Dividends aren’t the only way a stock investor can generate income.
Investors often see dividends as a way to generate income. But dividend strategies are not the only way to produce cash, and investors should be aware of the potential trade-offs that accompany a focus on dividends.
For stockholders who own dividend-paying shares, those payments arrive on a schedule (quarterly, in many cases). The cash to fund a dividend must come from somewhere, however. We know the price of a stock is potentially influenced by all expected future cash flows to shareholders. If cash is paid today in the form of a dividend, the stock price—and total market capitalization—of the issuing company may therefore fall, as the hypothetical Portfolio A in Exhibit 1 shows. That means, all else being equal, an investor who receives a dividend may also be left with a less valuable equity holding.
An alternative method of raising cash is to simply sell shares. Exhibit 1 compares the two methods of generating income by contrasting Portfolio A with the similarly valued hypothetical Portfolio B. While Portfolio A receives income through a dividend payout, Portfolio B generates it through a stock sale.
The investor in Portfolio A, in which a dividend is issued, ends up holding the same number of shares as were held prior to the dividend payout, but we assume that those shares have declined in value. The investor in Portfolio B holds a reduced number of shares that haven’t seen their value decrease as a result of a dividend payout. The two approaches arrive at the same place—both investors end up with $100 in cash and $1,900 in stock, notwithstanding potential trading costs or tax implications. But there are potential downsides to the dividend approach when contrasted with the stock-sale approach.
First, the average proportion of firms paying dividends in the US was about 52% from 1963 through 2019,1 meaning an investor focusing only on those stocks is missing out on nearly half of investible US companies. A second consideration is that a dividend’s value, while not subject to the same degree of fluctuation as a stock price, isn’t guaranteed. Just 10 years ago, more than half of dividend-paying firms cut or eliminated those payouts following the financial crisis.2 More recently, a company that had consistently paid dividends for more than a century, General Electric, slashed its payout to just one cent a share,3 and the UK’s Vodafone Group cut its full-year dividend for the first time in two decades.4 Thirdly, investors may give up flexibility in terms of the timing and the size of the payout when they rely on company-issued dividends. With stock sales, an investor determines the amount and schedule of the income.
When considering an investment, it is also important to assess total return, which accounts for capital appreciation (or loss) alongside dividend income. High dividend yields may not lead to high total returns.
Exhibit 2 plots the trailing 12-month returns of Index constituents as of December 31, 2019, with each dot representing a company. It’s clear that companies with greater dividend yields, the dots located higher up the vertical axis, weren’t consistently those with a higher total return over that period. Income generation may be a priority for some investors, but other important investment considerations, such as diversification and flexibility, needn’t fall victim to that aim. While the use of stock sales instead of dividends to create cash flow may involve trading costs and tax considerations, those concerns may be offset by the benefits of investing in companies that don’t currently pay dividends. An approach focused on income derived through dividends may not be the most desirable choice when weighing broader investment goals.