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truthisntstupid (82.79)

Dividends Vs Buybacks Is WRONG...You Need BOTH!

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January 29, 2012 – Comments (38) | RELATED TICKERS: HAS

I'm not against buybacks. I view them as something of a necessary evil.

I'm a dividend investor. That doesn't mean I think it's desirable to have a payout ratio that leaves no margin of safety.

A company might have a return on equity of 25%, but that doesn't mean that by retaining all earnings the company will find 25% growth achievable in the real world.

By paying out some in dividends and spending some on buybacks, it can lower its sustainable growth rate to a more realistic figure...and, of course, the company has a lot more flexibility with the money being spent on buybacks.

Now, if you take either one of those two things away, that return on equity will decrease to the amount of growth achievable in the real world.

That return on equity is the return on shareholder's money.

(1 - Payout Ratio) X Return On Equity = Sustainable Growth Rate.

A dividend drops the sustainable growth rate figure, but usually not enough. After the dividend, the rate we're left with is often still too high to be attainable as a realistic rate of long-term expansion.

My last CAPS pick, Hasbro, has a return on equity of 28%. Its payout ratio is 39%.

(1 - 39%) X 28%...= 17%.

With only the dividend, the sustainable growth rate formula yields a figure that's still over 17%.

Hasbro is a $4.5B company with 5,800 employees. It is already one of the top two companies in its industry. Using the rule of 72 tells us that Hasbro would have to double in size every 4.2 years if it is to grow at 17% annually.

Obviously that probably won't happen. So if we want to maintain a return on equity of 28%, we need to further reduce the other multiple. By using a combination of dividends and buybacks, we can get that sustainable growth rate down closer to a more realistic figure.

Buybacks can help to bring the sustainable growth rate more down to earth.

Some arguments are made in favor of buybacks only. I think that's a mistake.

I believe that quite often buybacks are ultimately used mainly as devices to funnel "dividends" to high-ranking company execs and board members.

Further, I think the old "double taxation" argument is simply too shallow. When I go to work and earn a paycheck, my paycheck comes from customers spending their money. Each of those customers had to pay taxes on the money they're spending...which also, ultimately, came from customers of the business they work for spending money, which was also taxed.

Having the company retain the earnings they would have paid out might seem to be one of the only ways to earn tax-free income, but it will probably exact a price in lowered return on equity.

Again: (1 - Payout Ratio) X Return On Equity = sustainable growth rate.

If either one (dividends or buybacks) is missing, it seems to me as if return on equity must fall.

If the company simply retained earnings, my share of the pie remains unchanged.

Reinvested dividends increase my share of the pie. The argument could be made that the pie will be ever so much smaller, because a dividend could be correctly said to be a debit to book value and a decrease in owner's equity.

Those who reinvest dividends will probably compensate for the decrease in owners' equity that their dividend cost, and they will certainly wind up with a larger piece of the pie than those who take their dividends in cash.

I like to take mine in cash.

The fact that I want my dividends in cash costs the other shareholders nothing except MY share of the profits!

I may or may not reinvest them when the price warrants it. My choice.

38 Comments – Post Your Own

#1) On January 29, 2012 at 1:10 AM, HarryCarysGhost (99.70) wrote:

Truth, do you also factor in when the company does the buyback?

So many companies "invest" buyback while the stock is soaring, and when shares are dirt cheap they chicken out which is the exact opposite of buy low sell high.

As far as individuals reinvesting dividends go-

I'll take the larger slice of pie, favorite flavor-cherry red.

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#2) On January 29, 2012 at 1:24 AM, truthisntstupid (82.79) wrote:

Harry,

Obviously it's better if they buy back shares at lower prices, but waiting for lower prices for an extended period of time might have a price of its own in the form of lower return on equity.

Like I said, I don't like buybacks and I never will...but they're a necessary evil. And even some pretty good companies engage in buybacks for many reasons both good and bad, but without them, return on equity would decrease anyway. 

