I am continuously talking about dividends and how I am building my income portfolio around that philosophy. Dividend investing is one of the investing strategies among many other different styles of investing and trading strategies. In addition, I am a believer in two sides of a coin, I am a believer of black, while, and gray, and I am a believer in negative and positives.

Keeping with this, I am not dumb to believe that dividend investing is an ultimate panacea of all investing strategies. Anything that we do in our lives has two sides and we manage it in our own ways. Similarly dividend investing also has its dark side and unfortunately, it is often the focus in many discussions. We need to remove some of the myths associated with it and understand how it can be managed. Following is my attempt to bust some these myths associated with dividends.

We view dividends as are very small. Very low dividend yield (of the order of 1% to 3% only) is cited as being the main reason. It is said that these low yields do not even match the savings accounts interest rate of 7%.

Dividend yield is “dividends paid per share” divided by “stock price”. Now, if the stock price is over valued, dividend yield is bound to be low. If the stock is priced in excess of 20 PE ratio, dividend is bound to be lower than 2%. That does not necessarily mean that dividends have low yield. Stock price is governed by the market sentiment; it does not have any fundamental basis. If you choose to only look at high flyer stocks of the day, then you are bound to feel yields are less. This is addressed by investing in stocks whose dividend yields are based on fair value and earnings of the company. And not based on stock price on any given day, given week, or given year.

In addition, dividend investing is not about present yield. It is about what future yield (or your Yield on Cost) you will end up with. Does this bust the myth?

Many people use examples of developed world where dividends are 4% or more.

Historically, the dividend yields in developed world have been of the order of 2% to 3% as shown in my post dividend yield in global markets. In last two years, the equity markets have come down significantly, and hence the dividend yield appears to be in excess of 4% or more. In most cases (if not all), the stock prices are well below 20 PE ratio. Historically, even relatively safer utility stocks in developed markets have yielded in the range of 4% to 5%. Does this bust the myth?

It is also argued that when companies pay dividends and dividend tax, they are foregoing the earnings potential associated with that capital. They could have invested that back into the business to grow earnings and hence higher potential for stock price appreciation (i.e. more capital gains).

It is true that companies can use the capital for their future growth and help facilitate higher earnings (and higher stock price). The ultimate requirement for us investors is to convert those business profits into cash flow into our personal banks. A good management will strike a balance between profit sharing and need for future growth capital. That’s what CEOs are paid for? Isn’t it?

Any dividend investment is based on quality and consistency of the company. We have full control over which company we should be investing in. If we invest only in good companies with sustainable profitability and earnings, then we can control our dividends.

While capital gains from stock price is at the mercy of market. We do not have any control over it. Good companies get punished during stock market. If we want to focus on capital gains alone, then we better time the market properly. Does this bust the myth?

Mutual funds portfolio managers and agents will advertise their funds as being tax free dividends. Individuals do not pay taxes on mutual fund dividends.

In reality, these types of mutual funds have invested in dividend paying companies. So when the companies pay dividends to mutual funds, they are all tax free. The funds on their own are not giving you tax waivers. It’s the taxation policy in India that says dividends are tax free. Therefore, if you as an individual invest in any company, the dividends paid to you will also be tax free. So why do you want a mutual fund (middle man) to take that 2% commission without doing anything? Does this bust the myth?

Indian companies and their managements do not have favorable dividend policy

I actually commend Indian companies that they pay any amount of dividends. It is Indian government’s taxation policy that forces companies to pay reduced dividends. Our government asks companies to pay tax on dividends. It is tax deduction at source. Government has to use this process because rampant tax evasion in our country. In this taxation environment, companies get dinged by “dividends to shareholders” and “dividend tax”. In developed world, companies can deduct dividends paid (for tax purposes) and individual investor pays less tax percentage. Therefore, Indian companies need to be commended to pay dividends under this taxation policy. Does this bust the myth?

Companies in growth sectors need every rupee for investing back into the growth plans and hence, cannot afford to pay dividends. In fact they need so much capital that they issue new stocks and new debt.

It is true that companies in growth sectors need every bit of capital for continued growth. Therefore, a prudent dividend investing approach only includes mature companies. Any new company will rarely qualify as good dividend investment. I believe, even in growth sector, companies should be sharing their profits, albeit with less payout factor. In our personal finances, don’t we pay ourselves first by putting little amount in savings first? Do we ever spend it 100% saying it is investment for future growth? So why is it companies cannot do the same? Does this bust the myth?

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It is better for companies to pay of the high interest debt instead of paying dividends.

It is true that it is good for company to pay high interest debt first before dividends are paid. It is highly likely that such types of companies are new growth companies. Here again I believe management should use prudent payout factor to pay dividends and short time period. Over an intermediate to long term, if a company is continuously taking new debt, or not showing sign of debt reduction, it is actually a sign that it is not earning enough on its own. This in itself is a bad sign. In our personal home finances, don’t we attempt to balance housing interest payment with our other expenses? Or do we just focus on paying our debt first? Does this bust the myth?

Paying growing dividends in any given year puts pressure on management to pay growing dividends next year also.

It is true paying growing dividends puts pressure on management. But that’s what the management is paid for, to generate earnings by running the business on behalf of shareholders? Consistently paying dividends in cash is one measure to determine management is making good progress. Does this bust the myth?

I hope that this helps to clear some misunderstanding of the dividend based investing. As with anything in our daily lives, dividend investing is also not perfect. But if we understand it properly, we can manage it effectively. All stocks that are traded on stock exchange are not good stocks; similarly, not all companies that pay dividends are good dividend investments. Investors must do their due diligence prior to their purchase.