Why Dividend Investing Can Be a Losing Game

“I make 5 million won a month from dividend stocks.” You’ll see blogs or YouTubers using lines like this to lure people in. Even if we set aside the fact that dividend income tax prevents you from fully enjoying the power of compounding, the stocks we typically think of as “dividend stocks” are, in many cases, companies that are not attractive from an investment perspective. Compared with investing in growth stocks, you are more likely to lose out due to the opportunity cost. Of course, as we explained in AWARE’s real estate stock (REITs) investment strategy, dividend-paying stocks can be highly attractive depending on the situation. But I want to explain why in most cases, they are not.

A dividend stock is a stock where a company pays dividends to investors in return for holding its shares. Dividends are a portion of the profits a company earns through its business operations that it distributes to shareholders. When investors think of dividend stocks, they usually picture stocks that pay a lot of dividends among all dividend-paying stocks. You might wonder what “a lot” means here; broadly, there are two main criteria.

By combining these two metrics, you can identify companies that pay out a lot in dividends. Among the two, investors tend to prioritize dividend yield. That’s because, from an investor’s perspective, what matters is how much dividend income you receive relative to the price you pay for the stock.

There’s no need to get too excited just because you’ve found a stock with a high dividend yield. A high yield simply means that the current share price is low relative to the dividend. If you come across a stock with a 20% dividend yield, the metric you should really focus on is the payout ratio.

Some companies have a payout ratio above 100%. Suppose Company A earns 100,000 won in net income this year but pays out 200,000 won in dividends. Its payout ratio would be 200%. In that case, the company is funding its dividends not only from profits, but also by dipping into existing cash (equity capital) or by taking on debt.

A company with substantial assets might be able to borrow against them and use the proceeds to pay dividends, but ultimately, paying out dividends that exceed net income—the foundation of future cash flows—erodes its equity capital and is therefore not sustainable. So don’t automatically assume that a high dividend yield means a company is doing a great job of returning cash to shareholders. The higher the payout ratio and the more volatile the earnings, the more you should assume that the risk of future dividend cuts is high.

If you find a stock with stable earnings, a payout ratio below 100%, and a high dividend yield, you might feel like you’ve “hit the jackpot.”

Indeed, when markets plunge and a company’s cash-flow generation and dividend payments are intact but the share price has fallen excessively, dividend stocks can become attractive. However, in most cases, dividend investing is a losing proposition. There are many reasons for this, but the two core ones are “inefficient capital allocation” and “weak compounding effects.”

Most dividend income is taxed. Dividends you receive from investing in Company A’s stock are subject to a 15.4% dividend income tax each year, and if your total financial income exceeds 20 million won, you become subject to comprehensive financial income taxation and must pay additional income tax. Even if you reinvest the full amount of dividends back into Company A’s stock, assuming an average tax rate of 20%, that 20% is shaved off your compounding effect every year. Company B, by contrast, is growing at 50%, so its return on equity is far higher than prevailing interest rates. If it reinvests its net income back into the business, its future cash flows will keep rising (assuming that high growth rate is sustained). When you invest in Company B’s stock, the company’s value increases over time, yet you pay no dividend tax—and you don’t pay capital gains tax until you actually sell the stock. Because you’ve invested in a growth stock, the company reinvests your capital on your behalf, and you don’t pay taxes along the way, allowing you to fully capture the power of compounding.

Assuming capital markets are efficient (a BIG if), a company’s CEO and CFO have a responsibility to deploy the capital entrusted to them by shareholders as efficiently as possible. If the company’s return on equity (ROE) is higher than market interest rates, then it makes sense to reinvest profits back into the business. For most companies, reinvesting profits signals confidence in future industry conditions and the company’s own business prospects, whereas returning most of the profits to shareholders via dividends can be interpreted as a lack of confidence in future business conditions and growth prospects, effectively signaling that future growth will be hard to come by. Companies are generally valued based on the present value of the sum of their future cash flows, and one of the most important variables in that calculation—future cash flows—varies greatly depending on the growth rate. At first glance, Company A, which earns 1 trillion won a year, should be more valuable than Company B, which earns 100 billion won. But if Company A’s five-year average profit growth rate is 3% and Company B’s is 50%, then you can reasonably assume that Company B’s future cash-flow generation potential is much higher. In a typical U.S. corporate setting, Company A, with its low ROE, would return most of its net income to shareholders as dividends, while Company B, with its high ROE, would reinvest most of its net income into the business. As a result, Company A would have the higher dividend yield and payout ratio, but Company B would be more valuable.

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As of today (May 17, 2024), over the past six months the AW portfolio has outperformed the S&P 500 Index, which tracks 500 leading U.S. companies, by 27.90% without using leverage (margin). As we note on our About Us page, this is because AWARE looks at the market from a differentiated perspective, analyzes companies that are poised to become leaders, and invests in them ahead of the crowd.

For a U.S. stock investor with around $10,000 invested, even after paying an annual subscription fee of $500, it was possible to outperform the index by 22.90%.