 

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#3) On January 29, 2012 at 3:36 AM, Starfirenv (< 20) wrote:

Troof, nice work and I agree.  Exactly what I was looking at yesterday and I found FGP, a LP LP..  I like it at $17- 11.8% div, $25MM buyback. In/2 yr.

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#4) On January 29, 2012 at 11:25 AM, truthisntstupid (82.79) wrote:

Hi, Starfire! Thanks!That sounds worth looking into! Is that Ferrel Gas? I guess I'll find out when I look.

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#5) On January 29, 2012 at 12:32 PM, mm5525 (< 20) wrote:

PM has the best of both worlds, as well: An ever-increasing dividend and buying back 5 billion in stock per year. Since spinoff from MO in 2008, PM completed a 12-billion buyback program averaging 4 billion per year through 2010. Now they're at 5 billion per year, which started in 2011. That is serious capital, not some wimpy buyback program like some companies do. Of course PM being a mega cap helps, as it's basically like an aircraft carrier. The dividend has almost doubled since spinoff as well. PM is my #1 holding by a considerable margin. It's been a wonderful ride.

PM's IR emailed me saying they simply buy on regular intervals and do not try to the market. I had "recommended" they buy back their stock when it was in the 40s when Greece first started their crumbling. It's probably their standard answer to say they don't try to time the market, but surely someone there knows when it's "cheap" compared to overvalued. Who knows.

JPM, on the other hand, is another one of my top holdings, and they blew through their allotted buyback capital halfway through 2011, per a recent conference call, and they admitted they did it (buybacks) way too early. While the stock has rebounded in 2012, JPM got all the way down to the upper 20s with all their buyback capital exhausted well before the lower 30s.  

In general, I think companies do a poor job buying back their own stock. If I had to choose buybacks or dividends, I'd take dividends any and every day of the week and twice on Sunday.

 

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#6) On January 29, 2012 at 1:01 PM, truthisntstupid (82.79) wrote:

mm5525

PM has been great. I, too, would pick dividends over buybacks any day, but both are better. If I had to pick one or the other, I'd choose dividends every time.

I do understand the (potential) advantages of buybacks over dividends. But in practice it just doesn't usually work out that way and,also, I don't make a lot of money at my job. When I invest, I am literally buying more income.

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#7) On January 29, 2012 at 1:20 PM, truthisntstupid (82.79) wrote:

As usual, I think I could have titled it better. Rather than saying you "need" both, I should have just said, "Both Are Better."

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#8) On January 29, 2012 at 2:02 PM, shamapant (79.94) wrote:

Truth,

Just wondering where you got the formula from? I think its a really interesting way to look at it.

(1 - Payout Ratio) X Return On Equity = Sustainable Growth Rate.

(net income/equity)-(dividends/equity)= Sustainable Growth rate

Net income-dividends= retained income

retained income/equity=sustainable growth rate 

I wonder if thats more of a 'business return on equity' or something that measures the return on equity the company is sacrificing to pay its dividends?(ROE-Sustainable Growth Rate=the ROE sacrificed for the benefit of shareholders).

 

Also, forgive me for my amateurity, the buybacks factor into the formula because they reduce equity right?

 

Thanks,

Shamapant 

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#9) On January 29, 2012 at 2:04 PM, jmclr (99.26) wrote:

Great link for dividend 

http://www.peopleandpicks.com/blog/rjm77me/3754688

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#10) On January 29, 2012 at 2:40 PM, truthisntstupid (82.79) wrote:

shamapant

I learned this formula from The Ultimate Dividend Playbook by Josh Peters.

In it, he uses a similar example using UPS. Whatever the ROE of a large company is, retaining the earnings it's paying out in dividends does not mean it can grow at that rate. You can read that example in my reply to this blog in comment #34, here:

 http://caps.fool.com/Blogs/dividends-how-about/313058

The sustainable growth rate is supposed to measure how much a firm can grow without borrowing more money, according to Investopedia.. However, after the calculation is done, the figure we're left with is still usually unrealistic. 

