Don’t Overvalue Dividends

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My advisory firm is a big fan of stocks that pay dividends. Segment's tax-efficient rising dividend portfolio is our most popular strategy. But if you dig into the numbers, the dividends our holdings pay are not huge. This is because we manage for total return, not maximum cash flow.

We buy stocks with a mind toward dividend sustainability and a history of payment hikes. This contrasts with normal bias toward dividend shopping, where one would simply buy the highest-yielding companies as though nothing else mattered.

This bias manifests in conversations where a client needs some extra cash but then says, "Don't sell that one because it pays me $6,000 per quarter."

It may seem obvious, but everyone needs reminding that dividend cash comes from somewhere. Follow the math with me here. Let's say there are two oil companies with nearly identical business metrics. They operate in the same fields and have similar exploration budgets, etc. One pays a 6% dividend, and the other company pays nothing. All things being equal, over time, that non-dividend payer's share price would likely outgrow the dividend payer's price. It's simple math; the cash that didn't get paid out as dividends now resides in the company's financials instead, and will eventually make its way into the share price. That non-payer probably has better financials, pays its invoices sooner, has less debt, borrows more cheaply, and negotiates better terms with suppliers. That is how the stock price might average a 10% bonus to return, not merely the retention of the 6%.

There are also investor tax benefits to capital accumulation in the form of those retained earnings. While the distributed cash of a dividend does have the benefit of a low maximum tax rate of 23.8% currently, that value could instead be an unrealized (untaxed) gain if retained.

There are numerous strategies to maximize the value of that type of gain, many of which render it tax free or tax deferred. This is why the billionaire Warren Buffett does not allow his flagship holding, Berkshire Hathaway, to pay a dividend. Buffett does not want a personal annual tax bill of $500 million in distributed income he will never spend. He would much rather it pile up as capital gain, and so should you.

Let me be clear that I am not shunning dividends. On the contrary, they can be a fantastic attribute of investing, and I own the segment tax-efficient rising dividend strategy with my own money. I'm simply warning against letting the tail wag the dog.

Gil Baumgarten, president of Segment Wealth Management, is a 36-year veteran of the investment industry. In 2010, Gil made a break from the brokerage world to start Segment, a fiduciary firm where the interests of the client and the firm could align. He is a multi-year recipient of the Top 1,200 Financial Advisors in America distinction by Barron’s and is a newly published author. His first book launched in May 2021 titled, FOOLISH: How Investors Get Worked Up and Worked Over by the System.