Understand the fallacy of dividends that Barsi does not tell you, but Buffett assumes – 05/14/2023 – From Grain to Grain

Last Friday, I wrote an article pointing out the average return of dividend-paying stocks versus other strategies. MSCI data indicate that the strategy of investing in companies that combine, in addition to high dividend payments, sustainability and persistence of these, was one of the worst strategies in the last decade and in the last year.

I received some questions about how this would have happened, since, supposedly, dividend-paying shares should be better, according to the preference of popular investors, for example, Luiz Barsi.

Dividend-paying companies may even be good investments, but the act of paying a lot of dividends may be related to negative aspects of the company’s business.

The most recognized investor in the world, Warren Buffett, understands this well and has already stated that he is not in favor of paying dividends. His company, Berkshire, for example, never paid dividends. Not coincidentally, his shares appreciated more than the S & P500 over time.

Technical books on corporate finance explain the fact that investing in companies with higher dividend payouts can perform worse than other strategies.

The dividend is a proportion of profit distributed to shareholders. The company’s board has two choices: it can distribute part of the profit in dividends or reinvest.

Usually, the decision to distribute more dividends instead of retaining and reinvesting occurs for two reasons: either the company’s business does not offer new investment opportunities, or the investment opportunities for retained earnings have a worse return than the company’s cost of capital. .

The lack of new growth opportunities compromises the growth of future profits. Everyone knows that the value of a company tends to follow the evolution of profits. Therefore, with lower earnings growth, the potential return on this company’s stock is impaired.

In the case where the motivation for distributing dividends is because the investment opportunities have a return worse than the cost of capital, then the shares of this company may have a similar consequence.

If the new investment opportunities have low returns, either the company will not grow as we have already mentioned or, even worse, the company’s current returns may converge to these new returns presented. In both cases, the consequence can be bad for the future profitability of the shares.

I am not arguing that one should invest in companies with low dividend payouts. This strategy, it turns out, is even worse. Undoubtedly choosing dividend-paying companies is better than randomly selecting.

However, there is evidence that other strategies have greater total return potential than simply choosing the highest dividend payers.

Remember, two truths. First, when a company pays a dividend, the price of that share is adjusted by the payment amount. Therefore, the simple act of receiving a dividend does not mean a positive return. Second, the total return on your investment is what counts. This profitability is the sum of the dividend gain and the capital gain.

A stock investment where you earn dividends but lose as the stock price declines is a bad investment.

In this way, it is not appropriate to decide on the purchase or sale of shares simply because it has a high or low dividend payment.

The only reason to buy a corporation’s stock is the potential total return on investment. For this, it is necessary to carry out the valuation of this firm and, thus, discover the potential for appreciation by capital gain.

Only by knowing the two sources of return would it be possible to make an adequate decision about the investment.

If you do not carry out the valuation work before investing, I suggest that you follow the recommended portfolio of analysts who do this work or choose a manager who will do this work for you.

Michael Viriato is an investment advisor and founding partner of Investor House.

Talk directly to me via email.

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