Unless you’ve been living under a rock recently, you can’t help but notice the number of prediction betting companies that have sprung up everywhere. There’s DraftKings, and FanDuel, and Kalshi, and Polymarket. While access to these sites has historically been restricted in Canada, in the past few weeks, investors can access Kalshi via Wealth Simple. I know all of this because it has come up repeatedly in conversation, especially around the FIFA World Cup watch parties that I attended all of June and July.
At one of these parties, during yet another of these conversations where I told the group that I don’t participate in this form of betting, one of the attendees responded with, “That’s right, you gamble in the stock market instead.” Another friend, a loyal reader of this column (Hello, Dan!) piped up with, “No, she doesn’t! She only buys income funds for the distributions.”
Sigh.
Dividend first (or even dividend only) strategies seem to be popular among readers. I think this because many of our most read columns feature some kind of dividend conversations. And clearly many people, including my friends (really, Dan!) think that dividend investing is all I do. But I don’t do that, and if that is your only strategy, you might want to talk to a planner and figure out what you actually should be doing. What I do is budget, save, and then invest towards my financial goals, and some of my investments include an income component. Not all of it is dividend geared.
The popularity of dividend investing makes me think that we should talk about dividends today – what they are, what are some of the benefits, and why a dividend strategy might, or might not work for you. Let’s get started with the first question –
What Are Dividends?
A dividend is a portion of a company’s profits that are paid back to the shareholders in the form of a scheduled payout. So, if a company – say Royal Bank of Canada as an example – earns $100 as profit and reinvests $90 of it, it could pay the $10 to investors as a dividend. Your portion of this $10 would then be deposited into your brokerage account on a set schedule. The dividend payouts are often done each quarter.
Some people believe that this dividend is “free money.” That is not the case. Dividends are paid out from the money that the company has. Meaning once the dividend is paid out to the shareholders, the company no longer has that money to invest in the business, pay off debt, or buy back shares. The company has, instead, distributed a part of its overall value to the shareholders. This means that after the dividend is distributed, the company’s value is a little less.
Who Are Dividends For?
Dividends provide a source of cash flow for investors who want income without have to sell their investments. As a result, income seeking investors such as retirees, or people who are chasing F.I.R.E. (Financial Independence, Retire Early), often look to build dividend heavy portfolios. Dividends and their regularly scheduled payouts offer these investors a kind of “predictable paycheque” in the form of quarterly cash infusions in their accounts.
The Benefits of Dividends
- Tax Efficiency: Canadian-source dividends are treated more favourably than interest income. The marginal tax rate on eligible Canadian dividends is lower than it is on employment income, interest, or foreign dividends.
- Regular Income Without Selling Shares: An acquaintance of mine used his dividends to fund his travel account, so every dividend dollar that came in went to his next vacation. Psychologically, for him, these dividends are “free vacation money” though he knows that the value of his holdings are lower than the amount of dividends paid out, it is a tradeoff he can live with.
- Careful Cash Management: Companies that announce a regular dividend schedule tend to be more careful in cash management, leading investors to believe that all dividend payers are “safer” than companies that do not pay out dividends. While this can sometimes be accurate, it can also be false, as we will see in the next segment.
The Drawbacks of Dividends
- Missing Out on the Entire Investable Universe: Many companies reinvest in their business, and don’t pay a dividend. Some examples include Warren Buffett’s Berkshire Hathaway, Amazon, Shopify, and Tesla.
- Sector Concentration: As you can likely tell, growth stocks tend to not pay dividends, but defensive stocks like financials and utilities do. So, if you chase a dividend only strategy, you might end up with your entire portfolio in only a few sectors.
- No Guarantees: And this is the most important point of all. Dividends are not guaranteed. Companies that chase dividend payouts could end up in trouble – for example, in May last year, Bell Canada cut its dividend by around 50%. A high dividend yield in a struggling sector could be a sign of trouble to come.
When Do Dividends Not Make Sense?
There are a few situations in which it might not make sense to chase dividends.
- You’re accumulating. If you’re in a phase of life when you’re building a portfolio, it might make sense to reinvest all your earnings and dividends and not take money out. In this case, dividends might not be the best strategy.
- You don’t have time or knowledge. If you’re still learning about investing, or don’t have time to track your portfolio on a regular basis, you might not know the best stocks to buy, or when you should buy them. In these circumstances, you might not be best served with an active dividend strategy.
What Should Investors Do?
One of the people I admire the most in the investing world is Warren Buffett, who in his 2012 letter to Berkshire Shareholders answered a question from a shareholder about why Berkshire does not pay dividends. I highly recommend you read the entire answer, which starts on page 19. He explains the math behind paying dividends vs a strategy where dividends are not paid out, but the investor sells off shares on a similar schedule as a dividend payout. Spoiler: The math is very much in favour of a sell-off strategy. Buffett then ends with:
“Above all, dividend policy should always be clear, consistent and rational. A capricious policy will confuse owners and drive away would-be investors. Phil Fisher put it wonderfully 54 years ago in Chapter 7 of his Common Stocks and Uncommon Profits, a book that ranks behind only The Intelligent Investor and the 1940 edition of Security Analysis in the all-time-best list for the serious investor. Phil explained that you can successfully run a restaurant that serves hamburgers or, alternatively, one that features Chinese food. But you can’t switch capriciously between the two and retain the fans of either.
Most companies pay consistent dividends, generally trying to increase them annually and cutting them very reluctantly. Our “Big Four” portfolio companies follow this sensible and understandable approach and, in certain cases, also repurchase shares quite aggressively. We applaud their actions and hope they continue their present paths. We like increased dividends, and we love repurchases at appropriate prices.
At Berkshire, however, we have consistently followed a different approach that we know has been sensible and that we hope has been made understandable by the paragraphs you have just read. We will stick with this policy if we believe our assumptions about the book-value buildup and the market-price premium seem reasonable. If the prospects for either factor change materially for the worse, we will reexamine our actions.”
Disclaimer
The views and/or opinions expressed above are of a general nature and are for informational purposes only. The contents should not be considered as advice and/or a recommendation to purchase or sell the mentioned securities or used to engage personal investment strategies. Investors should consult their investment advisor before making any investment decision.
Commissions, management fees and expenses all may be associated with investing in Harvest Exchange Traded Funds (managed by Harvest Portfolios Group Inc. (the “Funds”). The funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the relevant prospectus before investing.