The formula itself, as you can see, doesn't factor in buybacks. But buybacks can provide an additional reduction in retained earnings that can lower the final result to a figure more achievable in the real world. 

There is no way Hasbro is going to sustain 17% growth for long, if at all. The pure formula leaves you with a 17% expected sustainable growth rate. Since Hasbro can't be expected to sustain that level of growth, then return on equity would fall until it equaled the actual growth rate achievable without a further reduction in the other multiple. 

Buybacks can serve to further reduce the other multiple.

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#11) On January 29, 2012 at 2:54 PM, truthisntstupid (82.79) wrote:

I really must once more throw in a plug for Josh Peters' awesome book...The Ultimate Dividend Playbook...the best book on dividend investing I've ever found.

Josh Peters is the guy who runs Morningstar's monthly newsletter DividendInvestor.

Get it in hardback. You'll want it to last forever.

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#12) On January 29, 2012 at 3:00 PM, truthisntstupid (82.79) wrote:

jmclr

Nice link!

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#13) On January 29, 2012 at 3:38 PM, yonkmember (70.37) wrote:

Hi truth,

   I am just out of school and getting into investing and I find myself interested in the dividend investing approach.  Although I have a few dividend books on my "buy" list--ones that I have taken from your blogs, for the record--I am still relatively new to this and haven't jumped in the deep end yet.  I have a few questions for you about your post though:

 

You state that (1 - Payout Ratio) X Return On Equity = Sustainable Growth Rate.  Why is this the case?  Is there a theoretical underpinning to this, and if so, which book might describe it?  

Additionally, you discuss reducing the sustainable growth rate.  What I suspect is that you mean that the above calculation gives you a theoretically (idealistically) attainable growth rate that will not be approached in practice.  Therefore share buybacks increase the practical growth rate closer to the theoretical rate?  Should the amount of share repurshases be included in the payout ratio itself, or does it get directly applied to the growth rate side of the equation? Is this correct? 

I enjoy your blogs about dividend investing and think you make a very strong case for this strategy.  Keep up the good work!

proteinhunter 

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#14) On January 29, 2012 at 3:41 PM, yonkmember (70.37) wrote:

Oops, started my comment and then went back to work only to finish it just then.  I unfortunately had not refreshed...

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#15) On January 29, 2012 at 4:13 PM, truthisntstupid (82.79) wrote:

proteinhunter

Look at it this way. If a company retains all its earnings, then its sustainable growth rate would be equal to its return on equity, as long as there was no financial leverage (debt), which also enters into return on equity calculations.

But most companies utiize a complex capital structure, including debt financing. Since the sustainable growth rate is supposed to measure how much a firm can grow without borrowing  money, financial leverage isn't part of the formula. The formula is based on applying the return on equity to retained earnings.

Both dividends and buybacks reduce retained earnings. If all earnings are retained, the earnings that aren't going out in dividends and buybacks will probably exceed the amount that can be reinvested in the business with any realistic expectation of producing an adequate return, and most companies currently paying dividends and buying back stock would experience a drop in return on equity.Companies at the top of their niche run into the law of diminishing returns.

I think buybacks should be part of the sustainable growth rate formula, but they aren't, and I guess I'm just not smart enough to know why!

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#16) On January 29, 2012 at 4:20 PM, truthisntstupid (82.79) wrote:

 "What I suspect is that you mean that the above calculation gives you a theoretically (idealistically) attainable growth rate that will not be approached in practice.  Therefore share buybacks increase the practical growth rate closer to the theoretical rate?"

The company does the best it can to increase the practical growth rate in other ways. Dividends and buybacks decrease the theoretical growth rate to a more attainable level. If not, then the growth rate achievable in practice would dictate a lower return on equity.

