Warren Buffett: The Big Problem with Dividend Investing
Why won't you pay a dividend to your shareholders?
Well, we think our shareholders 5 years from now will be wealthier counting what they would get from the reinvestment of the dividend. We think they'll be wealthier if we hold on to the money now. We may be wrong in that, but historically we've been right. If we had paid a dividend over the years, our shareholders would be considerably poorer.
If you spent any time in the personal finance and investing space of YouTube, you’ve probably come across what is known as dividend investing. Dividend investing primarily involves buying stocks in companies that pay regular dividends, with dividends being essentially payments made to shareholders out of the company’s profits. There’s a common belief out there that dividend investing is the key to financial freedom - just sit back and collect your dividends. It’s easy to see why this message resonates with so many people. I mean, who wouldn’t love passive income after all?
But what if I told you that dividend investing could cost you over $2.1 million across your investing lifetime? Stick around, and I’ll explain how. Unfortunately, I have some bad news for those that consider themselves members of the Cult of dividend investing. Many times dividends can actually hurt investors, costing them cold hard cash over the long term.
By the end of this video, you will see why dividends are actually irrelevant. Before you come at me with your pitchforks, it’s not just me saying this. It’s actually legendary investor Warren Buffett, and this may come as a surprise to you considering that Buffett’s stock portfolio is set to rake in $6 billion in dividends this year.
In this video, we are going to cover why dividend investing has become so popular, why Warren Buffett believes dividends can actually be bad, and how dividend investing could cost you potentially millions of dollars in investment returns over your lifetime. Here's Buffett explaining why his firm Berkshire Hathaway doesn’t pay a dividend:
"Um, well, the answer is I do believe in dividends in a great many situations, including many of the ones that companies in which we own stock. The test about whether to pay dividends is whether you can continue to create more than $1 of value for every dollar you retain. And there are many businesses, we take C’s Candy, which we own. C’s Candy has paid everything virtually out to us that they’ve earned because they do not have the ability within C’s Candy to use large sums which they earn intelligently in their business. So it’d be an enormous mistake for C’s Candy to retain money. So they distributed Berkshire and we hope that we move that around in some other area where that dollar becomes worth $1.10 or $1.20 in terms of present value terms."
"If we do that, the shareholder, whether they’re taxable or whether they’re not taxable, whether they’re a foundation or whether they’re living on income, even they are better off if we retain the money. Because if they were going to get a dollar in dividends and it became worth $1.10 or $1.20 in market value immediately on a present value basis, they’re better off selling a small percentage of their stock and realizing the required amount that way. They will have more money when they get all through doing that than if we paid it in dividends."
"But if the time comes, and it will come someday, when the time comes when we don’t think we can use the money effectively to create more than a dollar market value per dollar retained, then it should be paid out. And like I say, we do that individually within Berkshire, but because we have this ability to redistribute money in a tax-efficient way within the company, we probably had more reason to retain all of our earnings."
"If C’s Candy were a standalone company, we would simply pay out a lot of the earnings, practically all of the earnings, in dividends just like we do now, except it goes to Berkshire. We like the companies in which we have investments to pay to us the money they can’t use efficiently in their own business. In some cases, that’s 100% of what they earn; in some cases, it’s 0% of the earn."
To truly appreciate Buffett's wisdom from that clip and how it applies to dividend investing, you first have to understand a concept in investing known as capital allocation. If your goal is to build significant wealth in the stock market, you absolutely must know about this concept. The technical definition of capital allocation is the process of determining the most efficient investment strategies for an organization’s financial resources with the goal of maximizing shareholder equity. Although I much prefer my own more straightforward definition, which is that capital allocation is what the company does with its cash generated from its profits.
Let’s use Apple stock as an example. Apple is by far the largest position within Warren Buffett's stock portfolio. Apple generated approximately $100 billion in cash in 2023—a truly staggering amount of money when you take a second to think about it. Broadly speaking, there are two main buckets for what Apple can do with its cash.
The first bucket is to reinvest in the business, and this can take the form of what is known as organic or inorganic growth. Organic growth is growth that is achieved from a company investing in its internal initiatives to improve its business model, resulting in improvements in the company's revenue growth rates, profit margins, and operating efficiency. Businesses can achieve organic growth by expanding into new markets, improving their existing product or service mix, enhancing their sales and marketing strategies, and introducing new products. In the case of Apple, this organic growth might take the form of money spent on developing new products—an example being the Apple Vision Pro, Apple’s virtual reality headset. This use of cash is considered organic growth.
