Nothing seems to attract investors so much as high dividend yields and their reinvestment. For some years now dividends have become the „new interest income“ among institutional investors. Individual investors have also discovered dividends and have been blogging about everything to do with „dividends as a second source of income“. There has been an explosion in the number of dividend blogs. Moreover, on websites, investors often only buy those stocks which pay the highest dividends. Many investors hardly bother with a fundamental analysis of the companies in question. A broad spread across 50 stocks or more aims to protect from risk. Special stocks (e.g. American master limited partnerships) or stocks which pay a tax-free dividend are often added to portfolios without any previous checks.
Much as we welcome the fact that German investors are now also investing more in equities as part of building up a pension pot, shareholders should rid themselves of the notion that dividend payouts are a panacea in investment. We list a number of reasons below why investors should not focus solely on the level of the dividend yield:
– Dividend payouts are not reliable, above all in times of recession
Widespread dividend cuts usually happen during an economic downturn. How extensive can these cuts be? A review of recessions in Germany in 1983, 1993, 2003 and 2010 gives an initial indication. Around these periods of economic weakness, earnings estimates for DAX companies fell by an average of 44%. Companies were especially hard hit in the last downturn. During this period, earnings forecasts were reduced by 72%. Dividend payouts were also cut during the recessions, on average by a quarter (ref. graph).
– Dividends are taxable which reduces the interest effect
Dividends are part of a company’s taxable profits and investors are liable to taxation on dividends before reinvestment into new shares. The precise tax rate depends on where the shareholder is domiciled. Individual investors in Germany pay a withholding tax of 25%, plus a solidarity tax (5.5%) and church tax, if applicable. Investors are therefore taxed 26.9% or more, so that 1 euro in gross dividend only leaves 73 cents which can be reinvested. Investment capital multiplies considerably faster if companies do not distribute their profits, but rather are able to reinvest them in their own business at an average (or even above-average) return on investment. Here the second taxation level does not apply.
– Dividends are inferior to share buybacks
Companies with substantial free cash flows cannot do their shareholders a bigger favour than buy back their own shares. There are companies for which share buybacks are firmly anchored in the corporate culture. These include blue chips such as IBM, which has bought back just under 60% of its shares in the last 25 years, Coca Cola (27%) or American Express (25%). One criticism: as far as share buybacks are concerned, Germany is still a developing country: very few companies have been using this tool successfully for a long time.
– Dividend income reinvested at market price
If dividends received and taxed are immediately reinvested to buy new shares, then investors are buying the shares at the current share price. If the price is too expensive, then over the long term, investors have got a bad deal.
– Most companies are not reliable dividend payers − they have not been in existence long enough
For every company which is visibly successful at present (e.g. Apple and Samsung with Smartphones), there is always a “graveyard” of companies who have fallen by the wayside (e.g. Blackberry, Nokia, Siemens/BenQ, SonyEriccson, Palm). Over the long term, companies which are unable to stand out from the competition through a lasting competitive advantage (for example brand names, cost leadership, licences/patents/ rights, network effects), become sidelined through the market entry of new competitors and the subsequent competition. Most companies in the world have no lasting competitive advantage. For this reason, in the long run, a company with a competitive edge but only a low dividend yield is far superior to a company without competitive edge but with a high dividend yield.
In light of these risks, investors should not bet blindly on stocks with the highest dividend yields; instead, they should pay far more attention to whether that company can generate an average return on investment. A fundamental analysis of the business model and analysis of the competition is still essential for long-term dividend investments, just as it is essential to find out whether the balance sheet will ensure the sustainability of the dividend payouts.