Last Updated on 12, April 2014
I read an article which recommends buying high dividend yield stocks in times of crisis like this. As I read, I recall that I have many clients whose personal portfolios exceeding six figures are all invested in high dividend yield stocks. Needless the say, these portfolios were dangerously concentrated. Here are some points to note before you invest in high dividend yield stocks:
High dividend yield stocks are low or no growth stocks
Why is this so? As a large part of cash is distributed back to shareholders, little amount is left for the company to reinvest in existing and new projects. If the earnings growth is going to be low or none at all, it means there is little room for capital appreciation.
Instead of looking at dividend yield investing, investors should always consider the total return – which is the sum of capital gain and dividends collected. It is incorrect to focus on dividends but ignoring the capital gains. If there are two companies both of which are able to give a total return of 8% but one gives out more dividends (thus less capital gain) as compared to the other, it is better to invest in the company that is able provide a higher capital gain (but lower dividends) – assuming all other things are equal. Assuming the company is not involved in any fraud and is profitable, the company that pays low dividends is able to reinvest in profitable projects. On the other hand, shareholders who receive dividends must reinvest in other companies on their own. But this tends to be expensive and time consuming for the ordinary retail investors.
"A bird in the hand is worth two in the bush"
Some people felt that “a bird in the hand is worth two in the bush”. Thus, it is better to receive dividends than to enjoy capital gains. Many investors fear that the companies which they invest may be mismanaged and thus it is better to get cash out than to enjoy a paper gain.
I agree that such risks cannot be ignored. Just look at the Singapore S-chip companies, they are a disgraced to Singapore’s good reputation. Nevertheless, such non-systematic risks can be completely eliminated through diversification. The issue of non-systematic risk should be address at the portfolio level. It incorrect to manage non-systematic risk at the stock level by demanding high dividends after all non-systematic risk can never be removed at the stock level. Moreover, this “bird in the hand” approach is related to a human bias called ‘Self-Control’ which is well documented in behavior finance. Such a bias behavior tends to produce non-optimal decision making process. For example, investors would totally exclude investing in growth stocks if the only goal is to invest in companies that pay good dividends. Under dividend yield investing, you would never have invested in Microsoft which did not pay any dividends until 2003.
Tax implication in dividend yield play
Singapore investors need to be aware of the tax implication if they are looking to invest in high dividend yield investments. In Singapore’s context, dividends paid by Singapore listed companies are not taxable in the hands of investors. This does not means there is no tax to pay as the company has already paid its corporate tax. Therefore, there is no tax difference whether the total return comes mainly from capital gains or dividends. However, in other countries, tax could be imposed both on dividends received and capital gains. If the effective tax on dividends is lower than capital gain, naturally it is more beneficial to invest in high dividend paying stocks as far as the post-tax return is concerned.
Many Singapore investors who read investment literature written in foreign context are often confused by this and thus they are easily misguided. Due to the prevalence use of the Internet, many investors are able to invest in securities listed in foreign exchanges. The tax implication becomes even more important to the extend it is possible to overpay more than 20% in the stock price.
I read in someone’s blog that he or she invests in a high dividend yield counter listed on the New York Stock Exchange. This is unwise as he or she will suffer a whopping withholding tax of 30% while an American investor would pay a lower tax. Do not underestimate this withholding tax. To illustrate the impact of this withholding tax, let’s use the famous Gordon constant growth model which state that the value of a security is D(1+g)/(r-g). Let’s say the American investor pays an income tax of 10% while the Singapore investor pays 30% due to the withholding tax on dividends. The values of the stock to both investors are significantly different. To the American, the value of the stock is D*0.9(1+g)/(r-g). But to the Singapore investor, the value is D*0.7(1+g)/(r-g). Let’s say the American investor sells this stock to the Singapore investor. By definition, there is only one transaction price called P. Let’s say the American sells his stock at the fair value (from his point of view it is P=D*0.9(1+g)/(r-g) ), the Singapore investor ends up overpaying for the stock by a whopping 0.9/0.7 – 1 = 28.6%! Note that this overpayment is based on the investment capital! If you had invested $100,000 in high dividend yield stocks in such a jurisdiction like NYSE, you could end up overpaying by more than $22,000!
