Does investing for dividends make sense? Isn’t it all about capital growth? A summary of the implications of investing for dividends.
What is a dividend?
Established companies that make profit can choose to give a portion of that profit out as a payment to members. This is called a dividend. A company has to pay this out of cash on its books, it can’t pay it out of its own capital.
Why do companies exist?
Companies exist to make money for shareholders. Obviously there are exceptions, like charities, social enterprises and companies limited by guarantee instead of by shares, but the general rule is that they exist to make money for shareholders.
The two ways that a company can make money for shareholders:
- Become so huge and have so many resources that when the company ultimately decides “enough is enough”, it can sell up and distribute the cash (capital) to all its shareholders after paying off all its debts.
- It can pay dividends while still running.
That’s it. Everything else that a company does is a means to making one or both of these two things happen.
Why do companies pay dividends?
Companies pay dividends to achieve their goal of making a return for shareholders. When they have profit, there are two things a company can do with it:
- Reinvest in projects that will grow the value of the company; or
- Pay dividends.
Often they do a bit of both. You’ll spot that these two things are basically the same as the two ways that companies generate a return for shareholders.
Reinvesting in projects can often grow a company’s value – and therefore share price – faster than simply paying out dividends. In a young, growing company, you would expect lots of reinvestment in projects and very little payment of dividends. Sexy-looking tech companies quite often don’t pay any dividends for this reason.
In a mature, stable company that’s doing its job well – perhaps a supermarket chain – there’s only so much growth a reinvestment will do. Not every project will make a big enough return for the company to affect share prices. If Tesco reinvests all of its profits into making own-brand items, the share price of Tesco probably isn’t going to budge. However, paying a chunky dividend will probably attract big investors.
Many directors of public companies are paid more in their bonus if the company’s share price on the stock market grows. This encourages them to pay dividends, as we’ll explore below.
A company’s valuation isn’t dependent on dividends… or is it?
In a private limited company, dividends directly reduce the value of a share. A share is simply a right to a portion of the property and profits of a company, so if you pay some of that away there’s less to share around shareholders.
This isn’t straightforward for public companies, like the ones you and I will buy from a stock market. No, market forces of supply and demand drive up share prices on a public company. Paying a 5% dividends doesn’t necessarily mean that your share price drops by 5%.
This is something that’s often misunderstood by investors.
When a company pays a dividend, its price does often drop. Part of that is because of derivatives and institutional trading, which involves discounts being applied to those kinds of buyers who aren’t eligible for the dividends that normal shareholders are getting.
However, the price doesn’t have to drop.
Sometimes, the price increases. The company might be going from strength-to-strength. Investors might see it in the press: “hey, MegaCorp paid 3% this quarter? Maybe I should look into buying MegaCorp shares…”.
There’s also the fact that companies like to keep investors happy.
What kinds of investors love and hate dividends?
Shareholders have votes in how the company does business. In theory, enough upset shareholders can sack directors. Directors therefore try to keep shareholders happy.
Here’s the thing, though: depending on who your big shareholders are might change how you make them happy.
Some shareholders, like big pension funds, might insist that directors consider dividends. They need to pay pensioners, after all. Pension funds probably won’t sell shares in the company too often except to rebalance a portfolio, not when they can threaten the board with a shareholder revolt.
For UK companies, a 5% shareholding is enough to demand a general meeting of shareholders.
Pensioners themselves might be investors and need the return of their capital more than they need the growth. To them, the dividend paid today is more certain than the promise of bigger returns in a decade. This is sometimes called bird in hand theory, based on the saying that a bird in hand is worth two in the bush.
Conversely, a popular company might have lots of younger investors, who don’t need a return on their money any time soon. They might not want to sell for a decade. Funds are the biggest holders of most public shares, but index funds (rather than pension funds) or actively-managed tech funds might be the biggest investors, so there’s less concern about dividends and more concern about the share price increasing due to the company becoming popular.
Do you think Tesla shareholders expect a dividend any time soon?
This idea is called the clientele effect, and it’s basically the argument that who your shareholders tend to be might determine how likely your company is to want to pay dividends.
Is a dividend the sign of a good company?
A company can use the clientele effect to make a company seem like a better investment than another possible company.
Directors are “insiders” for the various market abuse and insider trading laws. They have inside information on how well a company is really doing, but the law occasionally prevents them from broadcasting this out to the world without committing an insider trading offence.
