You DON’T Need Dividend Stocks To Retire. Here’s Why

When people tell you that one day you could retire a millionaire and live off the dividends by investing a few hundred dollars a month into high-yielding stocks, you might think, oh my God, why would I even bother with growth? What they don't tell you is the many ways in which it could be riskier and how your returns could end up being much worse. I'm James Helliwell, I'm a former professional trader turned financial educator, and in this video I'm going to show you 3 things: how dividends can actually make your portfolio riskier, why reinvesting dividends is an inefficient way to compound, and why you don't need dividend income to retire. There, I said it because it's the truth based on my 15+ years as an investor. And if you stay to the end, you might well be able to add 5 or even 6 figures to your portfolio. Now, I'm not going to bore you with the basics of what dividends are because there are thousands of YouTube videos exploring exactly the same thing. I'm going to assume that you've already got some experience, so hopefully you're going to understand this perspective that can take your investing to the next level. And the first problem here is that people think that dividend investing reduces risk. But the reality is that high yield stocks, which is ultimately what you're focusing on, show up routinely in things like banks, energy, REITs. And these sectors by and large tend to be more cyclical, they tend to be more capital intensive, and as a result, more sensitive to changes in the economic outlook. So rather than reducing risk, you're actually just concentrating in similar sectors. And that goes against the whole idea of safety that investors think they gain with dividends. So let me break it down for you. Here's an example of the so-called Dividend Aristocrats ETF. This is essentially an index of companies that have never cut their dividend and obviously pay a reasonable yield. Now, more than 50% of this ETF is in basically financials, industrials, and basic materials. So even this is pushing you into cyclical sectors. Now when you look at the top 10 highest yielding companies, dividend yields, in the S&P 500, this company's on top. And again, it's in a cyclical sector, basic materials. It moves in a very clear cycle. In this case, LyndenBasile produces things like packaging chemicals and so on. When you overlay the business cycle depicted by the ISM, a leading indicator of that, you can see how correlated the two are. And this proves my point about dividend payers generally drawing you to more cyclical sensitive sectors. Another example would be Franklin Resources— it's the official name of Franklin Templeton Investments— a financial stock, clearly as an asset manager, that once again is highly cyclical. And you can see here treasury bond yields following the same kind of cycle. So this is what's driving the share price more than anything. So when you're investing in dividends this is ultimately what you're exposing yourself to— greater macro sensitivity and portfolio volatility by concentrating in these rate-sensitive sectors. And even in the case of things like utilities and staples, there's still a macro bet at play on inflation and government bonds. So if you're seeking stability, you shouldn't let your income goal force you into the most cyclical parts of the market, because whilst the dividend yield might be enough to for you to sit through some downturns in the near term, you could be in for a nasty shock if you overlook what I'm going to show you next. And it's not quite as simple as just looking at the company's dividend history and assuming that it's going to continue to pay forever. Now, there was an economist by the name of Hyman Minsky— very unusual name— who had this theory that stability breeds instability, meaning that as trends become more established, investors tend to become overconfident, which leads to excessive risk-taking and then the eventual shock. And there's a similar paradox here when it comes to dividends, because many investors assume that the so-called aristocrats that we've just seen will pay out regardless of the economy, and even if the share price falls, they can still collect dividends while they ride it out. But that's not always the case, because dividends are discretionary, and that means that cuts can happen fast, especially when the price has already cratered. And that's what creates this yield trap. So you'll see what I mean here with Walgreens. This company was in the Dividend Aristocrats Index. It had not cut its dividend since 1933. That was until the dividend was cut and it dropped out the index. Another case in point was Boeing, which for 8 years saw its dividend soaring. That was until it ran into difficulty and once again came up with a massive cut. GE, once the world's biggest stock by market cap, also produced the largest dividend cut outside of a major crisis in 2019. Shell is another example close to home in the UK. During the pandemic, it cut its dividend for the first time since World War II and saw a mass exodus from the UK pension fund industry. And BP of course had the Macondo oil disaster, and it rather appropriately cut its dividend at the time. What I'm trying to show you here is that things can change suddenly, and it might not always come down to the companies. In the case of the pandemic, the Bank of England, which runs the Prudential Regulatory Authority, actually announced a restriction on both dividends and share buybacks for all financial firms indefinitely. So even if the likes of Barclays were still willing and able to pay a dividend, the regulator ruled it out. But for the most part, it comes down to quality fundamentals here, absent pandemics. So first of all, have a look at the so-called dividend