Investing for income – known as dividend investing when applied in the stock market – is a strategy that involves investing for yield while planning not to access the capital. Often it entails a preference for high income yields. But necessarily so. Dividend investing may also entail buying stocks that can grow the dividends they pay out over time. Either way, the underlying motivation is investing to capture an income stream.[1]
Income investing can be popular among wealthier individuals. It is often considered suitable for retirees, including parts of the super industry, on the basis that the aim during retirement is to generate ‘income’ to live on.
Does the strategy make sense? There are arguments on both sides, and no definitive answer. The discussion here focuses on dividend investing as a case study.
Arguments in support of dividend investing
- When investing for long term, only the income matters – Holding a stock indefinitely means the entire ‘return’ comprises the dividend income received. Meanwhile, the share price in the interim may be viewed as largely irrelevant. Adopting this mindset can have behavioural benefits. Specifically, it supports the investor to look through market ‘noise’ and price volatility and encourages them to stay the course and not sell out in response to market declines.
- Limiting the costs of investing – Holding stocks indefinitely to collect the dividends reduces the cost of investing through minimising transaction costs and potentially capital gains tax (CGT).
- Capturing franking credits – Franking credits can provide a ‘return bonus’ to the extent that franking is not ‘priced’, i.e. embedded in share prices and hence lower dividend yields and expected returns. The consensus from the academic literature is that franking credits are partially priced at best.
- Evidence that higher payout ratios are associated with higher earnings growth – Research finds that higher payout ratios (i.e. percentage of earnings paid out as dividends) have historically been associated with higher rather than lower earnings growth as might be expected. This implies that investing in stocks that pay generous dividends offers the potential to generate higher total returns[2].
Arguments that question dividend investing
- The source of returns is secondary – Wealth generation depends on total return: whether this arises from dividends or capital gains is of limited consequence. Money for spending can be either taken as income or by selling some shares. One modest caveat is that the equivalence may be disrupted by differential tax rates on income versus capital and transaction costs. (Note: The tax impacts are complex.)
- Dubious strategy for retirement – If the aim is to convert savings into retirement income support of spending during retirement, then dividend investing becomes quite dubious. Only spending the dividends received and not drawing down on the capital guarantees not fully utilising the savings. Worse still, if earnings and dividends rise over time then retirement income will grow. This pattern grates against the propensity for many retirees to decrease spending at older ages. (A caveat here is that retaining and growing capital may be appropriate if the aim is to leave a large bequest.)
- ‘Never need to sell’ mentality not necessarily beneficial – Adopting a stance of focusing on income while intending to never sell only works if the rationale for holding a stock is enduring. It can work if a blue-chip or growth company can be found that survives and continues to prosper – although finding such stocks is easier said than done. A more important issue is that share price after purchase is not necessarily irrelevant. Dividend yields and expected returns constantly recalibrate as prices fluctuate. If the stock rises too high and the dividend yield decline, it may make sense to sell and redeploy the capital into better opportunities.
- High dividends yields can be warning sign – High dividend yields may be a sign of unsustainability, i.e. a ‘dividend trap’. Dividends can also be generated by financial engineering, e.g. paying dividends out of capital rather than earnings. For example, a company could raise unneeded equity capital or borrowing to pay a higher dividend, but is essentially distributing capital not income.
- The game may have changed for franking credits – Many Australian stocks appear highly valued versus their global counterparts (e.g. the banks). This might be a signal that franking credits may have become fully priced.
No substitute for investment fundamentals
What really matters for generating returns is investment fundamentals, rather than whether the returns come in the form of dividends or capital gains. For instance, a company paying out a large portion of their earnings as dividends may be a signal of either capital discipline or an absence of growth opportunities. Conversely, retaining a large portion of earnings could reflect attractive growth potential or reluctance to return capital to shareholder even though it cannot be invested productively. Distinguishing which of such possibilities might apply matters more than the dividend itself. In general, the capacity of a company to create, or at the very least maintain, shareholder value is likely to be the primary determinant of whether a stock can generate good long-term returns for investors.
Also, a ‘never sell’ mindset can lead to ignoring signs of a fundamental change in a company’s capacity to create value. And it can also carry an investor all the way through into a bubble and out the other side, thus missing the opportunity to redeploy the capital elsewhere on more attractive terms.
So … does dividend investing make sense?
There is no definitive answer to this question. Dividend investing might work for some investors, most notably wealth accumulators with very long horizons that may benefit from making investment income the focus. The main suggestion for such investors is to pay attention to investment fundamentals and the price paid for the income, and not just adopt a ‘never sell’ mindset. Meanwhile, dividend (i.e. income) investing seems a poor idea in retirement, unless the aim is to leave a large bequest. Basically, it all depends.
[1] Here are links to a few articles that pursue this line of thinking: Warren Buffett hates dividends: These charts and ASX 200 stocks make the case for dividend investing; https://www.firstlinks.com.au/an-alternative-asset-class-for-income-seeking-retirees; https://www.firstlinks.com.au/thornhill-living-investment-income-retirement
[2] The evidence on whether high returns are also generated is more mixed. Also, whether the rise of the magnificent seven US tech stocks may change the conclusions is an interesting question.
Geoff Warren is a Research Fellow with The Conexus Institute, and an Honorary Associate Professor at the Australian National University.