A Final Word on Dividends and some challenging e-mail

by Ann Coleman (TMF AnnC)

Reston, VA (April 27, 1999) -- I enjoy challenging e-mail. A polite disagreement can lead to a reexamination of your beliefs, sometimes changing them, sometimes strengthening them.

Last week a reader challenged my conclusions about the Exxon (NYSE: XON) investor who was getting a 30% return on his initial investment by buying and holding a high yielding stock for a number of years. I thought that was a cool way to maximize dividend payout, but he wrote:

The example of the investor who was getting a 30% yield on his Exxon stock can be really misleading to the uninitiated.

In your Exxon example, with price at $100, basis at $10, and current dividend of $3, the question is not how do I beat 30%, but can I get more than $3.00 cash dividends somewhere else if I sell Exxon?

If you figure a 20% tax on the capital gain you would pay ($100 - $10)(.20) = $18.00 tax and have $82.00 left to invest (neglecting commissions). To get $3.00 on the $82.00 investment would require a yield of ($3)/($82) = 3.66%. So if current cash dividend is important to you, look around for stocks paying more than 3.66% current dividend yield.

My first reaction was that this was a good point. The writer is retired, and retirees certainly need to maximize the income from their investments. But that capital gains tax really bothered me. Once you send that cash off to Uncle Sam, you lose not just that money but all the cash that that money would generate as it compounds over the years.

I set up a spreadsheet to follow this strategy vs. a strategy where the investor simply continued to hold Exxon yet made up the dividend shortfall each year by selling just a few shares of stock. Here's how each account grows:

Account 1: Stock sold and higher yielding stock purchased:

Principal     Div.@ 5%

$82,000       $4,100
$94,300       $4,715
$108,445      $5,422
$124,712      $6,236
$143,419      $7,171
$164,931      $8,247
$189,671      $9,484
$218,122     $10,906
$250,840     $12,542
$288,466     $14,423

Account 2: Stock held and shares sold to make up difference:
                         Stock      Total
Principal     Div. @3%   Sales     Withdrawn
$100,000     $3,000     $1,100      $4,100 
$113,680     $3,410     $1,305      $4,715 
$129,166     $3,875     $1,547      $5,422 
$146,685     $4,401     $1,835      $6,236 
$166,485     $4,995     $2,176      $7,171 
$188,847     $5,665     $2,581      $8,247 
$214,076     $6,422     $3,061      $9,484
$242,514     $7,275     $3,631     $10,906
$274,534     $8,236     $4,306     $12,542
$310,547     $9,316     $5,107     $14,423

For this illustration I assumed a 15% return for each stock and "paid" a tax of 20% on the shares that were sold each year (i.e. the principal was reduced each year by the Stock Sales amount plus 20%). I also assumed that the investor could find an alternative investment that would pay full two percentage points higher, yet the stock price would still continue to grow at the same rate as the lower dividend-paying stock. While I'm not saying that that can't be done, it would be somewhat unusual.

Clearly the investor would be better off sticking with his original investment under this scenario. This illustration assumed one switch, but what if an even better stock came along? There goes another 20% of your gains. Switch to higher yielding stocks often enough, and your principal will grow like tomatoes in deep shade.

One factor that I didn't track is the full effect of taxes on the income generated. In the first scenario, the investor will pay taxes at regular income tax rates on all of his income, while in the second scenario, part of that income is being taxed at lower, long-term capital gains rates. Factor that in and less stock needs to be sold each year to have an equal amount of after-tax cash.

But suppose this investment were sheltered in an IRA? Might switching in search of higher dividends be a good idea in that case? Well, it would certainly be a better idea, however, you still need to carefully consider the growth potential of the stock you are switching into. Certainly, if you can find the magical stock with higher dividends and equal or higher growth, go for it. But that is often easier said than done. Trading in a stock that is growing at 15% a year for one that grows at 10% a year will give you an account balance that is 50% smaller after 17 years.

You would have to double your yield to get the same payout, even though you only sacrificed one third of your growth -- not to mention the fact that you would have half as much money! That higher yield could be very expensive in time.

Fool on and prosper!

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04/27/99 Close
Stock  Change   Last
CAT  +1  9/16  63.56
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    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     63.56    47.55%
 12/24/98    9 JP Morgan    105.51    137.75    30.56%
 12/24/98   22 Int'l Paper   43.55     55.75    28.01%
 12/24/98   14 3M            73.57     80.81     9.84%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1525.50   $491.50
 12/24/98    9 JP Morgan    949.62   1239.75   $290.13
 12/24/98   22 Int'l Paper  958.12   1226.50   $268.38
 12/24/98   14 3M          1030.00   1131.38   $101.38

              Dividends Received      $29.45
                             Cash     $28.26
                            TOTAL   $5180.84