cover. This is a ratio which shows how many times the dividend could be paid out of the profits that it has available in cash to do so. If the COVID ratio is 2, it means that it's paying out 50% of what it could do potentially. The next thing to ask is what's the earnings quality, so the profitability. Can the dividend grow going forward? Because if not, that coverage ratio is likely to drop, or there's not going to be any further growth from the dividend. Thirdly, it comes down to management, and this is a big one that too many people overlook. Might they abandon their policy? Because as we've seen, when earnings wobble, management will usually move to protect the business first, then the balance sheet, and the dividend comes last. So the dividend cut is rarely the whole problem. It's usually a symptom that arrives after the share price has already been crushed. And that's the classic yield trap, because dividends are only one way that companies can return cash to shareholders. And in today's market, they're not even the biggest one. And this is where things get interesting, because even when investors might do the previous bit properly and be looking at the right things, even when they avoid the obvious yield traps, many of them are still looking in the wrong place. And this brings me to the third problem that a lot of investors face, and it's when they ignore a huge contributor to shareholder returns. Beyond the dividend, buybacks make up a huge part of that return. Here you can see the S&P 500 over the last few years, the comparison between the total amount of buybacks and the total amount of dividends paid out by companies overall. And you can see that buybacks have massively exceeded the total value of dividends paid. So if you're not looking at this side of things, you're missing more than half of the story. On the left-hand side, you have the dividend yield going back to 2018. On the right-hand side, you have the buyback yield. If you don't know what buybacks are, essentially it's when a company reduces its share count by buying back some of its shares in the open market. It's meant to be when the company thinks that its shares are cheap and therefore it's a good use of cash to do that rather than paying out a dividend. But for reasons we'll get on to in a minute, it can be skewed a little bit. But that's the principle. It's a pseudo-dividend which doesn't incur income tax, unlike when you receive dividends. Now, the 3 most active firms in terms of the total value of shares bought back in recent years are Microsoft, Apple, and Google. Probably don't surprise you. In the case of Apple you can see first of all in orange the buyback yield, and in blue you've got the dividend yield. And what you can see is that the dividend yield is less than half of 1%. So if that was all you were looking at, you're missing, well, 5 times the story because the buyback yield is 2.5%. So whilst the dividend yield doesn't look amazing right now, if we do go back in time to 2019, when the buyback yield was super high, the dividend yield was still only about 1%. Apple went on to return 86%, followed by 80% the following year. And even though the S&P rose, which Apple would have contributed to— perhaps was the largest contributor to that— you're looking at huge multiples of what the market delivered. So investors were attracted to Apple by this incredible buyback yield. And it's a similar story with Alphabet, but the chances are you would have missed this one completely if you were only looking at dividends, because it's only paid a dividend for the last couple of periods. So these are the dividends per share, and in blue you've got the amount of shares that were repurchased. So these are buybacks in blue. So Google, or Alphabet, has been buying back its shares for the last 15 years or so, and it's been doing so very aggressively since about 2018, 2019, this trend here. But it's only paid a dividend in the last year or so. So if you are only looking at dividends, you'd have overlooked all of this activity. And to put this in perspective, you'd have missed out on these two opportunities which have absolutely crushed the Dividend Aristocrats Index. The ETF we looked at earlier, Noble. So the lesson here is to think of it in terms of the dividend and buyback yield combined, the so-called shareholder or total yield, not just looking at the dividend yield, because you're going to miss out on opportunities like I've just shown you. But just before we move on, I want to explain something really important around buybacks that not many people are aware of. So again, here we have the buybacks in blue, and this time in orange we have the amount of shares outstanding. So that's the number of shares on the common market, the open market. We're looking at an example here of Intuit, the provider of QuickBooks, the accounting software. Now what you can see they've been doing here is, sure, they've been buying back a lot of the stock, but simultaneously, at least since sort of 2016, The share count hasn't been going down as you would expect. They should be moving in opposite directions. You're buying back shares, your shares outstanding on the open market should be going down. What they've actually been doing is simultaneously issuing new shares. This is largely through the exercise of employee stock options and other things, but this is a little bit sneaky. On the face of it, you would say, okay, they're doing a hell of a lot of buybacks, surely that's going to give us a good return, having a big buyback yield in the same way as having potentially a big dividend yield. But in this case, for as long as the shares outstanding, the orange line, is not going down, it's going sideways, you're actually being diluted. It's been offset. So you're not getting any benefit from this