What Do You Do With Dividends?

Income investing is a big part of what I do. It’s rare for me to buy a stock that doesn’t pay a respectable dividend, and I have an entire newsletter – Peak Income – dedicated to finding decent yields in a world where most CDs and savings accounts barely yield anything at all.

But you know what’s surprising about all of this?

I don’t plan to retire for at least another 20 years, and I have no need for portfolio income today. I’ve instructed my broker to automatically reinvest my dividends in additional shares. I don’t get paper checks, and I don’t draw a single nickel out of my investment accounts. In fact, I’m aggressively saving and adding new money to them.

So, if I don’t need the income right now… why do I focus so heavily on getting paid?

After all, a dollar earned as a dividend should be no different than a dollar earned as capital gains. As far back as 1961, economists Merton Miller and Franco Modigliani elegantly “proved” that dividend policy is irrelevant to investors. They said whether a dollar in earnings is paid out to investors as a dividend or reinvested in the company, the investors make out the same either way.

Call me the cynical sort, but I’ve always believed that a bird in hand is worth two in the bush.

Whenever I buy a stock, I don’t know that it’s going to rise in value. Sure, I expect it to. I certainly don’t buy stocks that I expect to fall in value. But the market has a mind of its own, and it rarely does what you expect it to do. And it certainly doesn’t care what you want it or need it to do.

When your stocks pay dividends, you’re able to consistently realize real returns, not paper gains that can disappear in a heartbeat. And if you reinvest your dividends, the number of shares you own – and the dividends they pay – will compound with time. Even a boring, slow-growth stock can generate market-beating returns through dividend reinvestment and compounding.

As a case in point, imagine a stock with a $100 stock price and a 5% dividend. If that company raised its dividend by 10% per year, after 10 years you’d be earning a dividend yield on your original investment of 13% per year, plus whatever you earned in capital gains.

But there are other, more philosophical reasons to focus on dividends too. They tend to be a useful tool to hold companies accountable, which in the end, should mean more income and better returns for you.

1. Dividends keep management honest. It’s a lot harder to cook the books or engage in questionable accounting when you have to produce a dividend every quarter in cold, hard cash. (Incidentally, my friend John Del Vecchio specializes in uncovering accounting shenanigans with his Forensic Investor letter.
2. Dividends force discipline on management. Most management teams aren’t outright crooks. I would go so far as to say most are actually honest people. But that doesn’t mean they are always looking out for their investors. Management is often guilty of “empire building,” or wasting shareholder money on low-value projects that serve management more than the shareholders. Well, having to come up with cash every quarter to pay the dividend forces management to prioritize where it spends company resources.
3. Dividends remind management who the boss is. Remember, the guy in the corner office isn’t the boss. He works for you, the shareholder. And sometimes, the arrogant S.O.B has to be reminded of that. Paying the dividend every quarter is a subtle reminder to management that they work for the shareholders and not the other way around.

Getting down to more practical matters, there is another big reason why I’m focused on current income these days: stock valuations.

The U.S. stock market currently trades at a cyclically-adjusted price/earnings ratio of 29.4, which puts it 76% higher than its long-term average. If history is any guide, that implies losses of 1%-2% per year over the next seven to 10 years.

Now, expensive stocks can always get more expensive. But frankly, that’s not a game I want to play.

In Peak Income, I target investments that pay 6%-10% in current income, with the potential for solid capital gains as well. But again, I’m not depending on the capital gains. If they closed the stock market tomorrow and didn’t reopen it for five years, my income investments would still throw off a very decent return.

If you’d like to read more, click here for a free presentation, and start cashing your dividends.