I helped some of my high networth clients in international investments. Tax consideration is highly important as it can affect the overall return. Make sure your financial adviser know something about taxes.
Dividend yield investing has a tendency to result in concentrated portfolios. Known asset classes that tend to give our cash flows to investors are like Real Estate Investment Trust (REITs). I have seen clients who invested almost everything in REITs. One of the myths about REITs is that it is ‘safe.’
Far from safe, many REITs are known to be highly leveraged. Sometime, one wonders whether their dividends are paid out from income or from borrowings. In addition, the short-term financing of REITs tend to increase the risk of the trust not able to obtain attractive refinancing resulting it seeking refinancing in the equity capital markets via share issuance. This is often not the best interest because the cost of capital from equity market is the most expensive form of financing. In the worst case scenario of not able to obtain refinancing, it has to default which is the last thing any investors want. From portfolio point of view, REITs have been shown to be highly correlated with equities as well. So the over exposure to REITs has the tendency to result in a false sense of safety.
There is more than one approach in dividend yield investing. Another approach is through preference shares. I have seen people buying hundreds of thousands of dollars of preference shares from their private bankers. Obviously these are very rich clients who were invited to purchase these preference shares although the retail investors are not able to get hold of them in large number through the normal retail IPO process.
Preference share is a hybrid between a debt and share. As far as claims to the company’s assets are concerned, preference share owners have a higher ranking compared to ordinary shareholders. However, the preference share owners rank lower compared with debt holders. As for the rights to cash flow, debt holders rank first because interests have to be paid to them regardless of the profitability of the company. Preference shareholders rank second. Their dividends are not guaranteed although the company would pay them based on a ‘best afford basis.’ In the event when the company is not profitable, preference shareholders receive no dividend. Assuming the company is always profitable, preference shareholders receive fixed dividends. In other words, there is no growth in the dividends. Again, based on a Gordon constant growth mode, P = D(1+0)/(r-0) = D/r. Thus, the fair price which preference shareholder investors should pay for is given by the dividend payment divided by his required rate of return. It can be seen from this equation that there is no capital appreciation for preference share because of the lack of growth in dividends paid to him. We come back to the full circle similar to that of a high dividend yield stocks that have low or no growth prospect.
The danger of putting too much money in preference share is due to the fact that finance companies tend to issue preference shares as compared to other industries. During the financial crisis in 2008, I have clients who invest so much in preference shares that they almost got heart attack when banks all over the world started to fall. They realised that their portfolios were all invested in a very concentrated banking sector. Thus, the quest for a high dividend yield portfolio often results in a poorly diversified portfolio of banks.
Dividend yield is defined by the simple equation equal to dividend divided by price. High dividend yield ratio means that the denominator is low relative to the nominator. If given two identical companies, the one that has a higher dividend yield is undervalued relative to the other. If the company is truly undervalued, it means a savvy investor can buy in hope to earn a profit by shorting the overvalued company and long the undervalue stock. The question is whether the company is truly mispriced by the market or that the investor does not know something which the market does.
Confusion between value investing and dividend yield play
It has been said that undervalued companies are sick companies which the market dislike. However, value investors have been known to earn huge profit from value investing. But I want to caution here that dividend yield investing and value investing are not the same. A value investor seeks to look out for firms which have been mispriced by the market - dividend is not the primary focus. In fact, a loss making company which is unable to pay a single cent of dividend could have the potential to recover and earn a handsome profit resulting in huge capital gain for the shareholder when the market finally appreciate the true potential of the firm. Thus, value investing is not a high dividend yield investing although there is a tendency for high dividend yield investors to end up buying undervalued companies. Hence, those who are not careful could end up with a concentrated portfolio towards value investing although the primary objective was supposed to be dividends. Due to the greater risk in value investing, the investor may not be prepared for massive losses that could incur due to investing in ‘sick’ companies. This is especially dangerous during a financial crisis as ‘sick’ companies could end up becoming dead.