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#17) On January 30, 2012 at 1:24 PM, ikkyu2 (99.15) wrote:

Unless shares are held in a Roth IRA or similar vehicle, the money used to pay dividends is double-taxed at the time the dividend is issued.  Since dividends are a non-qualified business expense for tax purposes, the corporation, which is owned by the shareholder, must pay corporate income tax on the money used to pay dividends.  Then when the shareholder receives the dividend, he pays the dividend/LT-cap-gains rate on the dividend, which is 15-20% in the USA.

The share buyback money is also taxed at the corporate income tax rate but the shareholder has the choice of whether or not to sell shares and what the timing will be. 

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#18) On January 30, 2012 at 2:56 PM, truthisntstupid (82.79) wrote:

There two distinct styles of investing. I believe one has a much higher speculative component than the other.

To me, if you're buying shares (undervalued, growth, I don't care) with the intent of selling them later at a higher price, That's speculating on price movements. It's like flipping houses rather than being a landlord and owning long-term for the rental income.

Suppose I said, "Anyone want to invest in my contracting company? I won't pay you anything...but as business picks up the value should go up...right?"

If you ask me if I want to invest in your business, my first question would be, "Is it safe?"

My next question is, "How do I get my share of the profits?"

If you then start telling me that my cut is whatever value you can create over time, and I have to sell my portion of the business to get it, the conversation is over.

It's that simple.

If your company is really great at what it does, why should I have to sell it to get my share of the profits? Taxes or no taxes, that's a poor deal. If it's that good an investment, I want to keep it.

You can speculate on price movements. There are plenty of companies that pay no dividends. 

Without dividends, what do I have to show for my investment but a statement on a piece of paper?

Try paying bills with that.

An investor can plant a money tree that regularly throws their share of the fruit their way...or they can plant one that never pays out anything...and every time you take some of your "income" you're forced to sacrifice part of your ownership to do so.

I find the double taxation argument old and tired (as I said in the blog). All money we earn is double, triple, quadruple taxed, and more. 

That said, ikkyu is right. In theory, of course it would be better to let our investments compound tax-free. 

But an investment that gives me no income also takes away my main reason for investing.

Not all of us were smart enough to apply ourselves (OH my misspent youth!) and become doctors. (I'm probably not smart enough anyway). Some of us don't invest for twenty years from now. 

I invest my hard-earned savings to create more income now!

 

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#19) On January 30, 2012 at 3:06 PM, truthisntstupid (82.79) wrote:

I would be all for a change in the tax law that allows reinvested dividends to be tax-free. Wouldn't that solve this problem?

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#20) On January 30, 2012 at 3:42 PM, Hawmps (< 20) wrote:

Good points there in last couple comments truth...  your investing thesis will largely dictate your style and where you put your cash.  You gotta know your goals and make the decisions that best follow oyur goals.

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#21) On January 30, 2012 at 5:04 PM, truthisntstupid (82.79) wrote:

Hawmps

Thanks. Although I'm temporarily out of the market for now, in another two or three months, after I kill the monkey that's been on my back for 16 years (DIE! DIE!) I will resume striving to build a significant dividend income. 

Someone really should initiate a push to eliminate taxes on reinvested dividends.Then people that want their dividends paid in cash can pay their taxes on them and have them, and for the rest, dividends can be a corporate-finance-neutral event. 

"The argument could be made that the pie will be ever so much smaller, because a dividend could be correctly said to be a debit to book value and a decrease in owner's equity.

Those who reinvest dividends will probably compensate for the decrease in owners' equity that their dividend cost, and they will certainly wind up with a larger piece of the pie than those who take their dividends in cash.

I like to take mine in cash.The fact that I want my dividends in cash costs the other shareholders nothing except MY share of the profits!"

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#22) On January 30, 2012 at 7:16 PM, TMFAleph1 (95.07) wrote:

Very few share buybacks are accretive to value; most end up destroying value or being neutral, at best.

