Since 1930, dividend has been responsible for 42% (on S&P 500) of the stock market return so there’s little surprise that it is one of the main criteria we look for when picking stocks. However, in investing, everything involves an opportunity cost. So the question to ask is - Is focusing on dividend as a key selection criterion the right strategy for me? 

Before you decide if it is the right strategy, first we have to understand what it is. Let’s think about a bathtub system. In a bathtub system, you have water flowing in from the tap into the tub with some retain in the tub (or stock) while the rest flows out through the sinkhole.

When you apply this to business, what do the inflows represent? It’s the earnings. Or more precisely, the return on capital (ROC) for the business. The higher the ROC, the bigger the inflows. Once the water flows into the tub, the management will ask “How much should we reinvest to grow the business and how much should be paid to our shareholders?” The amount of dividend that is paid out is the outflows. And for every dollar paid out to shareholders, there will be one less dollar retained to grow the business.

That is the big picture. Dividend and growth come from the same pie (or the same tap). You cannot have both at the same time. It doesn’t matter how you cut or slice the pie, if the size of the pie doesn’t change, doing more of one thing means less of the other. If a company pays out a majority of their inflows as dividend, the future growth rate will be low. Whereas if a company wants to focus more on growth, they either have to 1) Reduce dividend or 2) Improve ROC.

So that’s the opportunity cost. If your focus is on dividend stocks, there will be less capital for these type of companies to compound future growth for you. The same analogy can be applied to personal finance. If you consume more of your savings today, there will be less for future wealth. A dividend is a form of consumption. Yes, there are disciplined investors that reinvest all their dividend but more often than not, most dividends are being consumed unknowingly rather than reinvested. A dollar of dividend that is not reinvested will lower your long term compounding power. It is like a car always on the 1st gear going up the hill. Here is an example.

Both stocks, A and B have a ROC of 20%. Stock B is a dividend stock, paying out 80% of their earnings and reinvest the remaining 20% for 4% growth (Growth rate = ROC*Reinvestment rate) due to lack of opportunities. Whereas stock A is a compounder. It is a small fish in a big pond and given there are many opportunities out there, it can grow at 16% (reinvesting 80%) and payout a conservative 20%.

You would notice there’s a slight difference between both CAGR figures. Stock B has a lower CAGR because the dividends are not reinvested. The difference of around 3% doesn’t sound much, but on a dollar level, stock A’s return is 80% higher than B after 20 years. Instead of $45 vs. $25, think $450k vs. $250k, or $45 mil vs. $25 mil. Dividend that is not reinvested might not amount to many each year year, but over the long-term, it becomes exponential.

When a company pays out a majority of their earnings, the weight shifted from the management to the shareholders. If dividend is to be reinvested, shareholders have to do the heavy lifting by finding similar or better opportunities in the market. Sometimes, the timing of dividend doesn’t always coincide with opportunities in the market, and at times, runs in opposite direction. In a bull market, there will be fewer opportunities as better earnings leads to higher dividend and share price gets bid up in the process. The opposite applies in a bear market. Shareholders also need to consider the time required to research and find these opportunities because time is an opportunity cost. And when time constraint and limited opportunities collide, there’s a tendency to make rash decisions that lead to bad investments. These are subtle risks that are less discussed when reinvesting your dividend but are nonetheless real.

On the flip side, dividend can be a better choice in some cases. If it is the main source of income for an investor or if a company has limited growth opportunities; poor allocation skills that lead to diworsification; face highly uncertain future prospect or destroys shareholders value by opting for growth that has a poor return, it makes sense to focus on dividend over growth.

For investors where dividend income is optional and can afford to wait 10-20 years, you can fully exploit this edge. The best way to do so is to leverage on stocks that can redeploy most of their incremental earnings at a very high rate for a long period of time - the compounders. As the example shows, 2 stocks can have the same ROC (and same cost of capital) but that doesn’t give you the full picture. The one that can grow faster is going to be more valuable. Make no mistake, compounders are the rare breed. Most companies cannot continue to maintain a high ROC for a long time or if they succeed, size will eventually prevent them from reinvesting all their capital. With that said, it is good to keep in mind compounders should always be the one you are looking for, especially during a crisis.

For dividend investors, dividend will continue to play an important role in determining long term return. The keyword is ‘long-term’. If you remember the bathtub system, it is worth the time to pay more attention and ask “How sustainable is the ROC in the long run?” rather than “What is the current dividend yield?” because when the ROC gets eroded by competitions, dividend will soon follow.

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