Thursday, May 8, 2008

* Stock Dividends - The Gift of Nothing

Have you ever been tempted to wrap up an empty box and give it to your spouse for your anniversary. You could say something mushy like, "this isn't an empty box, it is filled with all my love." I don't know how your spouse would react, mine would see through this ploy as me just trying to be cheap frugal.

A stock dividend, also known as a "scrip dividend", is a dividend payment made with stock instead of cash. Sometimes when companies are tight on cash, they will declare and pay a stock dividend in lieu of a cash dividend. Most shareholders feel like they are getting something. But are they really?

In short, a stock dividend is nothing more than a glorified stock split. At the end of the process, the shareholder has more shares that are worth less. Like a stock split, you can not create value by issuing paper and getting nothing in exchange. After a stock split or stock dividend, the company has no more assets or liabilities than before the transaction, so it is not worth any more or less. There are only more shares outstanding, thus each share is now worth less. The intrinsic value of the company is unchanged.

There are some arguments for stock splits, such as liquidity (how easily a stock can be bought or sold in the market). Once a share price reaches a certain level, fewer shareholders are willing to invest in it, thus marginally lowering it liquidity. The perfect example of this is Berkshire Hathaway (BRK.A), Warren Buffett's company, trades at about $130,000 per share. Though BRK.A has an astonishing history of excellent performance, I do not own it nor am I likely to buy it at any time in the future because one share of it would be over my allocation for any individual stock. If they split the stock, say 1000:1, I would certainly pick up some shares of it in my core portfolio.

It is important to note there are costs associated with stock splits and stock dividends (e.g. exchange fees, transfer agents, etc.) Stock dividends generally occur on a much smaller scale than stock splits. Normally stock dividends are in the neighborhood of 5%-10%, thus any liquidity benefit would be marginal at best. Given the real costs and marginal benefit, I personally do not see any reason to ever pay a stock dividend. In fact I view them as a red flag.

Sunday is Mother's Day. I don't know what I am getting my wife. But I can tell you now, it won't be an empty box!

Full Disclosure: No position in the aforementioned securities. See a list of all my income holdings here.

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- Income Annuities vs. Dividend Stocks
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