High dividend stocks are commonly viewed as investments that provide regular income to the stock holder regardless whether the market is bullish or bearish.
Many investment gurus also frequently recommend stocks with high dividend yields to their clients.
To most investors, dividends are like “free money” given to them for just owning the stocks of a listed company.
However, most investors fail to realize that dividend payout is NOT FREE MONEY.
It is NOT a regular real income that goes to shareholders for just owning the stocks of a company.
What does the word “Income” means to you?
Before I explain further, let us first define what does “income” means to an average person.
Investopedia defines “Income” as “Economic wealth that is generated in exchange for an individual’s performance of agreed upon activities or through investing capital”.
However, I like to further elaborate that a $100 income earned can be considered as real income ONLY IF you do not lose money somewhere else as a direct result of receiving that $100.
Let’s take a look at some simple examples:
If you are an employee with a $30,000 yearly basic salary, you will get that $30,000 salary every year without suffering any losses in any way as a result of receiving your salary.
That $30,000 is your real income.
If your property is worth $1 million today and you receive a yearly rental fees of $100,000 from your tenant tomorrow, your property is still worth $1 million tomorrow.
That $100,000 is your real income.
If you buy newly issued bonds and receive a regular 4% annual interest, you will still get back your full capital at the end of the tenor.
That 4% annual interest is your real income.
Why high dividend stocks do not provide real income to investors?
From my past experiences with stock investors, many of them view regular dividend payouts as a form of real income.
They believe that the dividend that they get from owning a stock is the same as the salary that they earn as an employee, the rental fees they get from leasing out their property or the interest payment they get for owning bonds.
That is simply not true!
Let’s explore the reality of dividend payouts
Dividend once paid out to you on the ex-dividend date, do not belong to the company anymore.
Other investors, who intend to buy the stock on the ex-dividend date and beyond, are no longer entitled to that particular round of dividend payout.
As such, whoever is keen to buy the stock on the ex-dividend date will naturally discount off the dividend amount from the price that they are willing to pay.
Once the market opens on the ex-dividend date, the stock price will usually fall by an equivalent amount to the dividend that was paid out.
To put it simply:
If you own a stock that closed at a price of $10 today and it goes ex-dividend with a $1 dividend payout tomorrow, your stock will usually open the next day at just $9.
You got a $1 dividend as “income” but you also have an immediate paper loss of $1 on the stocks you own.
If that is the case, can you still technically consider dividend payout as an income? Or should a dividend payout be considered as a cash withdrawal instead?
To further illustrate what I mean, I will provide two examples, namely Verizon Communications and Portugal Telecom.
The two examples are both telecommunications companies listed on the New York Stock Exchange.
Both are high dividend stocks that pay significant amount of dividends to their shareholders on a regular basis.
Portugal Telecom’s opening price reaction on ex-dividend date
The net dividend to be paid was $0.3395 (after deducting all relevant taxes and fees) and the ex-dividend date was on the 22 May 2012.
This means that whoever bought this stock ON AND BEYOND 22 May 2012 will not be entitled to the $0.3395 of dividend anymore.
On the 21 May 2012 (a day before ex-dividend date), this stock closed at a price of $5.20.
On the 22 May 2012 (ex-dividend date), the stock opened at $4.58.
It was a significant drop of $0.62 and the price plunge was nearly two times the net $0.3395 cash dividend that shareholders received!
This basically means that shareholders who received the $0.3395 cash dividend were slapped with a $0.62 capital loss right at the open on the ex-dividend date.
If I have to make this even simpler, this implies that while a shareholder received $0.3395 on their left hand, they were immediately robbed of $0.62 from their right hand!
Worst of all, the price continued to fall sharply after the ex-dividend date with shareholders continuing to see their paper loss ballooning.
This is definitely terrible business for investors who bought this counter for its stable dividends!
Verizon’s opening price reaction on ex-dividend date
The dividend to be paid was $0.50 and the ex-dividend date was on the 6 July 2012.
This means that whoever bought Verizon ON AND BEYOND 6 Jul 2012 WILL NOT be entitled to the $0.50 of dividend anymore.
On the 5 Jul 2012 (a day before ex-dividend date), Verizon closed at a price of $44.89.
On the 6 Jul 2012 (ex-dividend date), Verizon opened at $44.26.