really as an investor. So once again, it comes down to management, and this is the checklist that I'd run when it comes to buybacks. First of all, does the company have strong fundamentals? Because they could otherwise be using buybacks to reduce the share count and make anything per share, particularly earnings or free cash flow per share, look more attractive. You've reduced the share counts, so even if profits haven't changed, earnings per share is higher. The next thing is whether or not the company is likely to follow through with the plan. When a crisis hits, so when you get punched in the mouth, so to speak, the plan can suddenly change. And the third thing, as we've just seen in the case of Intuit, is to say, okay, if we see a lot of buybacks being done, is the company simultaneously issuing new shares? Because if so, and they're doing it at a similar volume, it could offset any benefit and neutralize the benefit of the buybacks, meaning you don't get anything as an investor. So the lesson here to summarize is to think in terms of shareholder yield. Don't overlook buybacks which have exceeded dividends in recent years. But beware of that dilution if management is simultaneously issuing new shares. But the real edge in all of this comes from something else entirely. It's compounding what you do with those dividends, or rather what the company does instead of paying those dividends. Now, it's true that you should always look to reinvest them. If you look at a chart of the S&P 500, you can see that without dividends reinvested, it would have returned less than £200K. And with dividends invested over this period, going back to, well, pretty much my lifetime, 1988, you'd have returned twice as much. So the problem here is that people seem to think that reinvesting dividends is an efficient way of investing because they look at headline numbers like this and the comparative return. But it's not, because beyond the likely tax liability, there's actually a much bigger reason why I think they're inefficient. And it comes back to investing in the right companies to begin with, because if a company could turn a dollar of profit into a dollar 20, then why would I want anything less than a 20% tax-free dividend? And that just doesn't exist. So imagine that the company was able to continue investing at that rate, turning a dollar into a dollar 20 each time, compounding that over 5 years without spitting out a dividend. That dollar of profit would have grown into nearly $2.50, and you won't possibly be able to beat that with any dividend that I know of. So let me show you an example of what I mean here. When you're looking to compound profits internally, what we're really talking about is the efficiency with which they can reinvest their profits. Now, this is the model that you're probably familiar with from my other videos. It's what I use to invest personally, based on what I developed back when I was running Money for the fund, and there are 7 factors to find quality companies. But in this case, I'm only going to focus on the 4 most relevant to finding these compounders and these potential alternatives to dividend-paying stocks— internal compounders rather than external compounders. So the first example here is a cybersecurity firm in Fortinet, and you can see on this radar chart it has a very high score for profitability. It's an outlier. In fact, as you'll see with each of these companies, it's the highest-scoring stock in its category. In this case, we're looking at growth in free cash flow rather than earnings, which are more prone to manipulation, and it's an absolute profit machine. And the reason we're looking at this first and foremost is, in the case of dividends, we need something to reinvest. There's no good having this amazing engine if there's no fuel. So this is the fuel that's going to drive the flywheel. Had you invested 10 grand in Fortinet 10 years ago, it would be worth $153K today. Compare that to the Dividend Aristocrats ETF over the same period, which would only be worth $28 grand. A lot less. When it comes to efficiency, this is essentially the big one— the return on invested capital. This is that dollar into dollar 20 that I was talking about. It's the internal rate of return, essentially. So for every dollar of profit that it doesn't otherwise pay out in dividends or spend on buybacks, it could potentially do this with— this is the internal compounding. It's at the heart of it. And in the case of Mastercard, you can see it scores very high for reinvestment, and this is why: a median return on invested capital of 56%. So with every dollar of profit that it retains, it can turn that into $1.56. That's absolutely incredible. Imagine compounding at 56%. You're never going to do that with dividends. And the result is that the stock has compounded over the last 10 years at 20%, which is almost double what the Dividend Aristocrats ETF has compounded at, at 11%. And before you go, well, it's a defensive play, it's dividends— this is total return, it includes your dividend. So you can see a massive difference here. And these aren't some pie in the sky or early stage companies, this is Mastercard. Now the highest scoring company for reinvestment currently in my universe is actually IDEXX. They specialize in diagnostic testing for animals, so things like blood tests, vaccines, and so on. And actually they get about 50-odd percent of their revenue from providing clean water for humans, which a lot of people overlook. But they're an incredible company. And unlike many of the names that you're likely looking at in the Dividend Aristocrats ETF that spit out dividends and probably do some buybacks as well, these guys, whilst there is a modest degree of buyback activity, could afford to do a heck of a lot more, which means that