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#23) On February 09, 2012 at 5:34 PM, ikkyu2 (99.15) wrote:

Your reply makes me sort of sad, truth.  I am a doctor and I did spend my youth on learning to become one; and I am investing for 30 years from now and hoping my dividends will take care of me when I am old.

But I sure don't feel like that was a smart decision, most days.  I love my work, but it is extremely stressful and I am working 90 hour weeks.  Don't think I'll get a vacation this year.  I would gladly trade it for a low-stress, normal hours career that started 15 years ago and paid half what I make now.

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#24) On February 09, 2012 at 6:11 PM, truthisntstupid (82.79) wrote:

Hi again, ikkyu

Wow. I haven't looked at this blog since Jan 30th, when I made my last comment. So much can change in such a short time. 

 Although I'm temporarily out of the market for now, in another two or three months, after I kill the monkey that's been on my back for 16 years (DIE! DIE!) I will resume striving to build a significant dividend income.

That's a debt that was over $15,000 just a few short years ago. On $9/hour it seemed insurmountable. By early April it will be in the past.

I don't see how you find time to study and learn outside of your demanding occupation, ikkyu. One thing I can say about my job in this tiny town of 250, 40 miles from the nearest other (tiny) town, is well, I like my job too. I had darn well better, because without moving or trying to commute 60 miles or more each way (with my old car?) this job is all there is here.

But my job takes no (or little) mental effort. If I'm reading or studying something I want to know more about, I can go about my day doing my job and my mind is free. 

I sort of have it made. I would never move away from here for $5 or even $10/hour more, because I have no rent here.

So when people remark as they sometimes have after some of my blogs that my time would be better spent getting a better job than investing, they're basing that opinion on incomplete information.

I have been a bookworm all my life. Dividend investing is the way to go, and it took me many years to give up the capital-appreciation mindset. Dividend investing just might allow this $9/hour restaurant cook to retire in about 10 years.

Don't be too sad, ikkyu. Your work is no doubt important to many people. Mine isn't.

That doesn't mean that each of us can't feel successful in our own way.

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#25) On February 09, 2012 at 6:17 PM, truthisntstupid (82.79) wrote:

And while I'm at it, why not throw in a plug for one of my favorite, longest blogs I've written? If anyone reads this, please don't forget to read comment#15 as well. It shaould have been part of the main blog!

 http://caps.fool.com/Blogs/the-evolution-of-a-dividend/650478

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#26) On February 09, 2012 at 6:22 PM, truthisntstupid (82.79) wrote:

BTW...to anyone who checks out that blog...in hindsight I hate the boldface, too...but I can't change it now.

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#27) On February 09, 2012 at 6:23 PM, mm5525 (< 20) wrote:

Check out PM's earnings and buybacks from this morning's report. Total domination.

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#28) On February 09, 2012 at 6:33 PM, truthisntstupid (82.79) wrote:

I saw that, mm

PM is a great company!

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#29) On February 09, 2012 at 6:53 PM, HarryCarysGhost (99.70) wrote:

Hey truth saw this on the buzz box when I first logged in today.

Heres an example of a Company that does buybacks and dividends quite nicely.

Full disclosure also my largest holding-

http://investor.visa.com/phoenix.zhtml?c=215693&p=irol-n...

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#30) On February 09, 2012 at 7:39 PM, truthisntstupid (82.79) wrote:

Hi Harry

Good for you! I thought I saw somewhere that Visa doubled their dividend!  I think I'll go look at it...

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#31) On February 09, 2012 at 7:53 PM, Hawmps (< 20) wrote:

#23) On February 09, 2012 at 5:34 PM, ikkyu2 (99.00) wrote:"I love my work, but it is extremely stressful and I am working 90 hour weeks.  Don't think I'll get a vacation this year.  I would gladly trade it for a low-stress, normal hours career that started 15 years ago and paid half what I make now."

