Total return income: Distributions vs capital sell-down

Just wondering if the wise experts feel there is an advantage either way.

In other words, say you want 5% income in a year.

You have two funds with same total return, call it 10%. One pays a distribution of 5% which means you have the same number of units, but they are worth 5% less after the distribution. The other fund pays no distribution, so you sell 5% of the units, which means you have fewer units but they are worth more.

Assume an international fund, so no franking, and that the distribution is due to capital gains.

 

Have a read of "the mystery of dividend preference' in this sub forum.

 

Dividends are not safer than selling stocks - Passive Investing Australia



https://www.pwlcapital.com/the-irrelevance-of-dividends-still-a-non-starter/

 

I am no expert, just someone who likes to try and work with the facts(?) as they apply to my situation and potential future situations.

1 - For me a dividend reduces my downside risk on a particular stock whilst maintaining 100% of my upside potential. Compare this with selling stock where selling a % of stock reduces your downside risk by that % whilst reducing your upside potential by that % as well.

An example.
A companies share is worth $100 and they give out $10 in dividends. The most I can now lose on that company is $90 but I can still receive 100% of the upside on future gains. Over time these investments will effectively become 'free' with no reduction on continued potential earnings.
vs
A company retains its profit and is worth $110. if I sell that share my risk goes to 0% but my potential to receive future gains also goes to 0.

2 - Dividends don't incur brokerage fees. In my situation I am not concerned with dividends being taxed (which is a big downside during accumulation) and so these dividends allow me to redistribute a small $$ portion of my investments as I see fit to maximize the potential to make more money, re-balance the portfolio or use for living expenses.


Each of us need to consider our own situation in the 'now' and also at different stages along our life path and how our investments interact with our tax and work situations at those points.

I dont believe there is a perfect answer, it more about working out what is best for you today, tomorrow, in 5 years time etc etc..

Good luck!

 

You are comparing different things. You would have 90 shares worth $100 dollars if you took comparable profits. If the company doesnt hand out capital to every-body and retains it , it should be able to increase earnings especially if it can earn +x2 for every $ retained and increase upside. Regardless ultimately SHARE PRICES WILL FOLLOW EARNINGS. Your shares will be just as free if capital is recovered from sales and the downside will be the same or even higher, if the company reduces it 's capital and doesnt reinvest and falls behind the competition

 

Absolute speculation based on best case scenarios and makes assumptions that boardmembers vote to disseminate dividends to the detriment of the company.

 

For this to be apples v apples you wouldn’t sell down entirely in scenario 2. You sell a % equivalent to $10 worth and your capital base, risk and income received (ignoring tax effect) is the same under both scenarios?

 

Provided both are long term CG there is no difference.

 

When you sell the units in the second leg of your example you need to know whether they are sold into the market - they remain in existence, OR they are redeemed by the issuer - they are cancelled = disappear. If sold into the market you now have a smaller share of the fund and so less value. If redeemed by the issuer then you still have less value in the fund unless everybody else also redeems 5% of the fund (individually or in total).

 

Correct

Sure,
Capital base - both scenarios put in the same amount and remove (divs or sale) the same amount
Risk - as above, both scenarios have reduced their risk (capital base) by the same amount
Income - varies pending situation but lets assume the same.

But what is different?

The Dividend scenario holds the same amount of shares as it initially held
The Sale scenario now holds less shares

Now that is the important bit (as I see it)..... so let me expand on it a little.
The Dividend scenario has reduced its risk but still retains the same amount of shares and therefore has NOT reduced its potential future earnings.

The Sale scenario had reduced its risk but to do so it has reduced its amount of shares and therefore has sacrificed potential future earnings to do so.

Now initially it might only be 100 shares vs 99 and minimal difference but over time that 99 will go to 95, 90, 80, 50. Yes, at that point 1 share sold might be worth multiple dividend distributions but eventually you run out of shares to sell and with every share sold you are reducing your potential future earnings.


Now, I will admit that sometimes im not the sharpest tool in the shed and sometimes I cant see what is directly in front of me, but for the life of me I cant see how what I have written is wrong.

Fundamentally, selling x% of a holding will reduce your future earnings of that holding by x%.

If there is a youtube video or article on how this is flawed please link it because seeing and hearing people say "dividends are the same as selling stock" just doesnt sit right with my (maybe flawed) logic.

Maybe i'm just dumb? I dunno

 

Dividends are not safer than selling stocks - Passive Investing Australia

Dividend investing vs total return investing - Passive Investing Australia

It seems like you'd rather own 100 stocks worth $1 than 50 stocks worth $2. Even though they're worth the same.

If you have a company worth $10M, and sell 10% of it, you have capital of $9M and $1M cash. If you pay yourself a 10% dividend instead, you also have $9M capital and $1M cash.

