Don’t just buy a stock for its dividend yield
Oct 18, 2013 12:06:08 GMT 7
puregold, cloverleaf, and 2 more like this
Post by oldman on Oct 18, 2013 12:06:08 GMT 7
Puregold, easiest way of answering your question is to paste what I wrote in my book: Your First Million, 2nd Edition:
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When we put money in a bank, we expect to get some interests on the money that we have deposited. Many use the same analogy and want to get dividends from their stocks as well. They feel that investing in stocks and shares is better than putting the same money in the bank because the dividend income is better than the interests from the bank and there is also upside in the capital gains when stock prices go up.
However, this thinking may be flawed as bank interests is, to all intents and purposes, risk free (unless of course, the bank collapses) whereas investing in stocks and shares will come with risks to your capital. Getting a dividend may make one feel better but in reality, it hides the important truth that you have now put your initial capital at risk. Your initial capital is usually many times the size of the dividend yield and hence, when you invest in stocks and shares, you should focus on the strength of its business rather than its dividend yield. A 30% collapse in the share price can more than wipe out six years of dividends even at a high 5% a year and assuming that the company can continue paying the dividend year after year.
In the past, businesses were relatively stable. One could predict with reasonable accuracy the company profits many years into the future. Nowadays, businesses are more dynamic as competition is now more intense as the world has become a global marketplace. It is not so easy to even predict the profitability of any business six months ahead, let alone years into the future.
If one is not able to predict future profitability, it will be difficult to be certain of the dividends from the company. If the company does not make sufficient money, or is losing money, it will be difficult for the company to continue its dividend policy. After all, dividends are usually a subset of profitability – i.e. companies cannot continue to give more in dividends than what they earn in profits – otherwise, they will be eating into their cash reserves. If companies fund dividends through their cash reserves, there will come a time when the cash will be depleted.
Hence, at the end of the day, dividends are closely related to profitability and when we invest in a company, we should invest in its profitability and not its dividend policy. For me, I look at the business first and if the company gives a good dividend, I am OK with this. But I do not go around looking for good dividend yields as the basis for my investing strategy because at the end of the day, we should invest in companies for their profit potential rather than their dividend policies.
If I were to ask you to put $100 with me and I will give you $5 return every year, would you rush to put $100 with me because of the $5 a year sweetener? The answer should be no as the $5 is just a carrot. The crux of the matter is still whether I have a sound business which warrants your investment of $100. Hence, for me, I do not let the $5 carrot dividend blur my main objective of investing. I invest in the company for its profits and not for its dividends. If the company’s profits increase, its share price is likely to follow and this then translates to a capital gain in my portfolio and maybe, some dividends will flow through as well.
Hence, no matter how we look at the issue, the primary reason we invest in stocks and shares should be for the capital gains as dividend income is just a small subset of our capital gains. Another way of putting it is that a small loss in the capital value of a stock may more than wipe out years of dividends from the same company. When a company makes money, it can either give out some of its profits as dividends or reinvest the money into the business. We should not fault management if they so desire to reinvest the money and not give out dividends.
In many parts of the world, when the company gives out dividends, this amount is taxable to the shareholder. Hence, management
may be better off reinvesting the money instead, especially if management can put the money to better use, like in the case of Berkshire Hathaway. Berkshire Hathaway only declared a dividend once in 1967 and Warren Buffett famously said that he must have been in the bathroom when that dividend was declared. Berkshire Hathaway never declared any dividend after that. Dividend-focused investors would have missed the opportunity to invest in this company because Berkshire Hathaway does not give out any dividends.
Regardless, there are many different ways of wealth creation and I am sure some dividend investors do equally as well, especially those who focus on investing in the right business first and dividends, a distant second. When I bought my first apartment in KL (Kuala Lumpur), I was sold on the fact that the property will yield over 8% annually. In fact for the first two years, there was a guaranteed yield. Hence, I thought it was a no-brainer, so I signed on the dotted line. Years passed and hopefully, I am a little wiser now, although a little poorer from the experience. Yes, they gave me that 8% yield for the first two years, but after that the problem is, no one wanted to rent the apartment. In fact, I later found out that no one ever rented the apartment. It was all a marketing gimmick and everything was already factored into the price that I paid for! The actual rental was closer to 3% rather than the 8% quoted.
The lesson I have learnt is that yields are only good if these are guaranteed almost for life. There are companies that are monopolistic or have such a strong brand name, like Coca-Cola, that investors can be almost certain they will yield yearly dividends. However, there are not many of these companies around.
For most companies, they not only have to face competitive pressures but also a constant decline in the selling prices for their products, as the world flattens and countries where labour is much cheaper, like China and India, become the factories of the world. The only way to stay ahead is to constantly innovate and this increases the R&D expenses, putting added pressures on margins. Not many businesses can be assured of consistent profitability, which is the foundation for a consistent dividend payout.