they reinvest the vast majority of their profits, and their profits are pretty damn significant. You can see the other factor here for profitability is also an outlier. So this is a brilliant setup. As such, the stock has compounded at 24% over the last decade, again compared to that 11% that we saw for the Dividend Aristocrats. So £10,000 would have turned into almost £90,000 compared to less than £30,000 for For growth, Meta, company you're no doubt familiar with. This is important because many investors, when they're focused on income, fall into the trap of basically owning cash cows, companies that are ex-growth. They've matured, and the only way is down from there, really. So rather than investing in a company like Walmart, for example, that is ex-growth, arguably, you could instead be investing in a similar dividend payer or high buyback firm in the likes of Costco, if you're looking at contrasting retailers. So getting back to Meta, this is self-explanatory. It's revenue. That kind of growth is what is obviously multiplying profits and contributing to this flywheel as it then begins to get reinvested through high efficiency, the return on capital that we looked at, and ultimately paying out a very low amount of that. So a lot of money is reinvested through this engine. Meta's compounded again at around 20%. There's a common theme here, they're all about 20%, give or take, compared to Dividends Aristocrats. Now, put together a report that you can get for free. There's a link in the description, and it shows you the remainder of these companies for all of the 7 factors that generally produce quality stocks, which is where I focus. And there's a subset of that, it will probably help you with your income or dividend investing in this case. Focusing more on compounders, finding companies with the ability to pay a dividend but who choose to reinvest instead. Like I say, and you can see the overall performance here, whilst this of course is historical and it's for educational informational purposes only, it's not financial advice, has clearly outperformed the MSCI World ETF and most likely the Dividend Aristocrats ETF too. The goal here is not to now turn this into retirement planning, but to just run through how you don't need to be depending on income in order to retire inside of your portfolio when instead you can sell down shares. And I know some people in the comments are probably going to tear into me for this because it's one of those commonly repeated things on the internet, but what they've often failed to do in my experience is validate it with what I've just shown you, the reason why you can responsibly do that rather than just hope that the S&P is otherwise going to grow sufficiently fast, which is a different kettle of fish. So let me introduce you to the 4% rule. Again, you've probably heard of this in other videos, so I'm not going to labor the point. I want to get to the nuance here, which is hopefully where the value is for those of you who are more experienced with your investing. Nonetheless, it was based many years ago on the idea of a 60/40 portfolio, so a balanced portfolio between stocks and bonds, withdrawing, as the name suggests, 4% per year in retirement. And that should in theory see you not run out of money over a 30-year horizon. So if you retired at 67, you could probably live until 97 and still not have run out of money. And that's the biggest fear for people. It's, of course, running out of money in retirement. But what I'm about to show you here is the nuance, especially when you could potentially generate a higher compound return inside of your portfolio. The total return including dividends, or without any contributions to dividends, a greater capital appreciation that offset the need to rely on yield. So historically, this 4% withdrawal rule was actually proven to be extremely conservative. It was based, rather than on the average return in the 60/40 portfolio, on the worst-case historical sequence. So it's more like, what's the worst present-day scenario that you could possibly retire in at that point in time? And then go from there. So it'd obviously be just before the market dropped, hypothetically. And more recently, as researchers kind of gone back to scrutinize this, what they've actually found is that roughly two-thirds of the time, people following this 4% withdrawal rule finished with more than double their starting wealth. Now, by finished, unfortunately, we mean when they died. But the point here is that your portfolio net of withdrawals has the potential, the majority of the time, two-thirds of the time according to research, to outgrow the withdrawal rate because it was based on such a conservative estimate. And particularly if you're focusing on the right companies which are compounding profits internally rather than giving them to you to try and compound your dividends externally, you have an edge over the general market return. So if your portfolio compounds at this higher rate, you can afford to be less sensitive to yield, which is the whole point that I've been building up to in this video. And what that means is that it might well enable a greater withdrawal rate than this 4%, and as such, a greater income than you would have received with dividend yield alone. Now whilst this isn't financial advice, I hope that this has dispelled some myths for you around dividend investing and why I hate dividends. It's not to be controversial, I love profits, but I don't want to receive them externally and be taxed and have a replacement cost, the opportunity cost, to try and invest them somewhere else. If you've enjoyed this video, then check out this one next, which YouTube thinks you're going to love. And if you don't, I will give you a full money-back guarantee, 100%. See you in the next one.