Sources of dividends are important
When seeking to invest in companies with high dividends, it is important to find out the source of the dividends. There are three sources of dividends. Dividends could have been paid from financing, from investment and from operation.
If dividends are paid by financing, this means that the firm borrows from someone to pay dividends to shareholders. This is usually not a good sign as there is a limit as to how much it can borrow to pay dividends. If dividends are paid by investments, it is also a bad sign. It means the firm is selling assets to pay dividends. Of course I am well aware of the one-off dividend payment to shareholders after the firm sells its assets. However, problem arises if the firm is in the habit of paying dividends by selling its assets just to make its shareholders happy. Since there is a limit as to how much assets it can be sold, it means these dividends paid cannot be sustained. Moreover, selling assets could have an impact on the firm’s business operation. Finally, dividends could be paid from cash flow from operation. In this case, it may be a good sign because the sources of monies came from operation.
Sometime ago, I was evaluating an investment in a high tech company. It is something like a private equity investments for my high networth clients. The return showed by its marketing brochure looks fantastic resulting in double digit annualized return. I emailed to some of my clients and they were willing to invest six digit sums. When I obtained the financial report, I was stunned to see its cash flow from operation and cash flow from investment as negative. Its cash flow from financing was positive. Thus, the source of ‘good’ return was from financing. The underlying operations were still suffering from negative cash flow funded by financing. I have to tell my clients not to invest. Of course, I lost tens of thousands of dollars in commissions by telling them to stop. But this is how I prefer to do business although it is totally illogical in the industry.
I have listed out many disadvantages of purely focusing in investing in dividend paying stocks. The financial industry is well aware of people who like some kind of cash flow from their investments. Thus, the financial industry manufactures synthetic financial products that pay cash flows similar to ‘high dividend yield’ stocks. Such synthetic financial products can be found in unit trusts, anticipated endowments and structured products. Dividend yield investing often results in investors been taken for a ride.
It is known among financial practitioners that many unit trusts pay ‘dividends’ out of the capital. This means, they have to sell assets to pay unit holders. Put it the other way round, investors are merely receiving back their own money. ‘Receiving back your own money’ can also be seen by those anticipated endowments. The most notorious one are those that pay coupons every alternate year although the policyholder pays a regular premium. I can never understand why would anyone want to pay $1000 to receive $500 of his own money back? Many policyholders think that the $500 is the ‘profit’ earned but they don’t realised that it is not possible for the insurance company to earn such a profit in mere one year. So the policyholder is merely getting back his own money. I find this to be so silly and yet it sells like hot cakes. After Ms Lorna Tan from Sunday Times wrote an article on ‘retirement products’, I received a few queries. These are actually anticipated endowments. I told those who asked me to forget about it. I even turned down a six figure case. When I review my clients’ insurance policies, I will tell them how they have been taken a ride. They actually know it but needed someone to confirm. My clients would almost always curse at their insurance agents for misrepresented to them the merits of the products. What is it that their insurance agents did not tell them? These anticipated endowments return can never been better than the participating fund. The par fund is a gigantic portfolio managed by the insurance company. Everybody’s endowments are invested into this giant fund. Thus, everybody’s return can never be better than the par fund’s return. In fact, it will be lower after commissions and marketing cost. The bottomline is that it is the IRR that is the most important but many policyholders do not look at the IRR but focus too much on the ‘dividends’ being paid. To make the matter worst, they thought they are getting insurance coverage because they insurance agents told them the products are a combo of savings and insurance. As a result, they end up becoming underinsured.
For me, I prefer to turn away six figures investments (or insurance) than to sell rubbish products to my clients.
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