For more than a year, there has been spirited discussion on Seeking Alpha about the merits of dividends. Camps of dividend-lovers, dividend-agnostics, and dividend-haters have formed.
The question comes down to what you want a company that you own to do with its last dollars of earnings, its “excess cash.” Should the company distribute some of those dollars as dividends or not?
This should not be an emotional topic, but it has turned out to be one. Some seem determined to prove that their approach is the one and only correct approach. Others state that they are willing to “agree to disagree,” only to get mocked for being willing to let it go at that. Still others reason that the way one thinks about dividends may be a function of a particular investment strategy or one’s stage in life, and that multiple views may be valid depending on circumstances.
I have no illusions that this article will settle anything. But my intent is to suggest a lens, a way of thinking about dividends, that may help. The lens is this: What do you, as a shareholder, want your company to do with its last dollar of earnings?
Investors are often advised to think as owners of a piece of a company. I believe in that. It is the major distinction between investing and trading. Most of my career was spent in corporations, and I was at high enough levels to observe that the actual controlling owners of companies themselves view dividends in very different ways. Therefore, simply viewing the company “as an owner” does not end the dividend debate.
Reasonable owners can and do differ in their views of what makes sense for the business. Many owners want dividend payments from their companies, while others do not. I am not talking here about the small shareholder who owns a couple hundred shares. I am talking about founders and owners who control their companies through majority ownership or by owning a more powerful class of shares than the public. They are intelligent, long-term owners with deep and sophisticated knowledge of their businesses. Despite this seemingly common perspective, they themselves have conflicting views about dividends.
So, let us break down the income of a corporation and see how it might be allocated. The following is highly simplified, but it is meant to get to the important points outlined at the end.
The first thing a well-run corporation needs to do with its revenue is to maintain operations. The company must pay for all the line items in a typical corporate budget: Production, sales, marketing, administration, manufacturing, service creation and delivery, customer service, shipping, human resources, protecting “secret sauces” and brands, maintenance and replacement of hard assets, and the like. The well-run corporation will seek to economize on all of these functions, but not so much as to deteriorate the core business or dilute competitive advantages.
Let’s say that our company makes near-perfect decisions in this area, and that results in the consumption of 20% of its revenue. The build-up of value within the company takes place at its highest level in its best business(es). This is where the cash cows are.
Next, most companies are interested in growth and improvement. Grow or die. New products must be introduced, new markets penetrated. The company has developed procedures for introducing and vetting ideas, creating brand extensions, and so on. Internal projects aimed at improving operations must be considered and some of them tried, sometimes requiring large investments. Opening new markets may take years before paying off at anywhere near the rate of established markets. An entire portion of the company may be devoted to research and development whose results are uncertain.
This growth and development area is one where even the best companies make some investment and allocation mistakes. They may pursue projects that turn out to be duds. Or they may overreact to dud risk by creating hurdles so high that worthy projects don’t get through the filters and are abandoned, only to later turn up as successes in the hands of competitors.
Management may fail to see the commercial possibilities of existing internal tools that are right under their nose, while at the same time wasting money on sexy but impractical proposals. They may simply misjudge the value of some initiatives. Every company finds it extremely difficult to compare, contrast, and evaluate short-term versus long-term projects. Overall, very few companies make near-perfect decisions in the areas of research and business development. But let’s say that our company is very good at this and consumes 15% of its revenue in these pursuits. The return on this money depends on batting average, optimal expected value, and what timeframe you are talking about. The return on even successful projects will not be as high as that already delivered by the cash cows, at least not for a long time.
The company must service any debt it has. And it must pay taxes. Let’s say that its total spending for these things is 40%.
That leaves 25% of its revenue. These are the company’s profits or earnings, unneeded for anything already mentioned. What should the company do with its excess capital?
There are basically three choices:
- Keep the money. Build a war chest, a rainy-day fund, an acquisition fund, a cushion against unforeseen difficulties, or plow more money back into operations, development, or expansion.
- Buy back shares.
- Distribute dividends to shareholders.
As we look across the landscape of companies, we see that examples of all three choices take place all of the time.
Keep the money. Young fast-growing companies usually keep all the money. They need to have as much on hand as possible to be able to jump on any opportunity that comes along. They may not have a core business yet, indeed they may have no profits. Paying a dividend in their situation would be foolish.
Paying a dividend would also be foolish for a certain number of well established companies. In this crème de la crème category, companies successfully create or discover a never-ending parade of ways to put the money to good use, compounding success upon success. They are the absolute best capital allocators. There is no such thing as “excess” cash. They always have a good use for it.
But most companies are not in this top category. At some point, even very successful companies enter a phase where they do, in fact, generate cash that they do not really need. Yet some cling to their original ways, keeping all of the money all of the time, and often that leads to three results, none of which is good for shareholders:
- They make ill-advised acquisitions, often at inflated prices. Activities that would never come close to being approved as internal projects somehow seem more attractive when an outsider is doing them. The company may get into a bidding war and overpay for even a sensible acquisition.
- The money just piles up, unused, earning essentially no return.