In addition to organic growth, another use of cash could be what is referred to as inorganic growth. I know us finance guys and girls are very clever and creative when it comes to naming. Inorganic growth is when a company buys another company in order to grow, as opposed to developing its existing operation. Compared to other companies and relative to its size, Apple doesn’t spend a lot of money on inorganic growth. However, an example of this would be Apple’s purchase of Beats headphones for $3 billion back in 2014.
The other main bucket for what Apple can do with the cash that it generated is to return it to shareholders. This is the beauty of investing in the stock market; for every share you own in a company, it makes you essentially a part owner in that business. Just as if you’re a part owner in your favorite local small business, your ownership stake makes you entitled to your percentage share of the profits. Typically, a company will return its cash to its shareholders when it doesn’t have attractive reinvestment opportunities for either organic or inorganic growth.
Management of the company can choose to pay you out those profits in the form of a dividend or a share repurchase, also known as a buyback. With share repurchases, the company buys back its own shares, then turns around and subsequently cancels out those shares. This decreases the number of shares in circulation, resulting in each remaining share representing a larger ownership stake in the company.
Apple has spent over $250 billion over the last 3 years repurchasing shares. With each share the company repurchases, Buffett's stake gets larger and larger. This is such an important concept that Buffett even wrote about it in his widely followed annual letter. Here’s what he said: “Apple, our runner-up giant as measured by its year-end market value, is a different sort of holding. Here, our ownership is a mere 5.55%, up from 5.39% a year earlier. That sounds like small potatoes, but consider that each 0.1% of Apple’s 2021 earnings amounted to $100 million. We spent no more Berkshire funds to gain our accretion. Apple’s repurchases did the job.”
With dividends, management pays out a cash payment to shareholders. The shareholder can take that money and do whatever they please with it. This is one of the core attractions to dividend investing and is why it’s become so popular on the internet. The Cult of dividend investing would lead you to believe that investing exclusively in high dividend-paying shares is the key to building passive income and financial freedom. However, this thinking is highly flawed.
Following dividend investing in the manner promulgated by many financial influencers on the internet has the potential to cost you millions of dollars over your investing lifetime. Just take a look at the performance of the S&P High Dividend Yield Index compared to that of the S&P 500 Index. The High Dividend Yield Index has generated a net return of 7.49% over the last 10 years. The S&P 500 has returned 12.33% over that same period. That 4.84% difference might sound harmless at first, but it actually has catastrophic effects over the long term.
To explain this, let’s introduce you to two of our investor friends, Matt and John. At 25 years old, both Matt and John have $25,000 that they want to invest in an index. Matt has watched far too many videos on YouTube about the benefits of dividend investing, and hopeful for early financial freedom, he invests his 25 grand in the S&P 500 High Dividend Yield Index. John, on the other hand, invests his 25k into the vanilla S&P 500 Index. Neither of them touch their investment accounts again until they hit retirement age.
Given the 7.49% annual return for the dividend index and the 12.33% annual return for the S&P 500 Index, how much more money do you think John would have than Matt when they both hit 65? The answer might shock you. Assuming that both reinvested their dividends, Matt has $550k to his name, whereas John has over $2.6 million. That’s almost $2.1 million more than Matt, and if they didn’t reinvest their dividends, the gap between their returns would be even wider.
As you can see, the High Yield Dividend Index has dramatically underperformed the S&P 500. So now that we understand capital allocation, I’m going to spend the remainder of the video talking about the three big problems with dividend investing.
The first point has to do with what is known as the business life cycle. Just like living organisms, businesses have life cycles too. There's the introduction phase where the company is new and its products and services are getting introduced to the market. Next is the growth phase, where the company's products have found what is known as product-market fit, and the business is growing rapidly as a result. I run an investment fund that invests in and builds privately owned high-growth tech companies. These are the two stages of the business life cycle into which we invest because it’s where we can generate the highest returns for our investors.