It is because of this that I do not put too much value on dividends when I look at any company, unless of course, the company has a monopoly or has such a strong brand name that they can increase their pricing without affecting the demand. If a company does not produce enough positive cashflow to cover the dividend payment, the analogy may be very similar to the way I bought my apartment in KL. That is to say, it is an illusion.
If a company has a PE (price-earnings ratio) of 10 – and assuming that there is no creative accounting, and its cashflow is similar to its profits and it gives out 100% of these profits as dividends – then the dividend yield will be 10%. Is this company more ‘investible’ than a company that gives out a 1% dividend yield but has the same profitability? The answer to that shows why it really does not make sense to me to invest purely on the basis of dividend yields. Likewise, you should not buy a stock just because the stock is offering you a 5% yield. Your decision to buy the stock should be based on the fundamentals of the stock and not on the 5% yield ‘carrot’.
It surprises me to see so many stocks trying to place themselves in this so-called ‘defensive category’ that provide high dividend yields. But truly, dividend is just a subset of profit. If a company has a low PE (price-earnings ratio), it can theoretically give a high dividend yield. If it chooses not to do so because it wants to pump its profits back into its core business so that it can expand quicker, how can we as investors fault the management? Also, by dishing out dividends, companies and individual shareholders would have to share their gains with the taxman.
But are high dividend stocks truly defensive? If dividend is a subset of profits, and if the company cannot guarantee consistent profits and therefore cannot guarantee consistent dividends, where is the defensive quality of high dividend stocks?
If one truly wants a defensive stock, he must firstly be assured that not only is the dividend guaranteed but also that his capital will not be compromised. There is no point receiving 10% dividend when the stocks fall over 10% in value. By the time one pays the taxman, he truly is worse off, even though he may think otherwise.
If one wants dividends without risk to capital, one should be putting one’s money in the bank. Stocks will always come with risk to capital. Stocks are best measured by the PE ratio and not dividend yields, given that dividends are just a subset of PEs. I would rather put my money in a company with a low PE, but which is aggressively using its capital to expand its business, than to pretend to be getting better value from a stock that is giving higher dividends when compared to interest from banks. As stated, the key is whether your capital is at risk.
If you invest in stocks, you are primarily looking for capital appreciation. If there are good dividend yields, this is just a sweetener. You should not use sweeteners as the reason to invest in stocks because all stocks go up as well as down.
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Hi, Oldman
Yes, valuing intrinsic value can be very abstract. Your definition of intrinsic value is to me a "bao jiak" valuation, very stringent.
Besides looking at your definition of intrinsic value, PE< 5, do you look at dividend yield?
Cheers,
puregold
--------------------------
When we put money in a bank, we expect to get some interests on the money that we have deposited. Many use the same analogy and want to get dividends from their stocks as well. They feel that investing in stocks and shares is better than putting the same money in the bank because the dividend income is better than the interests from the bank and there is also upside in the capital gains when stock prices go up.
However, this thinking may be flawed as bank interests is, to all intents and purposes, risk free (unless of course, the bank collapses) whereas investing in stocks and shares will come with risks to your capital. Getting a dividend may make one feel better but in reality, it hides the important truth that you have now put your initial capital at risk. Your initial capital is usually many times the size of the dividend yield and hence, when you invest in stocks and shares, you should focus on the strength of its business rather than its dividend yield. A 30% collapse in the share price can more than wipe out six years of dividends even at a high 5% a year and assuming that the company can continue paying the dividend year after year.
In the past, businesses were relatively stable. One could predict with reasonable accuracy the company profits many years into the future. Nowadays, businesses are more dynamic as competition is now more intense as the world has become a global marketplace. It is not so easy to even predict the profitability of any business six months ahead, let alone years into the future.
If one is not able to predict future profitability, it will be difficult to be certain of the dividends from the company. If the company does not make sufficient money, or is losing money, it will be difficult for the company to continue its dividend policy. After all, dividends are usually a subset of profitability – i.e. companies cannot continue to give more in dividends than what they earn in profits – otherwise, they will be eating into their cash reserves. If companies fund dividends through their cash reserves, there will come a time when the cash will be depleted.
Hence, at the end of the day, dividends are closely related to profitability and when we invest in a company, we should invest in its profitability and not its dividend policy. For me, I look at the business first and if the company gives a good dividend, I am OK with this. But I do not go around looking for good dividend yields as the basis for my investing strategy because at the end of the day, we should invest in companies for their profit potential rather than their dividend policies.
If I were to ask you to put $100 with me and I will give you $5 return every year, would you rush to put $100 with me because of the $5 a year sweetener? The answer should be no as the $5 is just a carrot. The crux of the matter is still whether I have a sound business which warrants your investment of $100. Hence, for me, I do not let the $5 carrot dividend blur my main objective of investing. I invest in the company for its profits and not for its dividends. If the company’s profits increase, its share price is likely to follow and this then translates to a capital gain in my portfolio and maybe, some dividends will flow through as well.
