The bigger “dividend mind trick”

I recently read Spencer Jakab’s Wall Street Journal article, “The dividend mind trick.” If you did, too, you know it’s not flattering to income investors.

Yet I found myself agreeing with a lot of it, dividend-focused analyst though I am.

Jakab accurately argues that investors too often become mesmerized by high dividend yields. He points to high-yielding S&P 500 companies like Pfizer (PFE), whose earnings growth and total returns have been disappointing.

In which case, Jakab is right that its higher dividend yield doesn’t mean much.

I know I've spent years warning investors about so-called “sucker yields.” These involve dividend stocks that look attractive on the surface. But underneath, there are deteriorating fundamentals, unsustainable payouts, excessive leverage, or some combination thereof.

So, again, I’m with Jakab on that. Where I part ways with him is how to fully interpret these observations.

Basically, I think he’s overgeneralizing.

One of my longstanding investment principles is that it's a market of stocks, not a stock market. That principle applies to income assets just as much as anything else.

You can easily see this in ongoing research over how much dividends contribute to total investment returns. That subject has been one of the most heavily studied financial subjects in recent years.

One with the most varied results, too. Different studies provide dramatically different conclusions.

I've seen some that suggest dividends account for 90% of long-term returns. Others put the contribution a bit above 50%. And still others drop that figure much closer to 30%.

Yet here’s the thing: Believe it or not, they can all be “right.” How you look at the data very often determines what conclusion you come to.

Even if that conclusion is ultimately incorrect.

Change a study’s start date, end date, or index, the types of companies evaluated, or whether dividends are reinvested or not… and you can produce very varied answers.

I’m not accusing anyone of being purposely deceptive. But math and logic can easily be manipulated, intentionally or not.

This is why I don’t recommend treating any broad academic study as the gospel truth. Otherwise, it’s a great way to build a faulty financial religion.

So how much do dividends matter? Here's my answer:

It depends.

They can be enormously important coming from one company and negligible from another. In which case, with all due respect to Jakab, it’s a waste of time to ask whether dividend stocks are inherently superior or not.

It’s much more important to consider:

If your primary objective is to establish reliable income either now or in retirement, you should probably focus more on dividend-paying companies. If you’re more interested in generating capital appreciation, growth companies might make more logical sense.

It’s as simple – and as complicated – as that.

Here’s another thing I actually agree with Jakab on: I don’t believe dividends are the be-all, end-all of creating total returns.

They don’t create wealth by themselves. You could even argue that investors already technically own that cash through their proportional ownership of the company.

Even so, that doesn’t make dividends irrelevant. It just means we need to ask whether they were the best way management could have spent that extra money.

Years ago, I reviewed a study titled, “Why dividends matter” by Dr. Ian Mortimer and Matthew Page. Their discussion of capital allocation was particularly telling.

For instance, predictably paying shareholders growing dividends can keep management in check. Knowing that a large amount of their excess cash is already allocated that way, they’re less likely to spend it on vanity projects, empire building, and unwise acquisitions.

And that, in turn, can encourage them to work harder at growing their earnings, creating healthy free cash flow, and generating attractive returns on invested capital.

Of course though – because, once again, there’s nuance to consider – this tends to work much better with well-established businesses. Newer ones should probably reinvest their dollars directly into operations, focusing on:

Since they have greater chances of failing, most of them literally can’t afford to pay dividends. Though, I imagine, there are exceptions to that rule, too.

There usually are, no matter how much we’d like to simplify life and how to live it.

I'm uncomfortable automatically elevating share repurchases over dividends for the same reason. Because it really just does depend.

Buybacks can create value when a company repurchases shares below their intrinsic value. And they can destroy value when management overpays.

This has proven true too many times to count. Think about how many companies have aggressively repurchased their shares near market highs… only to watch them collapse a few months later.

In those cases, management wasted shareholder capital. It lost that money, and there’s no way stockowners can get it back.

Dividends don't have that problem, however. Once they hit my account, they’re mine and I can use them as I see fit. That can be by reinvesting them in the same company, putting them into new opportunities, or paying off bills… all without selling a single share.

Can I waste that money as well? Sure.

But at least I got something out of it along the way.

As previously mentioned, Jakab uses Pfizer as one of his main examples.

Right now, it’s yielding close to 7%. Yet its post-pandemic growth has disappointed, and it’s consuming a significant portion of its free cash flow paying dividends.

So, yes, it’s not a flattering example of dividend worth. But there are plenty of other stock market examples where dividends are working out very well.

Should I take them as examples of how income plays always work out?

I’d be doing my portfolio a disservice by implementing either generalization. Much better to live by an adage I’ve been preaching for years…

Never buy a divided yield. Buy the business behind it.