Dividend Investing Is Overhyped!
On May 29th, I attended an event called “Investor Social Vancouver.” An event with some very notable Canadian YouTubers in the finance YouTube space. “Brandon Beavis Investing”, “Humbled Trader”, and “Canadian In a T-Shirt” just to name a few.
During the event, the event host asked how many people had started investing in the last year. About 1/4 of the crowd raised their hands.
The host then asked, “How many people have around 2 years of experience?” About 1/4 of the crowd raised their hands.
The host also asked, “How many of you are day traders?” Again, about 1/4 of the crowd raised their hands.
When the host asked the panel what their top holding was, a majority of them answered TD. The trend I find with finance on YouTube/TikTok/Instagram in general is that people really like dividend-investing stocks.
In this post, I will myth bust the dividend investing strategy.
*Legal disclaimer: This post is not investment advice. Please do your own due diligence. Please seek guidance from a professional financial advisor nearest you. Investing in stocks carries risk. No returns are guaranteed. This post is for entertainment purposes.
Why do people like the dividend investing strategy?
The charm of dividend investing is that it is highly approachable and easy to digest for most investors. The reason being, every quarter or annually, you see actual money deposited into your investment account. This is evidence that your money is working for you. If the principal value of your stocks is unchanged or has increased in value, your dividend increases the account size. This real-life scenario provides positive reinforcement to anyone looking to build a habit of consistently saving and investing.
I don’t know about you, but when I get a dividend, no matter how small or large, I get a little happy on the inside. If the dividends add up to a few dollars for that day, I would think to myself, "Hey, that’s a junior chicken or fries at McDonalds.” Anyone else? No, just me!
To not discourage those who are investing in the dividend strategy that these influencers preach, the fact that you are investing, frequently contributing to your portfolio, and going out to find sources for new dividend stocks is commendable on your part. You are taking control of your finances and investment future. That puts you leagues above most people already.
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The problem with adhering to the dividend investment strategy
Since dividend strategy influencers are targeting novice investors, if the dividend stocks go down in value, most of these novice investors will have no way to truly analyze each stock. They don’t know if they should buy more or cut their losses because the story has changed. If news comes out, they can only interpret it as positive or negative. They are not able to meaningfully quantify the approximate impact on the company’s value. In fact, I’d argue that some of the influencers themselves don’t know how to analyze the dividend stocks they preach. For one, the dividend influencers preach a diversified portfolio strategy. How likely are they to be experts in all 40+ names in their portfolio? This is a hard task for a full-time professional investor, let alone someone who is potentially a part-time YouTuber or has no real finance background.
What I don’t like about the dividend stock strategy is that those pursuing it have to pick stocks. Most don’t have the fundamental analysis ability to really go deep into these companies. Hence, they become “sheep.” “Sheep” are investors that follow someone else’s strategy and are unable to do any analysis themselves.
For my subscribers at Continuous Compounding, in all stock pitches that I do, my goal is not to make you a sheep. In addition to putting undervalued stocks on your radar, a side goal is to educate you on how to analyze a company.
My 80/20 analysis for CNTY, available for subscribers, goes into detail in explaining the business economics of casinos, the competitive advantage of the company, fundamental analysis, and a complete financial model. Users of my research are able to learn about the companies I pitch and what variables are most important in determining their value. Not only am I telling you where to fish, but I'm also teaching you how I approach fishing in different waters.
The framework I use to analyze one stock in a certain industry can be applied to other stocks in the same industry. If you've just started to invest, of course you’ll start out as a sheep, but my write-ups will allow you to compound your knowledge base and start analyzing stocks on your own.
Well, what if a dividend stock you follow reduces or cuts its dividend? You end up having to wait for the YouTuber to release a new video. Or better yet, subscribe to their monthly subscription to their private dividend discord or chat room. Sound familiar?
If all the influencer tells you is the dividend yield and lists only qualitative factors to defend their reasoning for holding the stock, it's likely their fundamental analysis isn’t sufficient. Here are a few fundamental questions I would need answers to before investing in any dividend stock:
*I would also use this criteria to assess any dividend investing guru to see how qualified they are. This is a very basic list. To keep this article short, maybe I can post a follow-up article on dividend investing later on.
What is the earnings yield of the company?
Meaning, for the revenue the company is generating, how much of that goes down to the bottom line/profit? Anything less than 10% means the business is likely in an industry that is quite competitive. Anything above 10-20% is quite good and means the business likely has some level of competitive moat or advantage. 20%+ Extremely high-quality business with a competitive moat (I would question why businesses with 20%+ earnings yield would issue dividends in the first place).
What is the dividend payout ratio?
Dividends don’t come out of thin air. Dividends come out of earnings. What portion of the earnings is distributed for dividends, and why? If the dividend payout ratio (DPR) is high, it is likely because the business has limited growth opportunities and is unable to allocate all earnings at a rate that is consistent with the company’s return profile. If the DPR is low, ask the question whether the company has the potential to utilize the funds that aren’t’ distributed effectively (I would ask this exact same question to companies that don’t issue dividends). A lot of companies issue a miniscule dividend relative to their earnings because they want to attract dividend investors.
The influencer should justify why the dividend payout ratio is appropriate or sustainable.
What are the competitive moats of the business?
Often times, dividends come from mature companies with less room to grow. We don’t want to invest in a business on its way out. Mature companies can attract competition or become complacent, which could result in a reduction in market share. Without a strong competitive moat, the dividend yield may look good for one year, but if earnings decline, so will your dividend yield. In the worst-case scenario, the company cuts dividends to survive.
The influencer should be able to justify why the earnings of the company are solid and are likely to grow, given a set of reasons about the company’s competitive advantage.
