Should dividend investors hold non-dividend paying stocks?

I have spent several years writing about dividend investments, and why I consider them superior for most investors . However, I do understand that dividend investing might not work for everyone.

For investors who have little or no time to focus on managing their portfolios, it is actually preferable that they put their money in index funds and fixed income. As I had mentioned in earlier articles, dividend investing could easily take approximately 10 - 15 hours/week on average. If you have a demanding career, and a growing family, your time could be better spent being invested in index funds, while learning about investments in your free time.

For those who have the time, it is important to have a strategy that identified great investment opportunities, no matter whether they pay a dividend or not. It is possible that there are many outstanding businesses that do not pay dividends. For once, Berkshire Hathaway (BRK.B) is one such business. The story of Warren Buffett, who is the current CEO of Berkshire Hathaway is legendary. While he has been dubbed a “value investor”, since the early 1960s, he has been able to make hundreds of investments which are outside of the box for value investing. In essence, the Oracle of Omaha has been able to continuously learn more about business, in order to respond to the changing environment quite accurately. This has resulted in him having a strategy whose goal has been to simply uncover attractive investment opportunities, regardless of investment classification. Buffett changed course from buying undervalued securities, to buying great businesses with long lasting competitive advantages. Unfortunately, there is one Warren Buffett, but over 100 dividend champions. In addition, while Buffett does not let Berkshire pay a dividend, he routinely invests in companies that distribute their excess cash flow back to corporate headquarters for reinvestment.

The investor that uncovers companies with durable competitive advantages, will likely do very well over time, especially if acquired at attractive valuations. A portion of the returns will come through capital gains, which would defer taxable liability for years. However, it would be difficult to live off such a portfolio if prices are flat or decline over time. Usually, markets might fail to appreciate a company’s growing earnings for several years, which could result in your selling great companies at low prices, simply to meet the everyday expenses of your demanding life. Of course, if you can afford to hold on to appreciating stock for years if not decades, you will likely do very well for yourself.

There are companies which are great, but might not be paying a dividend for a different reason. Sticking only to a dividend strategy might cause an investor to miss such opportunities. For example, Starbucks (SBUX) didn’t pay a dividend until 2008. Another company which I like is Buffalo Wild Wings (BWLD), but it doesn’t pay a dividend either.

There are many growing enterprises which reinvest all money back into the business in order to grow it. As a result, many are able to grow at a rapid pace for several years. Rapid growth does not last forever however, which is why investors need to avoid overpaying for expected growth today.

Investors need to understand what their investment style is as well. I have an acquaintance who worked at one of the fastest growing technology companies in the US. Being on the ground floor of this rapidly growing company, he saw that there were tremendous opportunities for years to come in the US and internationally. As a result, he has been able to deploy a large portion of his investment dollars into the company stock, and has made plenty of money. Of course, my acquaintance is at least 30 years away from retirement, which is why risky technology stocks work as his method of accumulating wealth. It is very difficult to live off a nest egg whose sole source of returns is the fickle nature of Mr Market.

One reason why income investors should keep buying dividend paying stocks is because this is what they know. If you have spent your time analyzing streaks of consecutive dividend increases, projected dividend growth, and understood the underlying fundamentals behind those outcomes, you would be effectively specializing in a strategy that you can do better than the average investor. If you are able to identify businesses with strong competitive advantages, and can buy them at reasonable valuations, you can generate respectable returns over your investing career. Knowing your strategy, and having a conviction in it based upon years of experience, would make it that much easier to stick to your equities when prices go down during the next bear market. For example, I am pretty familiar with the business model of Coca-Cola (KO), which has managed to raised dividends for over 51 years in a row. It is not difficult to understand that a company that sells its branded concentrates to bottlers and other middle-men, would earns high margins on that activity. It is also not difficult to understand that a company that sells differentiated branded products, will earn a lot of money when a growing number of global consumers are exposed to it.

