Dividends: to be or not to be? (episode 3)

In his last article, L'(Very) Private Investor gives us convincing examples of investment based on variations in share prices. By buying low enough and selling high enough, we can thus generate a particularly interesting profitability. The confrontation of points of view between approaches based on the price and those based on dividends seems a priori to draw a gap that is difficult to overcome. And yet...

Volatility

I know, I've already talked about it a lot in theepisode 1 and Thomas took over well in theepisode 2. But I think that volatility is at the heart of our debate. For the trading-oriented investor, this volatility is an ally. It is thanks to it that he will be able to buy low and sell high. It is even commonly accepted that the The potential profitability of a security is correlated with its volatility.. It's a bit like a trampoline, to go high you have to make bigger and bigger jumps, but each descent is also bigger.

In theory, to get rich, we should invest in highly volatile stocks, sleep on them for a few years, and then cash in. The problem is that we are not purely rational beings, that we are bombarded with information all day long, that we can't help but go and see the value of our positions, freak out and eventually sell them, regretting it later. Raise your hand if you have never done that.

A stock that fluctuates sharply up and down is not riskier in itself, but it is riskier depending on the feelings of fear and greed of the investor, leading him to make bad decisions. By not knowing our limits, we are therefore our own worst investment advisors. It took me at least five years to realize that I was buying stocks that were too volatile for my risk propensityThe stocks I had bought were good, but I just couldn't stand to see their price fluctuate like that, so I sold them, and as is often the case, they went back up right after.

The other possibility is to trade like Thomas, in exploiting the peaks caused by this volatility. But here too, you have to have very strong nerves not to succumb to the panic caused by certain very brutal movements. As Thomas said in his stock market investment vision, what good father can stand the idea of losing 50% on his investments? The solution of course would be to set stop orders to protect his positions. Your money is certainly partly preserved but here too if you set the order at the level of what you accept to lose, on a stock too volatile for you, it will cross the trigger threshold and the price may well go back up right after! Who has never had this happen to?

Let us also note that Volatility is not always correlated with performanceThis is particularly the case for companies in difficulty. The example of General Motors between 2006 and 2008 is particularly telling.

All this to say that not everyone can stand to see the price of shares vary too much. Personally, I know that my preferred volatility zone is between 7 and 14%. Below, I get tired, above my emotions start to arise. Beyond 21% I make bad choices.

It’s not that I don’t like trading investments. I’ve tested it for a long time, many times, using different approaches and different tools. It’s just that it doesn’t suit me. I can’t get the performance I want not because of the securities themselves, but because of my emotions. Studies that analyze the correlation between profitability and volatility should also take more account of investor errors of judgment linked to volatility.

The performance

Dividend-paying stocks have a reputation for being "old-timey" investments, a bit soft. One reason for this is that these stocks are precisely low in volatility. But remember who ultimately wins in the fable of the hare and the tortoise... We have seen above that the investor himself, by wanting to play the hare too much, could do himself a very bad service. But we have not really stopped on the qualities specific to the tortoise.

In his last article, L'(Very) Private Investor compares 4 hares (AAPL, LAC.PA, HF.PA, ML.PA) to a tortoise (CL). Viewed graphically, representing the price of these stocks (and only the price), dividend payers look pale. But investors should focus on total profitability, incorporating both price changes AND dividend distributions. By relying on the ubiquitous charts on the web to compare the performance of their investments, Many investors are wrong and most don't even know it. These graphs do not take into account the impact of reinvested dividends.

AAPL is one of these rare growth stocks that manage to maintain their trend over many, many years. The stock reminds me a bit of MSFT which also had a huge increase in its share price until 2000. Whether for a dividend stock or not, the performance achieved by this type of stock is difficult to match. But I played the game and tried to compare the total profitability of AAPL with increasing dividend payers.

I reassure Thomas right away, over 10 years, indeed, there is no equivalent. The best I have found is NVO, with a total profitability of 1075%, which is not bad all the same. But over the last twenty years, TJX shows a Total Return of 7000% against "only" 4300% for AAPL. Thus, when one takes into account in stock comparisons not only the price variation, but also dividends, the difference in performance between hares and tortoises is much less obvious.

I quote Thomas again:

Be careful, I'm not saying that you should trade at all costs (I'm talking about a few positions per year here...), but that you should know how to take your profits when they come (...). The dividend investor will console himself with a few percent of gains, saying to himself, "it's a shame, I had +20% at the beginning of the year"...

When you factor in total profitability as you did above, it becomes less attractive to take profits at peaks. There is the risk of making a mistake, the stress of tracking stock prices, and the bank transaction fees. Profit taking occurs naturally when the dividend is paid.. We have also seen at the'episode 1 that the return on purchase cost became exceptional over the years.

However, and here I agree with Thomas, there are times when you have to know how to sell.

Dividends are not a right

L'(Very) Private Investor reminds us of an obvious fact that unfortunately many investors had ignored during the years preceding the subprime crisis:

Of course, there are American companies that have been paying dividends continuously for decades… But can this continue indefinitely? We should not confuse stocks and bonds…

Unlike with bonds, a board of directors can indeed choose whether or not to pay a cash dividend to its shareholders. I have always warned my readers against this risk.

There are obvious incentives to maintain or regularly increase dividend payments: they help attract investors and are a sign of financial strength. But in times of severe uncertainty, especially in a credit-fueled panic, reduce or cut the dividend to preserve cash becomes a more attractive option for businesses.

When profits fall significantly, the company may be forced to reduce the amount it pays to its shareholders. This is especially the case when the distribution ratio is already high. While the company may have seemed like a good investment at first, you end up making a very bad deal, especially since the share price will undoubtedly have fallen in the meantime. In this case, you would have been better off buying bonds.

But sometimes the company is in such bad shape that it can no longer pay its shareholders. This is what happened with the banks in 2008. It can even last several years. It is as if you were the owner of a building and your tenants no longer paid you rent. Worse, at the same time your land loses value. Indeed, the share price, which contains the value of profits and dividends, collapses as soon as the latter disappear.

But with a few precautionary principles, it is very easy to avoid these unpleasant surprises:

• Eavoid buying securities whose distribution ratio is too high and therefore sell to those to whom it would become so.  
• Focus on companies that do grow their dividend steadily and for a long time, proving the solidity of their Business Model.
• Stocks with stagnant distributions should be sold in favor of growing dividends, because they are less efficient than the latter and run the risk of reducing or eliminating their distributions, with the consequences that we know.
• Avoid titles that are too sensitive to the economic situation who move too quickly from a phase of growth in distributions to pure and simple elimination.