching for yield is essentially when investors take on more risk in an effort to secure higher income payments.  

In the short term, stretching for yield can have an immediate and positive impact on the share price of a company.  With retired investors lining up to secure an income, the price of the company goes up regardless of the underlying health of the business. In trying to provide for retirement, investors stretching for yield do the exact opposite and open themselves up to very real and potentially catastrophic risks that could put their retirement in jeopardy.  As discussed above – when the tide goes out and companies are faced with a tough time, investors who stretched for yield can end up with steep and painful losses.

Total Return Is What Matters

I believe investors have a bias towards dividends because receiving an income feels more real than a company that reinvests its profits back into the business.  But some of the world's largest and most successful companies either don't pay a dividend or didn't pay a dividend for many years. For these companies, the opportunity to reinvest profits and earn better rates of return in their business was better for their shareholders than paying the money out as a dividend.  This money was needed to grow these businesses into what they are today, and many have seen their returns on their shares far exceed what a typical investor would have been able to achieve had they received a dividend.

For fun, I went back 10 years to look at some of the top dividend-paying names and compared them to some other notable and large companies that were paying no dividends at the time.  I wanted to see the difference between total return which factors in capital appreciation and dividends paid.  As you can see focusing exclusively on companies that pay dividends would have left out some pretty great businesses.

Source of the data: Morningstar

Closing

Dividends play an important role in generating returns for all of our clients. We own several companies that pay good dividends and we like receiving that regular income, especially while we wait for share price appreciation.  At Endeavour Wealth Management, we don't dislike dividends.  We consider ourselves 'return agnostic' meaning we don't care whether our returns come from capital appreciation, dividends, interest income, so as long as the net 'total return' meets the goals of our clients.  

Although I understand investors' obsession with securing an income, as I've highlighted above, the income is never 100% secure and focusing solely on dividends alone is likely to reduce your lifestyle in retirement rather than to add to it.  Dividends will always play a part in earning the returns needed to fund your retirement, but at the end of the day, focusing on your total return is really what matters.

- Brandt Butt, Investment Advisor, CIM

Brandt Butt is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Brandt Butt who is an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.