Sometimes it is good to get back to basics. After a recent conversation with a family member, an elementary school teacher, about the school’s decision to rename improper fractions into something else (no, I’m not joking) I ended up thinking about some dividend basics. One of the basic properties in math, the commutative property, also applies to dividends and offers some interesting insights for dividend investors of all types.
Does anyone remember what the commutative property is? It basically says that in a mathematical operation you can move (commute) stuff around without changing the result. So, 2 + 3 = 3+2. Pretty basic. Remember now that the formula for dividends returns, what I called the magic dividend formula, says that Total return = Div yield + Div growth + Change in valuation. Ignoring change in valuation for now, the commutative property says that it does not matter what the composition of total return is. In other words, a stock with a 6% yield and 4% growth is the exact same as a stock with a 4% yield and 6% growth. Seems obvious at face value. I wondered about this when I saw how dividend investor’s opinions strongly fell into one camp or the other. There is a very strong growth over yield camp and an equally a strong yield over growth camp. Why is this considering the commutative property of dividends? Its turns out that it matters what kind of dividend investor you are and where you do your dividend investing from.
First, for dividend investors in non-taxable accounts (IRAs, 401Ks, etc..) and that are re-investing dividends, i.e. are focused on wealth building, then the focus should be an total return. The composition of that return is much less important. The commutative property of dividends applies 100% and a 6% + 4% stock is the same as a 4% + 6% stock. I find that when div growth or div yield advocates disagree on a particular investment the disagreement is often over stocks with different total returns and has nothing to do with yield or growth. For example, a 3% yield, 10% growth stock is obviously a superior investment to a 6% yielding stock with a 4% growth rate. One offers a higher total return than the other irrespective of yield vs growth. Just because there are many more 3% + 10% stocks versus 10% + 3% stocks says more about economics than anything else. The only thing I would say on return composition for these investors is that div yield is more certain than div growth – the company has committed to paying the current dividend but has made no commitments about the future. Also, because of the uncertainty of future growth I think the market mis prices future growth. Why else are there so many dividend stocks that have low to mid dividend yields, 2-4%, yet also offer such strong div growth rates (10%+)? Nonetheless total return should be the primary focus for these investors.
For dividend investors in taxable accounts and also re-investing dividends the composition of total return then matters quite a bit. Why? It comes down to one of the two unquestionable certainties of life – taxes. As a dividend investor in a taxable account, you pay taxes on the div yield component of the stock return but not on the growth component. The growth component is only taxed when you sell the investment. For example, take two 10% total return stocks, a 7% + 3% stock vs a 3% + 7% stock. Pre-tax the returns are the same but after tax the returns are different. It also depends if the dividend are qualified or not. The table below shows these differences. It assumes a qualified dividend tax rate of 15% and an investor in the 25% marginal tax bracket.
As you can see from the table the composition of the return matters. The after tax return of the 7% + 3% stock is 8.95% vs 9.55% for the 3% + 7% stock. Taxes matter a lot. The table also shows the tax dis-advantage of REITs in taxable accounts and the tax advantages of MLPs in taxable accounts. This does not diminish the importance of total return in any way but these taxable considerations could tip the scales in favor of one investment over the other.
In summary, total return is what matters for dividend investors whether the majority of the return comes from the current dividend or dividend growth. The commutative property of dividends holds. The passionate arguments in favor of one component or the other are really just about total return. However for dividend investments in taxable accounts the breakdown of total return into yield and growth can have a differing effect on after tax returns that investors need to be aware of. For these investors, stocks with higher growth components have higher after tax returns. Investors then need to weigh this benefit of higher dividend growth stocks with the accompanying higher uncertainty. In a follow on post I’ll tackle the issue of growth vs yield for investors who are living off their dividends.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.