Thursday, December 4, 2014

High Dividend Yield? Or Simply Left Pocket, Right Pocket?

So, networth talk has been flying around as well as dividend income. I'm going to talk about something slightly off-tangent.

Total Return = Capital Gains + Income Yield

For non-dividend paying companies, there is no income yield, so in this case, "Income yield = 0". They can only rely on capital gains.

For dividend paying companies there is an income yield portion which comes from the dividend payout.

What I have noticed is that a lot of people like to focus on the latter. Income investing is now the "in" thing that all the cool bloggers do. That is not to say that it is wrong, but I think an over-emphasized focus on just yield can be detrimental to your financial health.

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Example:
There is a company that engages in the business of selling something. It doesn't matter what.
This company says that it would like to offer shareholders high dividend yields.

The share price of the company is $1.00 today, and they decided to pay 10c of dividends.

The next day the share price of the company drops from $1.00 to $0.90, while you get credited 10c of dividends. 10c / $1.00 is a whooping 10% yield!

Total return = Capital Gains + Income Yield
-> Total returns = -10c + 10c
-> Total returns = 0.00

You just paid yourself your own 10c.

1 year passes and the business and stock has not changed almost at all. They declare 9c of dividends.

The next day the share price of the company drops from $0.90 to $0.81, while you get credited 9c of dividends. 9c / $0.90 is a whooping 10% yield!

Total return = Capital Gains + Income Yield
-> Total returns = -9c + 9c
-> Total returns = 0.00

Over 2 years, you have paid yourself 19c of dividends while your capital is now worth $0.81.

Left pocket, right pocket. No difference.

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The above example is what irks me because so many people don't seem to realize how dividends works. The ex-date is not a magical date where the company suddenly conjures up cash to return to shareholders as dividends. The cash comes from the balance sheet itself, it's own capital! Dividend yield itself as a singular metric means JACK SHIT. Give me your money, I can give you 100% yield. I just return your money back lor.

If capital gains are being reduced to fund a higher yield, making total returns close to zero, or worse still, negative, then this is a rubbish investment. Your broker and brokerage firm would love you deep deep though.

A proper dividend investment (in my opinion) has ample cash on hand to pay out as dividends, a healthy current ratio to meet obligations, positive earnings and positive free cash flow. A company does not need growth in revenues and profit to pay a steady dividend, it just has to not decline. A more holistic approach should be used when "income investing" instead of "transferring-a-lot-of-money-from-left-pocket-to-right-pocket investing".

Now, that being said, the long run average return of stocks is about 8%, give or take.

For the SPDR STI ETF since inception, it has generated 8.39% annualized returns. Roughly 5% from capital gains, 3% from dividends and the remainder is likely the bonus return from compounding.

Total return (SPDR STI ETF) = Capital Gains + Income Yield
-> Total returns (SPDR STI ETF) = 5% + 3%
-> Total returns (SPDR STI ETF) = 8%

If investing long-run in equity investments (REITs included) generate about 8% returns, personally, I would rather my portfolio give me my 8% in returns entirely through dividends and have 0% capital gains.

Total return (GMGH's Portfolio) = Capital Gains + Income Yield
-> Total returns (GMGH's Portfolio) = 0% + 8%
-> Total returns (GMGH's Portfolio) = 8%

Why? I will have the flexibility to choose how I want to re-allocate my 8% returns.

Is the broad market generally expensive, so should I keep this in cash and wait?
Is any industry in the market experiencing negative sentiment, so should I deploy more there?
Is any ticker overly expensive, so I should allocate my cash to other relatively cheaper stocks?

This is why although my personal SGX portfolio seems very yield heavy, I do not feel very jittery. With quite a bit of realized gains through dividends, my total return on my portfolio has never gone negative yet. The market has been kind to me so far.

This is just my personal view on "yields". Just as with everything in life, we should also corroborate out findings with other information that supports as well. Yield as a single metric will not serve you well, but as one of your metrics, it can be a very useful tool.

4 comments:

  1. Hi GMGH

    Good post.

    It clears things up on the cd and xd issues some people might be mistaken.

    Yield is definitely one metric but the underlying capability in doing that is what separates a good and great companies.

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    Replies
    1. Thanks B, I was also very confused by this when I first started out, hopefully it will be more clear to anyone that stumbles along my way!

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  2. Yield cannot be taken as a single entity..rather one needs to see a trend. An discernible ascending dividend yield over past decade tell a greater story than most other metrics n this excludes l to r right money transfer n other funny money transfer simply because its increasingly unlikely to fake n pay out more n more money over such a long time. One time high dividend is a PERILOUS criteria to enter a stock.
    my 2 cents

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    Replies
    1. Hi Paul,

      Thanks for your 2 cents! I agree, a good company would easily have a clear upward trend if you plot out its dividend payouts.

      However, some companies have reach their peak potential and are no longer growing (or taking a short break). I personally think that growth is a bit overrated. These are still decent businesses, but just mature ones. As long as they maintain their businesses y-o-y and continue to share their profits to shareholders, I find them very "bond-like". They are all badly priced by the market because they deliver almost no growth. I am okay with that, because I get bond-like returns with deep margins of safety already priced in.

      I think any dividend that is over 10% raises red flags and fireworks and they deserve to be carefully scrutinized to see where this money is coming from!

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