Dividend Shares – Read this Before Investing
Dividend shares are a way for companies to distribute revenue back to investors.
On the face of it, dividend shares sound great. They provide income like rental property without all the hassle that goes with renting out property.
Real money paid into your account on a quarterly basis. How good does that sound?
Normally, when you invest, you don’t realize any profits until the point at which you sell. In other words, you are dealing with paper profits which can evaporate before your eyes in a bear market or crash.
If you are lucky your shares might just increase in value, but even if that is the case the only way you’ll realize any profits is by selling them and losing your ownership stake in the company.
Hard cash
Dividend shares work differently. They pay out hard cash, that you can use at your leisure. Spend or reinvest, it’s entirely up to you.
You also retain your ownership stake in the business. No need to sell if you don’t want to.
Another bonus with dividends is they tend to keep pace with inflation.
For all these reasons dividend shares tend to hold their value better when markets go down.
As a result, lots of investors swear by dividend shares. They think dividend shares offer protection. If the stock price goes down and you still get your dividend you are essentially being paid to wait for the stock price to recover.
When I first got into investing, I loved the idea of dividend shares.
I saw them like rental property. You buy a share like you buy a house, it goes up in value, but at the same time, it provides you with income through dividends like rent.
In fact, I was thinking about borrowing money to invest in dividend shares, in just the same way you borrow money to buy rental property.
As long as your dividends are greater than your loan repayments you should be laughing.
What’s not to like?
On paper it all sounds good, but as with anything in life things aren’t always what they seem.
Borrowing to invest
The first point to make is that my original idea about borrowing to invest in dividend stocks isn’t such a good one when you get into it.
Essentially, borrowing to invest in shares doesn’t work like borrowing to invest in houses.
If you could get a 30 year loan at a really low fixed interest rate like you can when buying houses, it might be worth thinking about, but as far as I know, it’s near impossible to get long term loans at decent rates to invest in shares.
Most investors are only going to have access to margin accounts and they don’t work like mortgages at all.
You can read more about borrowing money to invest (using leverage) and margin accounts here, but to cut a long story shot, borrowing to invest in shares isn’t a good idea for most investors.
Dividend yield reduction
There’s no law that says a company can’t reduce or eliminate its dividend. Dividends are a way for companies to distribute their profits back to shareholders.
If profits go down or become non-existent dividends are quite likely to follow the same pattern.
In other words, just because a company pays a dividend now doesn’t mean they will in the future and even if they maintain it nothing is stopping them from reducing it.
High dividend yields don’t tell the whole story
A high dividend yield doesn’t tell the whole story either. Investment returns come from a combination of capital gain and income distributions. The dividend yield is a part of this, but capital gain is just as important, if not more so.
Lots of great companies that have grown their share price double digits annually don’t even pay dividends, and similarly, lots of companies whose share price actually goes down, pay good dividends.
Think about it this way, if a company’s stock gets hammered and they keep paying the dividend, the yield on the dividend will go up.
And a company’s stock price getting reduced, may be an indication that there are some issues with the company.
In all likelihood issues are going to equate to money problems, and money problems will probably lead companies to reduce if not stop their dividends altogether.
I’m not saying all high yield dividends are a bad sign, but some of them definitely will be. Put it this way, you need to do your homework.
When I see dividend shares that yield high single digits alarm bells start ringing!
Old-line industry
The vast majority of dividend shares are from companies in the utilities and old-line industrial sectors. Tobacco companies pay generous dividends. Take Imperial Brands, which currently has a dividend yield of 9% for example.
Alternatively, the bulk of faster growing smaller companies and many in the tech sector don’t pay dividends at all.
In general, companies paying dividend shares produce less price appreciation than other types of stocks.
Somebody focusing on dividend stocks at the expense of tech may be doing themselves a disservice.
Investor pacification
Company management can use the dividend as a way to pacify investors. Let me explain.
If the company continues to pay a high dividend, investors may turn a blind eye to bad management decisions or maybe not even concern themselves with what the management of the company is doing at all.
As long as the dividends keep appearing in your brokerage account what’s to worry about? ………..until the day you don’t receive a dividend because the company has gone bankrupt and your shares are totally worthless!
Tax
Dividend shares aren’t tax efficient quite simply because you need to pay tax on them. Perhaps, even more so if you invest in international shares.
People who need to reduce their tax liabilities may want to look for alternatives.
And lucky there is one. Dividends aren’t the only way companies can pass some profits to their shareholders.
Another option for companies to return value to shareholders is through the purchase of their own stock. That way as an investor you get the increased value without the tax liabilities.
When companies buy their own stock they essentially reduce the number of shares of the company, which usually increases the earnings per share and stock price accordingly.
Shareholders don’t actually get anything paid directly like with a dividend, but their investments will have gone up in value instead.
No option
One way of looking at dividends is that it shows the company hasn’t got anything better to do with their money. At the end of the day, when a company pays out a dividend, it is basically cheapening its own stock by the price of the dividend.
When you invest in companies you are essentially handing your money over to them, because you expect they can grow your money better than you can do it yourself. If they give it back to you, they are admitting that they can’t.
Instead of repaying that money to shareholders, it would be better if the company reinvested the money in the company, to grow, improve efficiency and improve or create new products and services.
The bottom line
When a company pays out a dividend, it is basically cheapening its own stock by the price of the dividend.
Additionally, investors pay income tax on this dividend, so those investors with higher tax liabilities might be better if they avoid dividends altogether.
Companies that do stock buy backs are a great alternative, because these increase the price of shares without these tax issues.
We’ve covered a lot of the negative aspects of dividend investing, but that doesn’t mean they are unsuitable for everyone.
In fact, if you know what you are doing investing in dividends may make sense. There are plenty of companies out there that pay dividends and are still growing.
Being aware of the pitfalls, doing some research, and being able to hold dividend shares in a tax sheltered account like an ISA will all tilt the odds in your favor.