It was a significant gap down of $0.63 and the price plunge was more than the $0.50 dividend that shareholders received!
This basically means that shareholders of Verizon who received the $0.50 dividend were slapped with a $0.63 capital loss right at the open on the ex-dividend date.
While shareholders received a $0.50 dividend gain into their left pocket, they were robbed of a $0.63 capital loss from their right pocket!
Do you understand the real implications of dividend payouts now?
In summary, both the stocks’ prices gapped down at the market open, more than the dividend that was being paid out on the ex-dividend date.
In the case of Verizon Communications, some might argue that the stock price recovered subsequently to the prior ex-dividend price level.
However, the recovery back to a price level before the ex-dividend date was in fact due to the prior uptrend momentum of the stock and not due to any effects of the dividend paid.
Had the dividend not been issued, the stock price would have climbed from the prior ex-dividend level to an even higher level instead.
Let’s explore what would likely have happened if no dividends were issued
I will be using Singapore Press Holdings (SPH), a blue chip high dividend stock listed on the Singapore exchange, also one of the component stocks of the Straits Times Index as an example.
As indicated in the dividend chart above, a total of $0.17 were paid out on the ex-dividend date on the 7 December 2012.
On the ex-dividend date at the market opening, the price of SPH opened exactly $0.17 lower than the previous day’s closing price.
As per the phenomenon that I explained earlier, the shareholders who received $0.17 of dividend on the ex-dividend date was slapped with an immediate $0.17 capital paper loss at the market open.
Despite the sharp price plunge, the price of SPH subsequently recovered over the next 3 months to a closing price of $4.20 on the 6 Mar 2013.
The price plunge due to the dividend payout on the 7 December has been fully recovered in these 3 months.
The above chart of SPH was modified with the assumption that no dividends were paid out on the 7 Dec 2012.
As you can see, if no dividends were paid out, the opening price on the 7 Dec would likely be similar to the closing price on the 6 Dec.
Subsequently, SPH will maintain its exact uptrend momentum and by the 6 Mar 2013, SPH will theoretically close at around $4.37.
Let’s now assume that you own 1000 shares of SPH and do a net worth analysis comparing the two different scenarios as illustrated above.
Scenario with dividend payout
On the 6 Mar 2013, your net worth (dividend received + stock holdings) will be $170 (1000 shares x $0.17) + $4200 (1000 shares x $4.20) = $4370.
Scenario with NO dividend payout
On the 6 Mar 2013, your net worth (dividend received + stock holdings) will be $0 (no dividend payout) + $4370 (1000 shares x $4.37) = $4370.
There is no change in your net worth whether you received any dividends or not!
The high dividends you received from your SPH stocks had no effect on your net worth compared to if there was no dividend payouts.
So what is the conclusion?
By now, I hope you have realized that high dividend stocks (regardless high dividend payout or high dividend yield) do not add to your bottom line, your profits or your real income.
Ultimately, whatever dividend that you received will immediately be taken away from you in the form of a price drop on the ex-dividend date.
All dividends that were paid out will automatically be discounted off from its stock price by the market on the ex-dividend date.
What is of utmost importance rather, is the price trend of the stock that you own.
You want to buy a stock in which its price is trending higher steadily (price appreciation) rather than trending down persistently (price depreciation).
At the end of the day, your net gains and income from the stock market will always be based upon how much the stock price has appreciated from the price at which you bought the stock, regardless how much dividends you have received during this period.
What you receive as dividends (regardless low 1% dividend yield or high dividend 50% yield) will be discounted off right at the market open on the ex-dividend date.
As a shareholder, a dividend payout no matter how big or small has no impact on your net worth.
If the price of a stock is climbing consistently, it is WORTH buying this stock regardless how little dividend you might be getting from this stock.
If the price of a stock is falling persistently, it is NOT WORTH buying this stock no matter how high the dividend payout or the dividend yield is.
Price trend is all that matters, not dividends, since the outcome of dividend payouts are factored into the price trend as well.
Do you know of any friends who buy stocks for the pure sake of “earning passive dividend incomes” without having any regards to how the stock is doing in terms of its price trend?
Please share with them about this article so that they can know the truth about this dividend income myth!
P.S. If you are still not convinced because the person (me) who wrote this article is from the technical analysis school of thoughts, have a read about this very same subject by a value investor from GiraffeValue.