However, there’s nothing to stop a company announcing a big fat dividend. That’s normal business.
The board of directors can announce a dividend as a show that a company is doing well and is expected to do well in the future. This is called signalling theory. The idea is to lure in more demand for the shares, boosting their share price on the market.
Of course, a chunky dividend might be given away as a cover for mediocre company profits. This is a risk of interpreting dividends as a sign of a good investment.
Do companies need to pay dividends?
Even if a company has a good history of paying dividends, it doesn’t have to pay them in the future. When COVID-19 hit in 2020, a lot of companies decided not to pay dividends that year.
Which could be a problem for any investors that were relying on them!
Is dividend investing less risky than growth investing?
Companies that pay dividends tend to be more established than companies which don’t. They tend to have a decent share of their target market and they tend not be threatened by the existential crises that a small, fast-moving company might struggle with.
Tesco might lose some market share to Lidl and Aldi, but ultimately these new kids on the block aren’t likely to dominate the market straight away and make Tesco an unviable business. There’s enough scope for several supermarkets, and Tesco has a diversified offering.
Conversely, if crypto takes off and the gig economy workers switch to a Decentralised Autonomous Organisation that offers to match customers to gig workers directly, Uber might go bust if TaxiDAO takes off. It doesn’t make much profit, it doesn’t have a big cash moat, and it relies on being more convenient and cheaper than traditional taxi companies to run, so something that can do the same but better will probably cripple Uber within a year or two.
There is no TaxiDAO, I made that up, but you get the idea.
From that point of view, a conservative dividend investing strategy might have less risk than a growth investing strategy.
On the other hand, dividends aren’t guaranteed, as we explained above. If you rely on dividends for a return and don’t get that return, a dividend company’s share price might drop (due to the clientele effect). You might be selling shares at a discount and not getting that sweet dividend income, which is a double-whammy of pain.
These risks aren’t the same, so you can’t say if one is more than the other. Essentially, you hope to have less volatility risk but you’re more exposed to systemic shocks like big recessions if you prioritise dividend investing over growth investing.
What’s good about dividend investing?
Prioritising dividend investing over growth investing can be good for getting passive income and choosing companies with stable market shares. You should consider that this passive income isn’t guaranteed in amount or frequency and that having a stable market share one year doesn’t mean a company will always have a stable market share every year. A dividend-paying giant company can still collapse, like a growth company.
The case for dividend investing in financial independence
Companies that like to pay dividends tend to increase them every year or so as the share price increases. This is to maintain a dividend payment yield or dividend payment ratio, which is usually expressed as a percentage of a company’s share price. Thus, if the share price grows, you’d hope that the directors would be encouraged to approve a bigger dividend that year.
In theory, this means that if your dividends are enough to support your lifestyle, you don’t need to worry too much about reinvesting when you’re financially independent. Inflation should be reflected in the share price growth of your company, so hopefully your dividend-paying pot doesn’t need to be worked out for inflation purposes: when you’re free, you’re free.
There’s also the psychological benefit to consider. Getting paid a dividend every quarter gives you that little dopamine hit that keeps you excited about investing. The financial independence campaign is long, and it’s nice to have mini-milestones on the way to make it fun.
Finally: you might just like dividends. That’s OK, too. An idea I took from The Psychology of Money is that a reasonable strategy that works is better than an optimal strategy that bothers you. If you just prefer the income to the capital, it’s better to invest for dividends than not to invest at all.
“Dividends don’t matter!”
The case against relying on dividends is generally attributed to the 1960-1970s capital authors Miller and Modigliani. Their theory, dividend irrelevance theory, is basically that dividends don’t matter as investors can just sell some of their shares/ fund units as the capital value (i.e. the price) grows. Shareholders can effectively create their own dividends.
When financial independence campaigners are talking about the 4% rule (or whatever percentage they see as “safe” for withdrawals), they’re usually following dividend irrelevance theory – or they’re in the fortunate position where they expect 4% return in dividends, which is possible but not common.
How to invest for dividends
If you’re going to prioritise dividends, you can look at dividend funds (usually ETFs). A famous one is the SPDR dividend aristocrats ETF (USDV) seen here on JustETF.com, which is an index of US companies that not only pays a dividend but that has been paying them for at least 20 years and has increased them every year. The fees are larger than a global all-cap fund, at 0.35% versus 0.22% for Vanguard’s VWRLD, but the dividend yield is around 1.98% at time of writing versus 1.58%.