Behind every stock is a company. Just because a dividend stock issues a nice dividend doesn’t make analyzing the stock any easier. Basing how attracted you are to a company purely on dividend yield is wrong. How attracted are you to the company? It’s tantamount to a man marrying a woman because she has big t*ts. TikTok, Instagram, and YouTube are flooded with dividend p*rn. As a subscriber to Continuous Compounding you are too intelligent and well informed to give in to this shallow content.
For my monthly stock picks, I provide as much detail as possible on the variables that are applicable to each investment. I even included a full Excel model of the company. So if, for example, interest rates rise or revenues for any segment are expected to increase or decline, you may adjust the variables to see how it affects the stock’s valuation.
I have no problem with this if the person who runs this business has the qualifications, but most of these YouTubers are simply passionate personal finance gurus who are good at marketing themselves, but if you ask them to really breakdown the fundamentals of the business beyond simply the dividend yield, I suspect they would be lost for words.
Dividend Flaw # 1: Companies that can reinvest capital at extremely high rates of return don’t issue dividends
Why would a company with high growth potential and a higher return on reinvested capital issue a dividend? By limiting your strategy to only dividend stocks, you are essentially cutting out a universe of stocks that have truly exceptional business economics.
Look at Berkshire Hathaway. Warren Buffett’s empire has never issued a dividend. Why? Warren Buffett is a genius investor who has compounded at roughly 20% over his investment career. If Buffett were to pay you a dividend, what is the likelihood, you would outperform Buffett’s investment record? Due to Berkshire Hathaway’s size, Buffett has said that future returns will not be like former returns given the amount of money he must allocate. A large fund size is the enemy of high returns.
Let me illustrate a simple example using a hypothetical company:
Company A is a Japanese arcade/bowling entertainment store. It generated 100 mm (mm=million) in revenue this year. It has an earnings yield of 20%. The company currently has 100 stores globally, but mainly in Japan. They have two stores in the US, and they are proving to be successful. They believe that if they open more stores in the US, the new stores will also be able to earn a 20% yield or even higher. It also has untapped markets in China, Hong Kong, and Korea, where arcade games are still popular and demand is high. Given that they own the exclusive rights to their own arcade machines and games, they have a unique game catalog and a lower cost basis than their competitors.
Company B also has 100 mm in revenue every year. It has an earnings yield of 20%. The company is a Tobacco company. Less and less young people are smoking. They are competing with bigger Tobacco companies for market share. The company is very efficiently run, and their factories are run at almost max capacity for the demand for their products. Unless there is enough demand, they won’t easily open up a new factory because they would have to spend large sums on capex and wait for demand to reach the output capacity of their factories.
Company A dividend policy: Company A is growing and actively expanding; hence, management believes they can effectively allocate funds into similar or better return-profile investments. Management has decided not to issue a dividend. The stock trades for 150 per share.
Company B dividend policy: Company B doesn’t have much opportunity to grow. They would rather wait for demand to pick up further before spending large capex on an additional factory. Hence, they have a payout ratio of 75% or a dividend of 15 mm or 15 per share with 1 mm of shares outstanding. The stock trades for 150 per share. You get a 10% dividend yield.
The group of dividend investors will filter for stocks that issue dividends. Hence, they would find Company B. Company A, which has no dividend, doesn’t show up on their screen. But which company is a better investment?
It should be obvious to you that company A is a better investment. The company has high margins and is able to generate high margins on reinvested capital. Company B cannot. What Company B has going for it over Company A is a juicy dividend. Assuming company B is able to defend its market position, its dividend yield should stay constant at 10%. If it cannot defend its market share, then revenues and earnings yield will likely drop with it, resulting in a reduction in dividend yield.
Dividend Flaw #2: Purposely limiting your investment universe
Does the dividend investing strategy beat the S&P 500?
I will say it is possible, but dividend investing is unlikely to outperform the market. The reason why dividend investing is unlikely to outperform the market is because you are voluntarily limiting yourself to a pool of potential stock investments that don’t pay a dividend. In fact, some of the best stocks out there don’t pay a dividend.
Berkshire Hathaway is an example of a company that could reinvest capital at high rates of return. The success formula came from accessing cheap capital from insurance float and having a genius capital allocator like Buffett at the helm. Berkshire Hathaway has never issued a dividend. If you had been a strict dividend investor since the early days of Berkshire Hathaway, you would have missed out on a great compounder because you wanted a set dividend yield each quarter.
Dividend Flaw #3: Dividend investing is more active than you think
Assuming you’re not a sheep, the amount of work you put into researching stocks, building a portfolio, and reinvesting the dividends into other dividend stocks is rather time-consuming. It makes a passive investing strategy quite active. If you have a long enough horizon, my recommendation is to simply stick with ETFs that mimic the S&P 500. Yes, there is more volatility, but if you can stomach it and your investment horizon is long enough, then ETFs will perform better.
Put it this way: Warren Buffett bet $1 million dollars against a fund of funds manager, that the performance of 5 funds of his choosing could not beat the performance of simply the S&P 500 index. The fund of fund manager lost. In the same light, if Warren Buffett offered a $100K bet to any dividend investing guru that they had to beat the S&P 500 using their strategy over a 10-year time frame, I’d theorize a majority of them would be hesitant to take that bet. If you stick to a purely dividend investing strategy, then you are unknowingly taking this bet.
But to be fair, a novice investor should expect that if they follow a good dividend investing strategy, their return is likely going to be lower than the market's, but this lower return is afforded by lower risk in the companies that typically offer dividends (i.e., Coca Cola) and higher predictability of earnings.
*Legal disclaimer: This post is not investment advice. Please do your own due diligence. Please seek guidance from a professional financial advisor nearest you. Investing in stocks carries risk. No returns are guaranteed. This post is for entertainment purposes.
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