It is a comment like this I see from time to time and hearing similar things from good people such as yourself that helps me sleep better at night knowing that I the carreer change I made last year is worth more than the $$ I left on the table. Thanks.

 

truth & Harry:  I'd love to see a "dividned blog" on Visa.

 

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#32) On February 09, 2012 at 7:54 PM, Hawmps (< 20) wrote:

Doh..... dividend (sp)   My left middle finger is asleep at the keys.

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#33) On February 09, 2012 at 8:55 PM, HarryCarysGhost (99.70) wrote:

Hawmps-

I'm a lazy,lazy Man.

So I would'nt be interested in rehashing all the reasons I like Visa.

But luckily theres a timeline that tells the whole story of Visa over on the boards.

blesto and I started the conversation way back at comment #75 .

It's at #182 now, over a yrs worth of events. So if you have an hour or two or four check it out-

http://boards.fool.com/visa-v-118878.aspx?mid=29835907

Trust me, it's also entertaining.

(If you have problems viewing, just give a shout out and I'll set up an invite so you can join)

Cheers.

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#34) On February 09, 2012 at 9:08 PM, Hawmps (< 20) wrote:

Cool, I will check it out.

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#35) On February 11, 2012 at 10:07 PM, truthisntstupid (82.79) wrote:

Dividend investing just might allow this $9/hour restaurant cook to retire in about 10 years.

Or most likely less.

Funny...all you folks that think you have to retire rich. Every year I get this statement from the social security people. I'm sure everybody gets one. The funny part is all these articles that have been written, that either have this question in the title or somewhere in the article.

"Can you live on $1100 a month?" (Or some such amount)

I have never answered this question. 

I have an answer.

Easily. Very, very, easily. It is way more than I've been living on for many, many years.

Ha. It doesn't matter whether you believe it or not. In comment #24, I spoke of a $15,000 debt I'll soon put behind me. I've spent years paying that off on $9/hour. I've also had to pay on student loans for a degree I never got to finish. It'll be another five years, maybe a little less, before I get those vanquished.

What it comes down to is that for the last decade-and-a-half, I've been opening thise statements from the Social Security Administration every year and staring at a number that was in excess of 300 dollars a month more than I've had left to live on while paying on these two bills.

But by the time I turn 65, the student loan payments will be history too.

I'll have me a decent-sized greenhouse, and grow my own hydroponic veggies year-round, and my cost of living will be even less than it is now.

In fact, I'm retiring at 65 whether they raise the social security retirement age or not. If I have to live on my own money for a year or two, I'll be prepared to do that.

I'll be eating a lot of fish, too. Gotta figure that in...

 

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#36) On February 12, 2012 at 1:08 AM, truthisntstupid (82.79) wrote:

This is how a dream becomes reality...^

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#37) On February 12, 2012 at 10:56 AM, HarryCarysGhost (99.70) wrote:

Morning truth,

Heres to the dream.

I got twenty years to go but am on my way. Not really holding my breath for social security to be whole.

Hmmm... Maybe I'll start brewing my own beer that would lower my cost of living expense.

Nah.... I'll just hold onto the Bud shares I bought at dirt cheap levels :)

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#38) On February 19, 2012 at 11:42 PM, Zack907 (99.40) wrote:

I enjoyed soaking in all your wisdom truth. One thing I noticed though was that you say that you don't want to buy an investment that requires you to sell it to see the money, but what happens when you sell a small portion of your share in a company? You lose a small percentage of the pie right? What happens when you take your dividend in cash? You lose a small percentage of the pie. Same thing. I totally agree that there are other excellent reasons for a company to pay dividends, but to avoid having to sell a portion of your holding to see the money seems like flawed logic.

As I right this though I imagine that the dividend has both a lower tax rate and less fees than selling a small share of your holding in a company when you want a dividend. 

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