- The money is recycled back into less-worthy projects that would have been rejected if excess money weren’t available. The company becomes a less efficient operation overall as it loses spending discipline. That does not mean that the company is not a terrific steward of its core businesses. It does mean that it does not need all of its profits to run its core businesses, and so some money gets spent sub-optimally just because it is there to spend.
Buy back shares. The second potential use is to buy back shares, and many companies do this. While often viewed as universally helpful to shareholders, many buybacks fail to deliver some of their supposed value:
- Some shares purchased are really to compensate executives and other employees. They are not a “transfer of value” to shareholders.
- Many share purchases are made at overvalued prices. The reason this happens is that companies tend to have money “left over” when they have been doing well. But the fact that they have been doing well often has caused their stock prices to rise. So they buy back shares at inflated prices. This has been documented in every market cycle.
The foregoing is not always true, of course. Some companies buy back shares when they are trading at depressed valuations. Such buybacks are beneficial for the remaining shareholders, who gain increased value at no additional cost and without taxable events. That said, many companies’ capital allocation skills are worse in buybacks than in perhaps any other part of their business.
Pay dividends. Dividends bypass the market and are sent directly to shareholders, so they are an efficient distribution of capital in that regard. On the other hand, dividends are usually taxable to shareholders, so the amount essentially comes with a “haircut.” For some shareholders using tax-advantaged accounts, the taxation impact is muted. Obviously, any money distributed to shareholders cannot compound within the company at either an optimal or suboptimal rate, because the company does not have that money anymore.
Dividend investors are sometimes asked, if you cannot trust management to allocate capital wisely, why are you invested in the company at all? The answer is twofold:
- The payment of a dividend does not necessarily reduce the compounded growth that the company would achieve if it kept the money. That corporate rate depends not only on the business model, but also on management’s skills in allocating capital in all situations. Management may be great at running the core businesses but less skilled at producing optimal compounding in other areas.
- Some investors may want management to allocate some excess capital to dividends, because they have built personal investment/retirement strategies around companies that have proven that they can both pay growing dividends and grow the company’s intrinsic value simultaneously.
That last point allows me to segue into the ultimate purpose of stock investing. The fact is that the ultimate goal varies from person to person. Much of the recent discussion about dividends has centered on the idea of compounding. Is it better to have the money compound within the company, or is it better to put the money in the hands of shareholders so that they can compound it, spend it, or do whatever they want with it according to their own goals and needs? Using the lens of what do you want your company to do with its last dollar of earnings, we can see that none of the alternatives is always “best.”
- If the money is kept within the company, the chances are pretty good that some of it will not compound as efficiently as that portion devoted to the most profitable core businesses. Some of it will be essentially wasted, while other dollars will end up in sub-optimal uses. So you have some money compounding at the highest rate possible, while other dollars compound less efficiently at a lower rate of return. The result for the whole company is a blend of the different compounding rates.
- If shares are repurchased, chances are pretty good that some of them will not be removed from the float and also that some if not most of them will be purchased at inflated prices.
- If dividends are declared, a taxation inefficiency is created at the shareholder level. The taxation haircut may have more or less impact on the shareholder than suboptimal compounding that might take place within the company.
I believe that it is incorrect to make flat statements about what is the “best practice” for all investors all of the time. There are too many nuances and variables to produce a one-size-fits-all answer.
Beyond the compounding question, there is another layer to the dividend debate that sometimes gets overlooked when appraising a business’s suitability for individual investment. That is the subject of retirement income. It is the explicit goal of some investors to build stock portfolios that generate ever-growing dividend streams. They intend to retire, or are already retired, on those dividend streams. They do not care if they retire with the biggest pile of assets possible, because when they need money, they don’t want to be subject to the vagaries of the market when they sell shares. If they are ever forced to sell at depressed prices, they suffer permanent loss. That is a risk that they want to avoid.
In other words, such shareholders may not be as interested in the absolute highest rate of compounding possible under the most ideal conditions. Instead, they may wish to build their investing and retirement strategy around growing dividends. They are willing to take the taxation haircut—recognizing its potential drag on compounding efficiency—in order to gain other benefits:
- Amelioration of some of the compounding inefficiencies that may take place within the company. The company cannot waste or misuse money that it sends out in dividends.
- Disintermediation of the market. Since dividends are sent directly to shareholders, they are not subject to the whims of the marketplace. The market does not overvalue or undervalue the dividend check, because the market is not involved in the dividend process. The amount the company declares is the amount the shareholder receives.
- Regular and predictable growth of dividend streams that exceeds that available from other investments.
- Amelioration of a bumpy income ride. Dividends from a portfolio of the best dividend-growth companies go smoothly up. Stock prices do not.
- Empowerment to make independent decisions about what to do the money.
It might be said that for such investors, the fact that a company pays rising dividends is part of the intrinsic value that they see as they appraise it for themselves. This is not nonsensical or irrational. It prioritizes income maximization ahead of wealth maximization and assigns a value to it. Unlike a corporation that has a theoretically infinite lifespan and can therefore use an infinite timeframe to wait for maximum capital gains, each of us has our own individual lifespan. We will need retirement income when we need it. Therefore, investing to maximize income when that time comes, as well as to create an income stream that grows faster than inflation throughout retirement, is a totally reasonable, practical, and achievable strategy for many individuals.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.