Dividend stocks or not? That is the question

The only thing that gives me pleasure is to see my dividend coming in.” –John D. Rockefeller

Dear Readers

When a company declares dividend to be payable, the share price of the company, on the ex-dividend date, will be adjusted down to take into account the anticipated dividend paid out.

For example, say Company A has declared a dividend of RM1.00. On the ex-dividend date, Company A’s opening shares price was RM10.00 and, when all things being equal, the share price of RM10.00 would be adjusted down to RM9.00 because of the eventual payout of RM1.00 dividend. The market capitalisation of Company A would also be reduced pro rata to the dividend payable.

However, on the ex-dividend date, market forces would still be influencing the price of Company A’s shares throughout the trading day. And at the end of the trading day, Company A’s share price could even be higher or lower than RM9.00. Your guess is as good as mine.

Now, to address the aged-old conundrum – if the share price of a dividend-paying company would be adjusted, why bother receiving dividends in the first place?

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As with everyone, I can only offer my opinion on this matter. But before I elaborate, my stance on dividend is that it is good and I would gladly accept it.

So, why is dividend good?

Strong fundamentals

A successful company is a company which brings in the cold hard cash (not profit on the profit and loss sheet). This view is shared the greatest investor of all time, Warren Buffett.

A declaration of dividend is an indication that the company is sitting on an excess cash that it does not need. After all, the law requires that dividend must only be payable out of profits of company. Hence, the payment of dividends itself is a validation that a company is making a profitable business due to many non-exhaustive positive factors such as prudent management, high profit margin, cost consciousness, sought after products, or strong balance sheet and etc.

Keeping profits

From an investment standpoint, every time a dividend is declared, you are getting a return of a certain portion of your investment. For example, if a company’s dividend yield is 10% per annum (grossly exaggerated..obviously), you’ll be expecting to get a complete return of your investment in 10 years’ time. Whatever obtained after that, if any, is purely profit. As for any investment, money in your pocket is what really matters. Also money received now, is more valuable than money received later, especially in an economy which experiences inflation.

On the other hand, an investment strategy, seeking to profit solely from capital appreciation of share (profit on paper), is uncertain. A profit is only made after your have sold your shareholding.

Risk mitigation

But say if the same company above went bust in 5 years’ time, at least you would have only lost 50% (5 years x 10% dividend yield per annum) of your investment because you would have already recuperated the other 50% though the receipt of dividend.

Therefore, in theory, dividend payments can be used to mitigate investment risks.

Compounding effect

Dividend also allows you to apply reinvestment strategies to achieve a compounding effect on your investment. Remember, compounding interest means obtaining interest on interest. The same is true for dividend as more returns can be obtained down the road when dividends are reinvested into the same company, or other ventures.

However, I wouldn’t recommend reinvesting dividends into the same company where the valuation of the company’s share has become pricey. You should treat the reinvestment of dividend, as you would, as if you would be investing in the company for the very first time – if the price is too pricey, just move along.

The disadvantages of paying dividends

So, before you decide to hop on the dividend bandwagon, there are some notable negatives in paying out dividends of which you should be aware.

Paying out dividends may not be in the best interest of a growing company as the company may have very little internal funds and may instead resort to borrowing to fund its expansion programme.

A company which constantly pays dividends may attract dividend investors but when dividend pay out becomes erratic, or reduced, then the same dividend investors may make a quick exit as they find the company becoming less appealing. This, in turn, may cause the company’s share price to slum.

Conclusion

If you, as an investor, are confident in your ability to achieve better returns by reallocating dividends to fund other investments, then you could consider holding a substantial portion of your portfolio, in dividend paying shares, as with Warren Buffett.

But the irony is that Berkshire Hathaway Inc, Buffett’s investment vehicle, does not pay dividend and is sitting on USD160 billion, in cash and treasury bonds.

Probably he believes that no one does investing better than him. I tend to believe so too.

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