Hence, no matter how we look at the issue, the primary reason we invest in stocks and shares should be for the capital gains as dividend income is just a small subset of our capital gains. Another way of putting it is that a small loss in the capital value of a stock may more than wipe out years of dividends from the same company. When a company makes money, it can either give out some of its profits as dividends or reinvest the money into the business. We should not fault management if they so desire to reinvest the money and not give out dividends.
In many parts of the world, when the company gives out dividends, this amount is taxable to the shareholder. Hence, management
may be better off reinvesting the money instead, especially if management can put the money to better use, like in the case of Berkshire Hathaway. Berkshire Hathaway only declared a dividend once in 1967 and Warren Buffett famously said that he must have been in the bathroom when that dividend was declared. Berkshire Hathaway never declared any dividend after that. Dividend-focused investors would have missed the opportunity to invest in this company because Berkshire Hathaway does not give out any dividends.
Regardless, there are many different ways of wealth creation and I am sure some dividend investors do equally as well, especially those who focus on investing in the right business first and dividends, a distant second. When I bought my first apartment in KL (Kuala Lumpur), I was sold on the fact that the property will yield over 8% annually. In fact for the first two years, there was a guaranteed yield. Hence, I thought it was a no-brainer, so I signed on the dotted line. Years passed and hopefully, I am a little wiser now, although a little poorer from the experience. Yes, they gave me that 8% yield for the first two years, but after that the problem is, no one wanted to rent the apartment. In fact, I later found out that no one ever rented the apartment. It was all a marketing gimmick and everything was already factored into the price that I paid for! The actual rental was closer to 3% rather than the 8% quoted.
The lesson I have learnt is that yields are only good if these are guaranteed almost for life. There are companies that are monopolistic or have such a strong brand name, like Coca-Cola, that investors can be almost certain they will yield yearly dividends. However, there are not many of these companies around.
For most companies, they not only have to face competitive pressures but also a constant decline in the selling prices for their products, as the world flattens and countries where labour is much cheaper, like China and India, become the factories of the world. The only way to stay ahead is to constantly innovate and this increases the R&D expenses, putting added pressures on margins. Not many businesses can be assured of consistent profitability, which is the foundation for a consistent dividend payout.
It is because of this that I do not put too much value on dividends when I look at any company, unless of course, the company has a monopoly or has such a strong brand name that they can increase their pricing without affecting the demand. If a company does not produce enough positive cashflow to cover the dividend payment, the analogy may be very similar to the way I bought my apartment in KL. That is to say, it is an illusion.
If a company has a PE (price-earnings ratio) of 10 – and assuming that there is no creative accounting, and its cashflow is similar to its profits and it gives out 100% of these profits as dividends – then the dividend yield will be 10%. Is this company more ‘investible’ than a company that gives out a 1% dividend yield but has the same profitability? The answer to that shows why it really does not make sense to me to invest purely on the basis of dividend yields. Likewise, you should not buy a stock just because the stock is offering you a 5% yield. Your decision to buy the stock should be based on the fundamentals of the stock and not on the 5% yield ‘carrot’.
It surprises me to see so many stocks trying to place themselves in this so-called ‘defensive category’ that provide high dividend yields. But truly, dividend is just a subset of profit. If a company has a low PE (price-earnings ratio), it can theoretically give a high dividend yield. If it chooses not to do so because it wants to pump its profits back into its core business so that it can expand quicker, how can we as investors fault the management? Also, by dishing out dividends, companies and individual shareholders would have to share their gains with the taxman.
But are high dividend stocks truly defensive? If dividend is a subset of profits, and if the company cannot guarantee consistent profits and therefore cannot guarantee consistent dividends, where is the defensive quality of high dividend stocks?
If one truly wants a defensive stock, he must firstly be assured that not only is the dividend guaranteed but also that his capital will not be compromised. There is no point receiving 10% dividend when the stocks fall over 10% in value. By the time one pays the taxman, he truly is worse off, even though he may think otherwise.
If one wants dividends without risk to capital, one should be putting one’s money in the bank. Stocks will always come with risk to capital. Stocks are best measured by the PE ratio and not dividend yields, given that dividends are just a subset of PEs. I would rather put my money in a company with a low PE, but which is aggressively using its capital to expand its business, than to pretend to be getting better value from a stock that is giving higher dividends when compared to interest from banks. As stated, the key is whether your capital is at risk.
If you invest in stocks, you are primarily looking for capital appreciation. If there are good dividend yields, this is just a sweetener. You should not use sweeteners as the reason to invest in stocks because all stocks go up as well as down.
----------------------------
Hi, Oldman
Yes, valuing intrinsic value can be very abstract. Your definition of intrinsic value is to me a "bao jiak" valuation, very stringent.
Besides looking at your definition of intrinsic value, PE< 5, do you look at dividend yield?
Cheers,
puregold