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Thursday, June 19, 2008

* The Dark Side of Dividends

In life there are precious few things that are lily pure in which nothing negative could rightfully be said about them. I am not foolish enough to believe that dividends are the ultimate panacea. Join me today as don myself in black and explore the the Dark Side of Dividends.


Here are the top five reasons for not paying a dividend:
  1. In the U.S. and some other countries, dividends are double taxed. Corporations pay taxes on their earnings, then when dividends are paid to shareholders they must then also pay taxes these distributed earnings.
  2. When an individual pays taxes on a dividend distribution, the future earnings associated with the taxes are forever lost. Some would argue that capital gains are better for this reason, since the investor chooses when to incur the tax.
  3. Companies in new and growing industries need every cent for future growth, thus can't afford to pay dividends. In fact they are usually issuing stock and debt to raise additional capital.
  4. If a company has old debt with a very high interest rate, it might be better off to reduce the debt prior to initiating a dividend program.
  5. It puts pressure on management to sustain the dividend in the future.
Black is just not my color. I prefer my white hat (with a crimson script A, of course). Here are my five responses to the above:
  1. It is true that dividends are double taxed in some countries. Many governments, including the U.S. have recognized this, and have provided tax breaks to minimize the double taxation. In the U.S., qualified dividends are taxed at a reduced rate of 15%.
  2. It is true that when an individual pays taxes on a dividend distribution, the future earnings associated with the taxes are forever lost. Ultimately, we will need to convert our investments to cash either through dividends or capital gains. Dividend consistency is related to the quality of the company we have invested it, while capital gains are often at the mercy of the market (good companies are often punished in a down market).
  3. It is true that companies in new and growing industries need every cent for future growth, thus can't afford to pay dividends. New companies rarely ever qualify as a good dividend company. Get back with me once you are grown and mature.
  4. It is true that a company with old debt with a very high interest rate might be better off to reduce the debt prior to initiating a dividend program. Again, this is likely to be a new or middle aged company, not yet mature enough to be a good dividend company.
  5. It is true that paying an ever increasing dividend puts pressure on management to sustain the dividend in the future. Isn't that why we shareholders pay them the mega-bucks to generate value for us by running a superior operation?
Though not perfect, dividend distributions meet a very specific need for investors looking for a reliable and growing revenue stream. Not all companies that pay a dividend are good dividend investments. Investors must do their due diligence prior to purchase.


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