## Monday, May 17, 2021 ... //

### Thirst for dividends and financial illiteracy

I simply had to use the word "thirsty" today for this reason.

My country restarted the capitalist system over 3 decades ago, and it's had centuries of experience with it before 1948. Western countries (in the Cold War sense) have lived in the uninterrupted capitalism for centuries. Nevertheless, it seems to me that only a tiny fraction of my nation – and Western nations – understands totally basic concepts of capitalism such as "the rational reasoning needed to figure out how much you should pay for a stock".

OK, one extreme level of this financial illiteracy is the people's "investment" in stuff like the Bitcoin or Tesla, things that obviously don't have the intrinsic value matching the price – they have no chance to repay the invested money. The people buying into these bubbles resemble a cult. They probably realize that the Bitcoin or the Tesla stock can never pay those $5,000 or$60 per stock in dividends which would justify the valuations. And they don't seem to care because they apparently think that just like sex according to the hardcore feminists, the price is a purely social construct. These "investors" don't have any method to estimate the fair fundamental value. All of them are "momentum traders" – i.e. bad investors – and growing and bursting bubbles is the only thing they can achieve.

But I think that most people who have common sense – and it may be a majority of my nation and our nations – do understand this issue and the fact that the huge valuation of the Bitcoin or Tesla is due to mass psychosis (and the growing bubble is a version of a pyramid game). However, I have noticed a misunderstanding that is perhaps less extreme than the misunderstanding of the fact that the fair value of the Bitcoin is zero. But this milder misunderstanding is still severe enough. Here I will call this misunderstanding "thirst for dividends".

Dropping stock prices on the ex-divident dates

This thirst has several consequences that seem to be repeating all the time. First, I have observed tons of people – from those in my immediate or broader family to many friends and strangers – who still think that it is an incredibly ingenious idea to buy a stock before the ex-dividend date. When they do so, they will get the dividends for free, right? So you must hurry up to buy the stock (e.g. the O2 stock) before the dividend date.

Of course, I have spent many and many hours in total by explaining that this strategy just can't work because every sane investor – and those still dominate the trading with most stocks – realizes that once he is buying a stock without the right to get a particular dividend (like the dividend to be paid later in 2021), he is buying a different thing and a less valuable thing than what he could be buying on the previous day. Less valuable by how much? Less valuable exactly by the dividend that most shareholders actually get – which is typically the smaller, after-tax dividend (because the dividend tax is normally subtracted automatically). That means that the price of the stock normally drops by the after-tax dividend, starting from the ex-dividend date! The actual price on that day may be a bit higher or lower than "the yesterday price minus the after-tax dividend" but that is due to other factors that we may say "noise", factors unrelated to the dividends, noise that occurs on every day. And the short-term probabilities of a rise and a drop of the prices are always balanced, in the absence of some very tangible new knowledge.

So the "mean value" of the stock drops exactly by the after-tax dividend. By holding the stock through the critical moment, you earn the right to get the dividend in a few weeks – but the mean value of the price of the stock drops by the same amount. I am describing these drops as "facts". Well, they are facts only assuming that most of the shareholders who trade and determine the stock price have an internally consistent, rational, quantitative method to calculate the value of their (and other) stocks. You may also rephrase the sentence into the rule that "you should" reduce your estimate of the stock price by the after-tax dividend once the stock loses the right for a particular dividend. You just don't gain – and don't lose – anything by having or avoiding stocks through the decisive moment, except for the fees and except for the tax optimization (which is clearly a more complex topic than the "students" may swallow).

In fact, if you deal with an imperfect market in which a majority believes that it is a great idea to buy a stock before the ex-dividend date and sell it after the ex-dividend date (to "pocket" the dividend "for free"), then a good strategy to increase the profit is to do the exact opposite of what these believers are doing! It's easy to see why. Their incorrect belief artificially increases the demand for the stock before the ex-dividend date, and this excess demand therefore artificially increases the stock price before the decisive moment. So that is the moment when you want to sell! And vice versa. These people are likely to sell, to artificially increase the supply of the stock after the decisive moment, and that's why the price unnaturally drops at that time and that is when you should buy. So when many traders believe that the stock price drop doesn't occur (or is smaller than by the after-tax dividend), then you should jump out of the stock for the critical moment because the drop will actually be larger. Well, we must be careful. These misguided people may place the same price on their buy-and-sell orders on the two days but if they do so, it will be impossible to realize their orders due to the absence of counterparties. If all these orders are realized, they must allow the price to move, and then it will drop by an amount that exceeds the after-tax dividend. (Extremely enough, if you are the only counterparty that trades with the "clever" traders who buy before the dividends and sells after the dividends, you may demand an arbitrarily good prices for you in both cases!)

I have explained those things many times to many people, sometimes showed many graphs, I was waving my hands while showing that the dividend is just the transfer of your money from one pocket to another one (so that a part is immediately taken by the government), and the "students" verbally said that they did get these points. But they just never did! When I wait for a minute or a few days, it becomes spectacularly obvious that they don't believe that the stock price drops. They just believe (and the belief seems permanent) that it is an ingenious idea to buy a stock before the ex-dividend date, to secure the right for a dividend. They are not capable of studying any graphs to see that their method wouldn't have worked. They are not capable of understanding any arguments. It is a seemingly simple idea but it goes well beyond most people's mental ability.

