There is a widely held beliefthat companies that havegood investment opportunities,and hence growth,can and should reinvest allof their income in the business to growthe company and its share price. Onlycompanies that do not have such opportunitiespay out any money they cannotprofitably reinvest to shareholders asdividends. Under this theory, dividend-payingstocks do not have good growthopportunities—they are mostly inmature industries—and over time theywill produce lower total returns thanstocks that do not pay dividends.Therefore, most investors should avoiddividend-paying stocks. Both theory andempirical evidence show that the conventionalwisdom is wrong.
Financial theory holds that in a perfectworld, whether a company pays dividendsdoes not matter. This would betrue in a world without taxes, but itshould still be nearly true in the realworld with taxes.
This is a puzzling statement andneeds some explanation. Briefly, the "ifeverything else is the same" part impliesthat if there are two companies that areidentical in every other respect, thenover time, they will produce the sametotal return even if they pay very differentdividends. Because if the companythat pays higher dividends needs moneyfor investing, it can always borrow thenecessary money. "In a perfect world" essentially requires that both investorsand business managers behave rationally.So in theory, there is no reason to takedividends into consideration whenselecting stocks for investment.
The Empirical Evidence
Empirical evidence shows that stockspaying good dividends over time significantlyoutperform stocks paying little orno dividends. As a matter of fact, amajority of the total return of moststocks over the long run comes fromreinvestment of dividends. Therefore,stocks that do not pay dividends arelikely to provide lower total return thandividend-paying stocks in the long run.
The empirical evidence contradictsthe conventional wisdom, but does itcontradict the theory as well? Not necessarily.Recall that the theory assumesthat business managers behave rationallyand would reinvest earnings in thebusiness only if they can do so profitably.It seems that a lot of businessmanagers are not rational. They reinvesta lot of a company's income in businessesthat do not earn an adequate returnon investment. In other words, theywaste a lot of the shareholders' money,and the shareholders of such companieswould have been better off if the managersdistributed a good part of the company'sincome as dividends. Paying dividendsremoves money from the hands ofthe managers that they would haveinvested poorly.
There are two major investmentimplications from the empirical findings.First, no matter what your age, youshould hold a number of dividend-payingstocks. If your current portfolioemphasizes value stocks, as it should,then you probably already have a goodsize investment in dividend-payingstocks because many value stocks payhigh dividends. Otherwise, add somemutual funds or exchange-traded fundsthat focus on dividend-paying stocks.
Second, unless you need the incomefrom your portfolio to live on, reinvestall dividends instead of spending them.While doing so, also reinvest all capitalgains distributions from your mutualfunds by choosing reinvestment ofboth dividends and capital gains—anoption that almost all mutual fundsoffer. The long-term compoundingeffect of doing so is enormous. In taxableaccounts, you will owe currenttaxes on all dividend and capital gainsdistributions. Try to pay the taxes fromnew savings to impose an additionalsaving discipline on yourself.
Chandan Sengupta, author of The OnlyProven Road to Investment Success (JohnWiley; 2001) and Financial Modeling UsingExcel and VBA (Wiley; 2004), currentlyteaches finance at the Fordham UniversityGraduate School of Business and consults with individualson financial planning and investment management. He welcomesquestions or comments at firstname.lastname@example.org.