Why are Dividends your Friends?

The buying and selling of dividend paying stocks is worldwide very popular. A dividend payment is, mostly periodical, a payment from the company to it's current shareholders. This dividend payment is a reward for the investors who take the risks of investing in the company. Most of the times this is done 1 x per year. But in the US this frequency is higher. The ex dividend day is the day the investor has to owe the shares in order to be entitled to receive the dividends.

In case the Heineken share is now trading at USD 30 and will pay 1 dollar dividend next week, then normally at the ex dividend date the share drops 1 dollar. Investors living in the Netherlands can visit the Dutch website Analist.nl with all about dividends. So, the investors who owned the shares on the ex-dividend date will receive the dividends. The investors who didn't own the share at the ex-dividend date will not receive it. So it doesn't matter: you can buy the share prior the ex dividend date and the price drops, or you buy it after the dividend date for the lower price. We already hear it you thinking, what is the case to buy dividend paying stocks anyway? Buying dividends on the short term doesn't make a difference at all.

The reason for it is information about dividends is most of the times very well processed by the markets (market efficiency). Higher or lower dividends are totally not relevant as the markets discount this information.

Why we prefer dividend stocks

What are the reasons we prefer to have dividend paying stocks? When looking back at the longer history we see quite a huge outperformance by the dividend paying companies versus the companies that didn't pay out dividends.

The fact that companies are able to pay out dividends can be seen as a quality variable. Normally speaking we could say that non-dividend companies have a lower quality. The fact that companies can payout dividends can be seen as quality indicator.

Of course this is very short sighted as there are many other variables that influence the company's quality (read: under- or overpricing). When we look at the short term we don't see any differences between the dividend paying and non dividend paying companies. But when we look at the long term we see higher total returns (price returns + dividend returns) for the companies that paid out dividends. This is mostly cause by the interest-effect. This is an exponential effect caused by the re-investing of dividends. This creates a kind of snowball effect.

You can see it like a young tree that gives more apples after the time passes. This compounding effect was called the world's 8th world wonder (by Albert Einstein). Well known dividend investors are T. Boone Pickens, Dennis Gartman and John D. Rockefeller.

Dividend taxes

Dividend tax is the part that is kept by the governments. Mostly investors can restitute a part of this back. One of the reasons for taxing dividends separately is to prevent tax avoidance: in a system without dividend taxes it is possible to have money streams via the dividend payments in order to avoid the income taxes. For foreign investors it's mostly only interesting to try to restitute all of the dividend taxes as the cost of restituting it are very high.

This is caused by the very high administrative costs which are normally way higher for the general investor than the withheld dividend taxes. Normally the breakeven point is around 250 dollars. This means in case your withheld dividend taxes are less then 250 dollars it makes no sense of claiming it back.

Dividends vary

Dividends are never stable and vary throughout the time. Companies can easily announce to stop paying dividends to it's shareholders. These insecurities almost always have big impacts on the share price.

When a company says it will decrease her dividend we almost always see direct responses at the financial markets. Of course this is because that current shareholders will earn less (they receive less or no dividends). So in case there are dividend adjustments we almost always see this back at the stock and option exchanges (in case options are listed on the share).

Watch out for the value trap

The investing based on a dividend strategy is all but an easy strategy. Historical dividends are just historical data and hardly say something about the future. This also because of the market efficiencies. For investors is absolutely relevant to focus further than just the dividend yield in order to avoid the value trap.

The focus on just high dividends could probably end up in a portfolio with low quality companies. It's crucial that investors have a total picture of a company's most relevant financial variables. Can the company afford to pay out the dividend is the big question.

Relevant financial variables that influence the company's financial position are the cash position, solvency, profitability, cash flows etcetera. All of these variables are itself also unpredictable so it's very hard to estimate the stability of a company's dividends.

The risks of too attractive dividends

Of course it's very logical just to hunt for the companies that pay out the highest dividends but it's not that easy. A dividend yield of let's say 6 percent is very rare and also quite dangerous. Bells should ring now. With this we mean that the effective dividend yield is way too high: either the dividend per share is too high or the stock price is just too low.

Both are possible but in the financial markets you never know it. There are lots of examples of famous companies that had high expected dividends but needed to lower or even stop them and got bankrupt.

Think of for example BankUnited Financial, General Motors and Global Crossing. Most of these shares had very high expected dividends and so extreme dividend yields. But when these dividends per share were lowered or even stopped the stocks crashed. And for most of them even further crashed after announcing the redemptions of the dividends.

The height of the expected dividend per share is nothing more then the consensus of the analysts. Of course companies also provide news about their future dividends but the current shareholders always need to agree with that at the general stockholders meetings. But in practice we rarely see it happen that current shareholders propose a lower dividend per share.

Returns USD 100 invested in European Dividend aristocrats

Dividend Aristocrats

Dividend Aristocrats are these companies that always have raised their dividends each year in their history. Of course this total number is getting smaller and smaller each year. Famous dividend aristocrats are Hormel Foods, CR Bard and Bernis.

The returns of most of these companies had been magnificent in history. This is partly caused by the interest effect (the re-investing of received dividends). But please don't focus too much on this.

These are just past figures, performances, returns, data etcetera and don't tell us much about the future. In the end there is no company that can ever keep on rasing her dividend. So forever rising dividends are a fairy tale. But the Dividend Aristocrats's long term performance clearly points out the positive effects of the re-investing of dividends.