Why High Dividend Stocks Suck
Picture the scene, you’re lying on a beach, the sky is blue, the sun is out. You take a sip of a nice cool Pina Colada. The sound of the waves crashing down on the rocks in the distance is briefly interrupted by the bleep of your laptop. You receive a message from your bank informing you of your latest dividend payment. That should more than cover your expenses until the next one arrives. Just like having a job and getting a salary but without the work part. I mean, does life get any better than this?
And let’s be honest high dividend stocks seem like a great investment right now. Compared to bank accounts paying 0% and bonds paying 1%, high dividend stocks look more than a little appealing.
But and it is a big but, there are a couple of major problems with dividends.
The first one is taxes. Yes you may be able to put your high dividend stocks in a tax sheltered account (ISA for UK investors) and UK residents may be eligible for dividend and personal allowances, but this only deals with UK income tax. And that isn’t the only tax you need to pay. There is another pesky devil called withholding tax that’s something that neither ISAs or personal allowances can shield you from.
These are taxes that are levied on the dividends of foreign shares. (If you don’t have any foreign shares in your portfolio it might be worth reading Investing Demystified where Lars Kroijer puts across a pretty convincing argument for why you should).
Different countries withhold different amounts. Usually about 30%, but not always. For example a US-UK tax treaty will reduce withholding tax on your dividends from 30% to 15% if you are eligible i.e. a UK resident. But even then you are still paying 15% tax and there is an alternative: Non-high dividend stocks!
As the saying goes, if there ain’t no dividend there ain’t no dividend tax. Dividend bugs will be shocked by the very thought, struggling to comprehend getting buy without any income, but if you really want income just sell some of your shares.
These days selling shares is as easy as a couple of mouse clicks. Shares in a tax sheltered ISA wouldn’t be liable for capital gains tax and expats don’t pay UK capital gains on the sale of shares in the UK anyway.
In one fell swoop, the dividend tax problem evaporates. You simply sell as many shares as you need.
And if you are not convinced by the tax aspect, how about the fact that there is an argument that dividends are a sign of a weak company. That’s because dividends are essentially money that could’ve been used to make a business better.
You see a good company wants to use as much money as they can to grow, and that means not giving it to people like me in the form of dividends. Instead, they should be looking at reinvesting the money to open new stores, or bring out new products, or even invest in new businesses.
The bottomline is the company should be able to get a better return on that money than I could. Either by investing it in their own business or by investing it elsewhere.
By paying me a dividend the company is basically saying little old me knows how to use this money better than they do, which is clearly not a good sign.
The likes of Amazon, Facebook and Alphabet don’t even pay a dividend. Why would they when they have all sorts of exiting ways to get a better return on money than I ever could. And by constantly reinvesting money in their own businesses these companies have been able to grow at phenomenal rates, which translates into share price growth and better returns for investors.
Think about is this way, when a company pays out a dividend they are effectively devaluing the company by whatever amount they pay out and in turn they are devaluing the price of their shares by an equivalent amount.
When people try to figure out how much a company is worth they include how much cash a company has got in their calculations. So it goes without saying that less cash equals a lower value.
Let’s say a company is worth £10 million and it has one million shares. Each share is worth £10, but then the company pays out £1 dividend, so each share is suddenly only worth £9 and in turn the company gets a new value of £9 million.
In reality it is a bit more complicated than that, but you get the idea. For most investors dividend payments aren’t necessarily a good thing.
At this point, it is also worth mentioning that high dividend stocks can also be an indicator of a struggling company. Investors often get seduced by high dividend yields, but often, these yields are high for a reason. Most likely because the company has run into trouble.
If a company’s share price is £20 and they pay out a £1 dividend, the yield is a not to be sniffed at 5%. But what if the company hits a snag and the share price drops 50%, but continues to pay out the same dividend. All of a sudden the yield is a whopping 10%. On paper a high dividend yield looks great, but in reality it is often a warning sign that things aren’t quite right, and worse still could precede a company going bankrupt.
Just to be clear, this doesn’t mean you should totally avoid high dividend stocks, lots of really good companies pay dividends, it just means you shouldn’t use a dividend as the only reason to invest in a company.