A second reason to hold on to dividend paying stocks is because dividends provide a component of total returns that is more stable than capital gains alone. When you need to live off your portfolio in retirement, you need to generate a stream of income which is relatively predictable in a manner of timing and amount of income. This makes relying on dividend checks superior to relying on selling off stocks to meet your expenses. A diversified portfolio of dividend paying companies with strong fundamentals, and a history of raising dividends for at least a decade will be much more likely to generate a rising amount of dividends even during a recession. You have to remember that you need to eat and live even during a bear market. Flat or declining stock prices are terrible news for investors who sell off stocks in retirement in order to cover expenses. This is because they would have to sell off ever larger amounts of their portfolio just to maintain the same standard of living, if stock prices stagnate or decline. With dividend paying stocks, you get a cash return on your investment, while still maintaining the same amount of share ownership. In addition, if you have excess dividend income, you can redeploy it back into quality companies at depressed prices during the next flat or declining markets. For example, shares of Procter & Gamble (PG) have decreased by 50% at least several times over the past 50+ years. However, the company has raised dividends for 57 years in a row to its loyal shareholders.

A third reason for holding dividend paying stocks is if these companies fit the investment goals and objectives in your retirement plan. The goal of my retirement plan is that my diversified portfolio generates a sufficient stream of income to cover my expenses after I stop working. Because dividend income is more stable than capital gains, it is a safer alternative that can deliver cash to pay for expenses on a timely and predictable pattern. As a result, the transition from being paid twice/month to receiving multiple dividend checks every month is easier on your personal finances. Therefore, if your monthly expenses are $1000 month, and your portfolio generates at least $1000 in monthly dividend income, you have achieved your objective. It is much easier to keep investing in income generating assets until you reach $1000/month in dividend income than worrying about accumulating a certain amount of funds first, and only then worrying about how to convert that into meeting your expenses. I find dividend investing to be a much easier approach compared to withdrawing 3% - 4% of my net worth every year.

A fourth reason to keep dividend paying stocks is because they are more stable and mature than non-dividend paying ones. Only a company that generates excess cash flows that are above and beyond its needs to grow and maintain the business, will be able to pay a growing dividend to shareholders. The growing dividend is an indication of a business model that has the competitive advantages to throw off so much cash. Most companies that do not pay dividends do so because they cannot afford to pay distributions. The ones like Berkshire Hathaway (BRK.B) are the more like an exception, rather than the norm.

Another reason to buy quality dividend paying stocks is because they are typically cheaper than some of the great growth stories out there. The growth stocks typically plow back every single penny back into building the organization. There is usually a lot of hype associated with many of those companies, which makes them sell at ridiculous valuations. If a company like Tesla (TSLA) sells at $150/share, this is because market participants expect it to earn several dollars/share in a few years. Given the company’s low current earnings, it seems that most of the valuation is dependent on future expectations, which can vary a great deal away from reality. If the expectations do not materialize, stock prices could be lower, and sources of return would be just from capital gains. It can work for many, but not for my style of investing. Most dividend paying stocks are usually cheaper because a regular 6 – 9% growth is seen as unexciting by market participants. This is ok, because a low entry price, coupled with modest but consistent growth can result in compounding miracles decades down the road. For example, if you can purchase shares of a dividend stock like Chevron (CVX) at nine times earnings, 9% earnings and dividend growth, and a 3% yield, you can do very well for yourself over time. Of course, if you can purchase the shares of a quality company that doesn’t pay dividends, you can also do well over time. However, your total source of returns would be capital gains. In my life, I prefer the diversified nature of both dividends and capital gains.

Overall, an investor would do great for themselves if they focus their energies on purchasing quality companies at attractive valuations. The vast majority of such enterprises are dividend paying ones, although there are some exceptions. In my stock portfolio, I hold only quality dividend paying companies, because I like the consistency in the nature, timing and amount of dividend payments. Therefore, I mostly focus on the dividend contenders and dividend champions list of companies for research. As a result, despite the exceptions, I do not believe that focusing only on dividend paying stocks is limiting me in any sort of way.

Full Disclosure: Long CVX, KO, PG

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