AMLP - A Focus On Dividends May Be Hurting Many Retirement Accounts

2023-07-21 12:38:22 ET

Summary

• Dividend payments reduce the intrinsic value of a company and its stock price, as they decrease the net cash on a company's balance sheet.
• High yield dividend investing can erode capital over time, and dividend growth investing has underperformed in the past decade.
• Investors should understand that dividends are not incremental to returns and are not independent of the stock price.

By Brian Nelson, CFA

It's important to mention at the beginning of this article that this work does not consider tax implications of any investing strategy, but rather explains the ins and outs of a dividend and how well one might have expected certain high yield and dividend growth strategies to have performed the past decade or so. Every reader is going to have a different personal financial situation with different goals and risk tolerances.

It's also worth noting that Valuentum has newsletters that focus directly on high yield dividend investing and dividend growth investing, so these strategies have certain merits for certain investors. With that said, I hope you enjoy the information in this work, and please do partake in the comments that are sure to be juicy and interesting with such a controversial topic as this one. Let's get started!

The intrinsic value of a company is based in part on the net cash on a company's balance sheet and future expectations of discounted free cash flow. Within the enterprise valuation context, these two dynamics are called the cash-based sources of intrinsic value. Because a dividend payment received from a company reduces the amount of cash that a company has on its balance sheet, the dividend payment reduces the intrinsic value of the company, and therefore its stock price. The dividend is a part of capital appreciation that otherwise would have been achieved had the dividend not been paid. The dividend is not incremental to returns; it is not independent of the stock price.

There are many readers on Seeking Alpha, for example, who are simply enamored by dividends, and for some, that may be all that they care about. Though this is okay for them to love what they want, I think it is very, very important for them to understand what dividends are, and what they are not. Understanding them better may impact how they think about valuation, the market, stock selection, their portfolios and so on. In a video by Chicago Booth's Samuel Hartzmark, it provides a very simple example to help readers understand the concept of a dividend. If you have a stock that is $10, for example, and it pays a dividend, you now have a stock that is priced at $9 and a $1 dividend. The video can be found here .

Still, many retirees seemingly continue to be enamored by the siren song that is a huge and sometimes double-digit dividend yield. Some of the most popular articles on Seeking Alpha, for example, seem to be focused on yield or have some ties to a dividend payment, too. We understand that many investors are looking for income, but income can be created in a variety of different ways, even by selling off appreciated stock. We wonder if high yield investors may not know they are essentially getting paid with their own money when a dividend is being paid. Would this change their approach to investing? Again, dividend investing is like buying a stock for $10, and when it pays you a dollar in dividends, you now have a stock priced at $9 and a $1 dividend.

This isn't theory either. For example, since late 2010, ETFs that track a basket of high-yielding energy master limited partnerships ( AMLP ) and a basket of high-yielding mortgage real estate investment trusts ( REM ), respectively, have fallen by 45%+ and 55%+, respectively. Think about all those MLP articles and all those mortgage REIT articles written on Seeking Alpha in years past, championing their yields. Quite simply: What good is a lofty dividend yield when the capital in one's retirement account has been halved along the way? That's not good at all. The 10-year cumulative return of the AMLP is negative, while the total cumulative return of the REM since inception in May 2007 is -34%, and the fund still has $700 million in net assets.

In some ways, the dividend, itself, is quite deceptive, and that may explain the popularity of these financial instruments. Perhaps readers continue to think that the dividend is incremental, independent of the stock price? Maybe some believe that if you buy a stock for $10, and it pays a dividend, one now has a stock still priced at $10 and a $1 dividend? It's all that we can come up with to explain the popularity of high yield and dividend investing. The type of thinking that a dividend is independent of the stock price, however, can be catastrophic to one's retirement portfolio--and what's worse, it's very likely that many that loaded up on high dividend paying stocks with double-digit yields years ago are now caught in what can best be described as a 'yield death spiral,' now requiring a higher and higher annual dividend yield as their capital base continues to be eroded by unsustainable dividend payments. They became addicted to a "drug" years ago, and now they need more and more of it just to get the same level of income.

Interestingly, we may be seeing this dynamic more and more with some of the articles on Seeking Alpha, at least anecdotally. Dividend growth and income investing has always been the primary topic of interest for many readers on Seeking Alpha, which is great, but some of the most popular articles used to be on blue chip stocks with mid-single-digit yields. Now, it seems like many are looking for stocks with 10%, 15%+ dividend yields. Have their capital positions eroded so much where they need higher and higher yields to make the same income? Remember: The higher the yield (dividend), the more and more it comes at the expense of one's capital position--which may erode at a faster pace than the yield which is received by the dividend. The math is simple: When a dividend or distribution is paid, the entity’s share price is adjusted down by the amount of the dividend payment, reducing the capital position of the investor.

Let's put up a comparison on dividend growth investing, as some may simply dismiss high yield investing as a foolish strategy in light of the free dividends fallacy. Let's now ask the hard question: Has there really been a total return benefit for dividend growth investing relative to just investing in the S&P 500 ( SPY )? Well, during the past 10 years, the return of the [[SDY]] after taxes on distributions and sale of fund shares stood at 8.11%. Meanwhile, the same measure for the SPY was 10.48%, indicating that dividend growth investors that bought a large basket of "Aristocrats" trailed a simple broad market index in the SPY by more than 2 percentage points a year for the past decade. It's a scary thought. High yield investors are seeing their capital bases erode, while dividend growth investors are trailing simply market indices. These conclusions just aren't what one might have expected given the popularity of these topics on Seeking Alpha, but it is what it is.

Concluding Thoughts

Investors already own the dividend as part of the stock price (their capital position) before it is paid. The dividend is not incremental or independent, but rather a part of capital appreciation that would have occurred had the dividend not been paid. There are no free 'income' lunches, and this is why some investors don’t use dividends in their approach to retirement at all. They can sell off some of their equity in the same manner that a dividend-income investor’s capital position is weighed down over time by the payment of a dividend. Their focus instead is on continuously growing their capital base such that they can maximize their total return, and therefore, the total distributions to them during their golden years. High yield dividend investing tends to erode capital over time, while dividend growth investing has underperformed meaningfully the past decade. We prefer Valuentum investing, which today is largely a diversified basket of large cap growth stocks.

This article and any links within are for informational and educational purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice. AI in part wrote the summary for this article.

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