Profit paid as a dividend vs reinvested profit

And there is another consequence of the "thirst for dividends" illiteracy that seems equally unable to evaporate and that is repeating all the time. It is the idea that the company that decides to pay a greater dividend for 2021 should have a more valuable stock. If the company decides not to pay any dividend, or if the regulator orders a bank not to pay a dividend in 2020 or 2021, these people – and I think it is actually a majority of the people who have some stock market account – think that this company's stock should be almost worthless or at least it should have no reason to go up, up to a new decision.

Now, assuming that the dear reader is financially literate, he knows why this reasoning is wrong. The purpose of a company is profit or the integrated future profits (and we may quantify it as profits per stock, ideally a properly discounted one, which may be compared with the stock price); the purpose of a company is not to convert a maximal fraction of some assets to cash that may be immediately spent.

Just like in the first manifestation of the thirst for dividends, this misguided quantification of the value revolves around the people's idea that the dividends are some free money that some extraterrestrials print out of the thin air and throw into the right shareholders' pockets. These people just fudging don't understand the trivial point that the dividends are just some cash that the company already had before it was decided to be paid as dividends, and this cash belonged to the same shareholders who will also get the dividends, with the same fractions for each shareholder. And this elementary point of capitalism seems as impossible to explain to most people, including these "shareholders", as the point that the stock price drops from the ex-dividend date.

An example that I faced today: two banking stocks, let me call them KB and ERBAG. KB generates profits to pay the after-tax dividend 1.5*D per year, whenever it is allowed, while ERBAG only pays 1*D per year in after-tax dividends. However, the KB stock is over 15% cheaper than the ERBAG stock. So it's a good idea to sell ERBAG and buy KB. (I think that ERBAG is relatively overpriced because the influx of the excess money is more easily directed to ERBAG, which is traded in several cities; or because many of the buyers who were driving these two stocks are actually financially illiterate in this very sense.)

OK, this simple point seems impossible to convey, too. I am told that "KB has no reason to grow because it was decided [safety of the financial system in the 2nd Covid year] that it would pay no dividend in 2021". What can I do with that, after hours that I have spent by explaining that this reasoning is completely wrong? The financial illiteracy of a similar caliber is really a mathematical illiteracy, too. If the dividends resume in 2022, will the stock become abruptly much more valuable? And if it will, isn't it clever to buy the stock before it jumps? It's simple, isn't it? But the men who are "thirsty for dividends" just aren't capable of going through any equivalent arguments.

Amazon is obviously the most prominent example showing how totally wrong this "everything is about the nearby dividends" thinking is. Why? Amazon has never paid any dividends. Its founder is the richest person on Earth and the stock price has gradually increased from $10 in 2001 to$3200 now. How is it possible that it is so valuable despite no dividends in the past and no dividends planned for 2021? It is just a Bitcoin-or-Tesla-like bubble? No, it is not. It's justified because the company has actually produced large and growing profits – which are huge – which were entirely reinvested. When they were not paid as dividends, they were not lost. (The KB's cash is not lost when the dividends are suppressed, either.) The company had a lot of cash, it could have bought and build things, and in this way, the growing company was increasing its ability to make profit. Amazon could decide to stop this process and start to pay dividends – which would terminate its growth trajectory – but there is no reason why it "must" happen. It probably won't happen anytime soon. Needless to say, I think that Amazon has been doing a wise thing – and I think that all companies that care about shareholders should replace dividends with buybacks because in many countries, this means to save the dividend tax. ;-)

I've been trying to figure out why it's so impossible to convey these very simple points. I think that the people were just taught not to think as capitalists, as owners of the means of production, ever. Cash in their pocket is the only asset class that they can understand and that they find valuable and they just don't want even to remotely think about anything else. They probably understand what sort of accounting is done by a pub owner; but they can't scale it. They don't understand that a shareholder's thinking is really a "scaled down" version of the thinking of a 100% owner of a business. They just want to get some free cash – they imagine dividends are the free cash – and they don't want to waste their valuable time with thinking what is happening that makes it possible. They don't want to have any real responsibility (some of them clearly think that they can and they should avoid all serious risks while having stocks – which is clearly impossible) and they don't want to study any processes that are happening inside a general company or a particular company they own. Mentally, they are simply not owners of the means of production. They are not capitalists.

For them, the "dividends" is just a fancy word for something that works just like the government's welfare cheques that are paid for free, and because they think it is a good thing for them, they want to prefer the stocks that are doing so. In this thirst for dividends, they become completely unable to understand the key and amusing point that when the dividend is paid to the shareholders, the shareholders are just transferring some cash from one pocket to another pocket (while a fraction is lost because the government swallows it as the dividend tax) so they are not making any profit by this operation at all. They don't see the diminishing cash inside the company because they are not looking inside the company at all. They think that the stock market is a bunch of welfare cheques with fancy names. A stock before the ex-dividend date isn't a better pick to be bought; and a company paying the maximum fraction of its profit as dividends shouldn't have more valuable stocks than than a similar-profit company whose profit is largely kept or reinvested. If you prefer cash in your pocket so much, you should never place it into stocks in the first place because the very purpose of the stock market is to invest the capital – to turn cash into some non-cash assets that are capable of producing more than dead cash in the savings accounts (in average).

On one hand, I hate the nanny state that regulates lots of things and "protects" the citizens against millions of threats – including the complexities of the financial world. Even the investment questionnaires are sometimes an annoying bureaucracy. On the other hand, I kind of agree that the people who only like the cash and competely miss the point of "investment" (transforming the cash to some non-cash assets that will become able to produce more cash in the future) should be kept away from the financial markets. It may be good for them to be protected in some way; and (this second point is often omitted because illiterate people must be pandered to in the PC world) it may be good for the health of the financial markets and companies, too (when they are shielded from the people who don't have a clue what they are doing).