The next stage we have is maturity. Here, growth in the business is moderated, and the market has become saturated with the company’s products. The final point in the business life cycle is decline. This is where technology or shifts in consumer preferences start to make a company’s products obsolete. By focusing exclusively on companies with high dividend yields, someone would find themselves investing into companies mostly in either the later part of the maturity phase or the decline portion of a business's life cycle.
As we talked about earlier, by definition, companies pay high dividend yields because they don’t have attractive growth opportunities to invest into. As a result, it should come as no surprise that these mature or declining firms that pay high dividends tend to underperform companies with attractive future growth prospects.
The second point is that often dividends don't reflect the underlying financial performance that dividend investors say they do. One of the pushbacks on this video from self-proclaimed dividend investors is going to be that dividend investing is not about finding companies with high dividend yields. Instead, it’s about finding companies that have a track record of consistently growing their dividends. That is the supposed appeal to neatly named groups like the Dividend Aristocrats, companies that have grown their dividend each year for the last 25 years.
Given the fact that investors will react negatively to cuts in dividends or changes in a dividend policy, many companies will attempt to smooth out their dividends each quarter or year despite the fact that the underlying financial performance of the business fluctuates. A perfect example of this concept is the logistics company UPS. This table here shows the company’s earnings per share and dividend payout by year. During this period, earnings per share grew by 39%; however, over that same time period, the company’s dividends grew by 95%. The company has increased its dividends almost 2.5 times faster than its earnings per share.
This might sound neat, but remember the dividends have to come from earnings. If UPS keeps this up, they will be paying investors 100% of earnings back in the form of dividends, leaving no earnings left to reinvest in growth. Now compare that with a company with good growth prospects reinvesting 100% of earnings back into growth. They will likely compound earnings growth at a much higher rate over the long term than UPS. This should help serve as a reminder that dividend payments don’t represent the underlying financial performance of a company in the way that many dividend investments would lead you to believe.
In fact, entrenching expectations of dividend payouts can create an unhealthy dynamic where companies feel obliged to pay dividends at the expense of reinvesting in growth. The third argument against dividend investing is what is known as the dividend irrelevance theory. The dividend irrelevance theory is a financial concept that states the value of a company is determined by the earnings and investment decisions, not by the dividend policy. According to this theory, investors are indifferent to whether they receive a dividend or capital gains as long as the total return is the same.
To demonstrate this concept, imagine you are a part owner in a local pizza shop. Let’s say that this pizza shop generates $100,000 a year in cash profits. From your net worth standpoint, it wouldn’t matter whether the pizza shop sends you a cash distribution for your share of the profits or whether the company retains that money in the bank account at the pizza shop. If the pizza shop retains $100,000 in the bank account, the value of the pizza shop would increase by $100,000.
This isn’t purely theoretical either; we actually see this in the stock market. If a company pays a dividend, it will have what is referred to as an ex-dividend date. This is the date where a new investor of that stock will not be paid the dividend. Coming in with this knowledge as a background, if an investor needs to make income from their investment portfolio, they can, in essence, manufacture their own dividend by selling a small portion of their stock portfolio, since long-term capital gains and qualified dividends are taxed at essentially the same rate to U.S. investors.
Investors should be indifferent on whether the income from their portfolio comes from dividends or capital gains from selling the stock. In fact, this is the advice that Warren Buffett gives to owners of Berkshire Hathaway stock. Despite having $167 billion in cash at the end of 2023, Berkshire did not pay a dividend and has no plans to pay one in the future. Buffett says that investors in Berkshire should create their own dividend by selling a small percentage of their shares in Berkshire each year.
In countries like the UK, dividends are often taxed at a higher rate than capital gains, meaning you’ll owe more in the form of tax from going down the dividend investing route. All else being equal, we’ve compiled a list of Buffett’s best quotes from his annual shareholder letters that summarize his view on dividends. If you’re interested, click the link in the description below to get your free copy.
At this point in the video, I hope you can see the potential issues with focusing exclusively on dividends when evaluating stocks. When researching a stock, understanding management's approach to capital allocation is absolutely critical. However, it goes much deeper than just whether the dividend payment is low or high relative to the company’s stock price and how much the dividend has grown in recent years.
If you’ve made it this far in the video, it’s clear that you’re interested in investing and building your wealth. If you want to learn more about these topics, check out this video here. Getting your first $100,000 saved and invested will transform your life in ways you cannot yet imagine. You’re going to find out why in this video.