 

All good I’m trying to learn and understand too. There are many on here that know this stuff much better than I, so hopefully they chime in. I don’t think it’s about no. of shares you hold, it’s your NAV. After all, your example is comparing two different companies, not the same one. You would now hold differing no of shares but your NAV would be the same in both scenarios so future earning potential exactly the same. Like comparing holding 1 share of a co. at $100/share V holding 100shares of a co. at $1/share

 

Thanks. Posted while I was replying

 

I think the issue comes from the mental accounting, and thinking about 100 shares being depleted down to 0 at a rapid rate. You're likely not going to own only 100 shares. If you have a $1M portfolio of VDHG, then that would equal to 18,896 shares. If I was drawing down 3% p.a., that's only 566 shares a year. It would take me 33 years to deplete my portfolio (if there were no changes to the value of the share). I would expect such portfolio to return ~5% p.a. after inflation, so I will actually be selling fewer and fewer shares each year.

Furthermore (and as explained in one of the videos I posted), you'd only be paying tax on the difference between the cost base (what you paid for the shares) and how much you sell your shares for. With dividends, you would be taxed on the total amount of the dividend.

 

1 vote from me for selling down trumping dividends.

I have to pay tax on the dividends in the financial year received and I have to find a place to reinvest them. I would rather the company retain them and reinvest well for growth, the share price should follow and I can sell down at my leisure after a few decades of tax free capital gains.

 

I think your view of risk is faulty. What you seem to be assuming is that risk is diminished if the percentage of your portfolio in the risk stock is reduced. The risk in that stock remains the same but your exposure to the risk in terms of your overall portfolio reduces slightly assuming you reinvest the sale proceeds in a lower risk stock.

Your valuation of risk vs the price of the stock/earning etc should determine whether you continue to hold the stock at all. Your choices should be to either hold as much of the stock as possible (within a sensible portfolio allocation) or sell the lot.

 

@MangoMadness, Just follow the numbers and it should become clear.

First set of numbers is a LIC that trades at NTA and earns a 4% return which it completely pays out. Beside the LIC's numbers are your numbers assuming you own $1Million of stock and the LIC has a NTA of $5.00



Hopefully if your playing along at home, you follow the above. You have received $800K in dividends and finish with the 200K of shares you started with.

Next set of numbers, the only thing that changes is the LIC doesn't pay any Dividend so you sell off shares to produce the same $800K income stream.


This time the retained earnings of the LIC because it hasn't paid any dividends NTA has risen to $10.96 after 20 years and because it trades at NTA the price is also $10.96, so the 91,277 shares you have left are still worth $1 Million dollars

If you are worried about the number of shares dropping to zero, stop worrying.
The chart bellow takes the sell for income approach out 100 years so you can see the projections of the share count and NTA balance.
NTA will reach the moon before No of shares will reach zero.


The numbers prove it irrelevant whether the company pays dividends or you sell an equivalent amount to produce income. EXCEPT for tax consequences

And here is the numbers for why people are indicating they prefer retained earnings in accumulation.

Numbers based on the 37% tax rate + Medicare


Mr tax man takes his pound of flesh. You get to re-invest whats left. End of 20 years you have 323,908 shares valued at NTA of $5 = $1,619,539. the good news is there is no growth so tax base is also $1,619,539

Here is the numbers for LIC not paying dividend.


You end up with the same 200K shares you started with but they are worth $10.96 each giving you a portfolio value of $2,191,123. the cost base is $1M so you will have a CGT liability but with 1.6M super cap limit, low income years post working, CGT discounts etc there is lots of scope to manage your capital gains tax affairs.

 

Well done on the explanation guys. It’s clear that growth / capital sell down is a more efficient in most circumstances.

Im not bias I will take either form of return on offer. Why not some of both. In reality most investments offer some of both regardless your preference.

I have always looked at investments from a yield paying aspect as my preference but have now understood that growth is the way to go.

 

DSSP offers both? assuming you don't sell down of course which may actually be the better tax outcome for you in retirement?
One reason I am looking favourably at AFI,AMH & MIR now

 

That is awesome and you sir are a gentleman and a scholar. That is fantastic information and having those examples really drive home the message.

I do however have a question about the 2nd graph.
The 2nd graph shows a 4% return that is then compounded over that time. I can certainly see how an ETF or LIC could use that 4% to purchase more shares and compound that kept dividend, however......

Would that chart be different when considering an individual company?

If a company is in a position where it cannot use capital to grow it often uses that money as a dividend or share buyback. If it simply decides to retain that capital as cash would that mean the chart would more look like the following with non-compounded returns.



Now, the reality is that a company probably wouldn't withhold 100% of its profits year after year, it would use it in some manner (good or bad) but am I correct in suggesting that if the withheld cash does not generate additional profit to the company then dividends are a better outcome than selling down shares? (pending the tax situation of course)

Note: In the non-compounded graph the investment hits $0 at around the 45 year mark.


Once again, great discussion, thanks again for contributing to my knowledge!