You might also consider an investment trust. These are actively managed investment funds, generally based in the UK, where you buy units instead of shares. Trust managers can use leverage to amplify returns and some investment trusts will look at unlisted private companies, too.
Typically, an investment trust might then take a portion of profits and issue a dividend from their activities. The City of London Investment Trust buys shares on the FTSE All-Share and has a dividend yield of around 4-5% each year. Investment trusts are like ETFs in that their price might be higher or lower than the value of the shares they hold.
This isn’t a recommendation, it’s just a real-life example. I haven’t invested in this fund.
Real Estate Investment Trusts (REITs) may be an option. They are compelled to pay dividends by law from the rent of the properties that they own. However, they only invest in real estate, rather than in commercial activities.
Of course, you could simply pick the individual shares you want to buy. Most brokers will show the yield per share, based on the previous dividend distributions. You will definitely suffer more price volatility if you pick a few shares versus a fund. There’s also concentration risk to consider. However, if you have enough time and money to pick a diverse bag of dividend-producing companies, you could conceivably build yourself a tidy dividend portfolio.
How are dividends taxed in the UK?
Dividends come under income tax rules, but they have their own tax rates. Firstly, if you’re earning them in an ISA, don’t worry about it – those dividends are tax exempt. After that, there’s a dividend allowance (of £2,000 in 2022-23) that protects the first part of your non-ISA dividends from the tax man. Above both of those, you pay income tax (but not national insurance) according to the following tax rates:
| Tax bracket | Income tax on dividends |
|---|---|
| Basic rate | 8.75% |
| Higher Rate | 33.75% |
| Additional Rate | 39.35% |
This isn’t a tax blog, so I won’t go too much into the calculations. Short version is that you add your dividend income to your wage income to see what gets taxed at which rate. Wages get taxed first though, so you can’t elect for £50,000 of dividends to be taxed at 8.5% while allowing a £16,000 part-time salary to get the brunt of the higher rate tax treatment.
Wait, there’s one other type that’s interesting. If you invest in shares that come under the Enterprise Investment Scheme, such as if you invest in a start-up on Crowdcube, and you have kept the shares that whole time, you *may* be able to avoid paying income tax on dividends. Same with units in a Venture Capital Trust.
Tax is tricky though and you should check with a professional if you’re unsure. Definitely don’t rely on a blogger on the internet alone.
My attitude to dividends
I’m still developing my attitude to dividends. Like any good investor or financial independence campaigner, I evaluate my strategy when new information or an opportunity comes along, so I’m quite happy to admit I can be persuaded either way.
My feelings at the moment are that a late stage (i.e. public) company doesn’t have to pay dividends, but I am sceptical about a top-tier company that has no intention of paying them.
I wouldn’t buy a share of Alphabet (GOOGL) because it does not and probably will never issue a dividend, despite having a near-monopoly on internet search provision and enjoying an oligopolistic position in many other industries, such as mobile phone software. Its products (software) are intangible and require constant maintenance or updating, so if Alphabet ever does wind up there’s probably not going to be much in the way of assets to share around. The way I see it, the only way to make a return from GOOGL is to buy the shares and then sell them to another buyer at a higher price, which isn’t any different from cryptocurrency trading but with a lower upside potential.
I have also historically bought National Grid shares because of their strong dividend, but this wasn’t the only factor in my decision. The main factor was that National Grid is pretty much a monopoly on the most valuable infrastructure resource in the Western world – electricity infrastructure – and although I see microgrids emerging as a competitor I don’t think it’s going to lose a dominant market position in the next twenty years.
This all said, while I like a dividend and do value them, they’re not the main focus of my investments. I wouldn’t stop investing in a solidly-performing fund because dividends are low, and I wouldn’t turn down a great opportunity because it doesn’t pay a dividend.
Is it better to invest for dividends or capital growth?
Like with most things, it depends. Dividend investing is ideal if you just want to leave your capital invested, then know that whatever’s in your broker account as cash is fair game to be spent. It isn’t something you can rely on 100% as companies don’t have to pay a dividend. Investing for capital growth in smaller companies might give you a better return if you can stomach volatility compared to investing in stable dividend-paying companies. That said, there is an argument that dividend companies should suffer less in economic downturns, as they typically hold dominant market positions, and that this may improve performance of your portfolio. Overall, you ideally want a combination and should look for total return on your money, rather than just one or the other.
