Passive-income investing isn’t just about dividends. The most obvious proof of that claim is the fact that investors can buy bonds and options in addition to dividend stocks. On a less-obvious level, even stocks that don’t pay dividends can be thought of as providing passive income eventually. If you hold a diversified stock portfolio over a typical investing lifetime, you’ll eventually reach a net worth where market downturns won’t leave you in too bad a position. Once you reach this portfolio size, you can simply sell off your portfolio on a regular basis, which produces a kind of passive income.
Dividends aren’t the only way to return wealth to shareholders
In fact, you can make the case that dividends aren’t the best way for companies to return wealth to shareholders. Warren Buffett argues that if a company has a competent management team and plenty of investment opportunities in front of it, it should invest money rather than pay it out. Buffett himself paid only one special dividend in his entire tenure as chief executive officer of Berkshire Hathaway, and he came to consider it a mistake. When Buffett finds meaningful investment opportunities scant, he usually invests Berkshire’s money into U.S. treasuries and share buybacks.
It isn’t just Warren Buffett who finds dividends overrated. The Nobel Prize-winning economist Eugene Fama finds them overrated as well. In fact, he finds them completely irrelevant! According to Fama’s “dividend irrelevance theory,” a stock’s payment of a dividend shouldn’t improve its total returns at all. If dividends are taxed more than capital gains are, they should reduce total returns!
There are other ways of creating a homemade dividend
In addition to being able to create a homemade dividend by periodically selling off stocks, investors can convert their shares to cash in other ways, too. They can sell options backed by their shares. They can borrow against their shareholdings (I’m definitely not recommending that one; I’m just pointing out that it’s a way to turn shares into cash). If they are institutional investors, they can even loan out their shares! Truth be told, there are countless ways to earn passive income with stocks — dividends as such are not necessary.
Still, some dividend stocks are worth it
Despite the fact that dividends don’t theoretically matter all that much, they can serve as proxies for quality. A stock that has a decades-long streak of paying and raising its dividend is likely better run than average. By investing exclusively in such stocks, you automatically screen most penny stocks and manipulated assets out of your investment universe. In other words, you screen for real businesses.
Consider Fortis (TSX:FTS), for example. It’s a Canadian utility that has raised its dividend every single year for 51 consecutive years. It aims to keep the dividend increases coming through to 2028.
How has Fortis been able to achieve all this dividend growth?
Through improvements in its business. In the last 10 years, the company’s earnings per share have approximately doubled. Its operating cash flows have increased even more than that. Despite all the growth, the company hasn’t levered its balance sheet too much, maintaining a 1.16 debt-to-total equity ratio — quite respectable for a utility.
The qualities above have powered Fortis’s dividend growth over the years. If you screen your stocks for “Dividend Aristocrat” or “Dividend King” status, you’ll find many names that have similar qualities. So perhaps, when we consider them as a “quality signal,” dividends aren’t so irrelevant after all.
