Yesterday, I read Arnold Landy's Seeking Alpha article about "The Misplaced Mania Over Dividend-Paying Stocks" that downplayed the importance of dividend-paying firms. Since a good chunk of the articles that I have written for Seeking Alpha have focused on the pursuit of accumulating an ever-growing arsenal of dividend-paying companies that will hopefully churn out enough quarterly cash so that I would never have to deplete my assets to meet living expenses, I usually read most articles that promote dividend agnosticism to see if there are latent holes in my thought process.
To be sure, I don't agree with Mr. Landy's conclusion of viewing "the dividend paying policies of most stocks with indifference." I personally like the role that dividends play in creating a potent offense-when the price of a company rises, an investor receives the benefit of the increased investment value, and when the price of a company falls, an investor receives the benefit of turbo-charged returns that comes with reinvestment at depressed prices. Over a twenty-year stretch, the combination of dividend growth and dividend reinvestment can produce remarkable gains for investors.
But then again, Mr. Landy seems to implicitly assert that these gains will automatically happen whether the company chooses to pay out a dividend or retain the earnings (hence the indifference). I have trouble accepting the notion that retained earnings are automatically better than (or at least equal to) earnings paid out to shareholders in the form of dividends. My main concern is that this assumes that management is capable of deploying all earnings equally-that is to say, I reject the notion that most companies can spend the first billion in profits as effectively as the tenth billion in profits, and that the tenth billion of profits can automatically be spent in a better way than sending the cash to shareholders.
If I may quote the Bruce Springsteen song Badlands -- I apologize if I'm intruding into Rocco Pendola's territory -- the Boss famously said, "You better get it straight, darlin'. Poor man wanna be rich, rich man wanna be king, and a king ain't satisfied 'til he rules everything." Applying these lyrics to dividend investing, it would be foolish to completely ignore the disciplining role of dividends in serving as a bulwark against managerial hubris. Let's take a look at the per share retained earnings for six mega-cap American firms with long histories of dividend growth-Coca-Cola (NYSE:KO), Colgate-Palmolive (NYSE:CL), PepsiCo (NYSE:PEP), Exxon-Mobil (NYSE:XOM), Proctor & Gamble (NYSE:PG), and Johnson & Johnson (NYSE:JNJ).
In the case of Coca-Cola, the company put forward normalized earnings of $3.85 per share in the past twelve-months (I'm ignoring the one-time accounting profit from the revaluation of the Coca-Cola Enterprises shares that temporarily spiked Coke's profit numbers), and the firm is currently making a $1.88 per share annual dividend commitment to shareholders. Since Coke has 2.3 billion shares outstanding, that means the company is paying out $4.3 billion dollars in annual dividends relative to $8.85 billion in annual earnings. When Coke's management decides how to deploy the company's profits--$4.3 billion is already committed- this forces management to put retained earnings towards the most profitable endeavors available rather than the most expansive opportunities to build an empire and satisfy ego.
In the 1980s, Coke's dividend payout ratio at times was almost half as low as the current payout ratio of 48%. And what happened? Coca-Cola executives started making decisions that can only be described in hindsight as quite odd-Coke started buying ownership stakes in shrimp farms, movie studios, and intellectual property rights in the entertainment sector that had nothing to do with the company's core competencies and this cost shareholders very real money in the form of squandered opportunity costs. Am I saying that if the company cancelled its dividends today, Coke would necessarily revert to these types of endeavors? No, but I do believe that the temptation to engage in these types of foolish side projects would grow stronger if the company did not have to face the reality or the pressure to pay out $4.3 billion in cash to shareholders.
That's why I have trouble getting on board with Mr. Landy's assertion that "for the vast majority of companies, which are neither piling up excess cash fortunes nor sinking towards bankruptcy, the dividend payment policy or lack thereof is irrelevant to an investor's total return." (Source)
When people look to the startling long-term success of Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), they often try to figure out what talent Buffett possesses that other executives do not. One of the secrets to Warren Buffett's success is that he is able to allocate the "last dollar" of profit almost as effectively as the "first dollar" of profit. While I'm sure that the managers of each of the companies I listed above all have fine ideas about how to allocate profits, the fact of the matter is that the handcuffing nature of a dividend commitment forces them to only focus on their best ideas, and this can serve shareholders very well in the long-haul. That is to say, for a company like that Johnson & Johnson that is committed to paying out about half of its earnings to shareholders, management only has the resources to allocate retained profits to their best ideas, rather than pouring $250 million into the 47th best idea.
I'm also not particularly on board with the assertion that "the proper way to view most stocks' rate of return is to look at total return. And it is irrelevant, except for personal income tax implications, how much of that total return comes from dividends versus stock price gains." That type of mentality is not compatible with my personal investing objectives. I can't speak for you, but here's a quick list of what my investment objectives are, and why I think that being a "dividend maniac" is my preferred method for trying to get there.
1. I want to grow my ownership stake in companies automatically during my "building" years. If I own 300 shares of Proctor & Gamble, every three months I will receive a check for $157.50 from P&G. That would allow me to increase my claim on P&G's future profits by giving me an additional 2.5 shares of the firm's ownership. In the first three months alone, my overall ownership stake would increase by about 0.83%. While that may not sound like much, over the course of time as the dividends rise and the reinvested shares continue to accrue, I would gradually increase my ownership in the firm, which ought to give me much larger dividend checks over the long-term.
2. Similarly, when I reach my "spending" years, I do not want to deplete my assets. Let's say that I own 100 shares of Apple (NASDAQ:AAPL), for a total investment of around $42,000. As great of a company as Apple is, all of that money remains unrealized until the moment I decide to sell. If I want to pay an electric bill, go on vacation, or give money to charity, I'd have to sell shares and thereby reduce my overall ownership in Apple, which is something I want to avoid. However, if I owned $42,000 in Johnson & Johnson, I'd receive about $1,450 in annual dividends to spend as I please without having to reduce the assets working for me.
3. I want to take agency over Mr. Market's vacillations. I try to take Benjamin Graham's advice that "The stock market exists to serve you, not instruct you" to heart. When I receive that $157.50 quarterly check from P&G, I can decide what I want to do with it: (1) I can reinvest the money into P&G, (2) I can put the money into a different company, or (3) I can take the dividend as cash to spend as I please. I like having these three options at my disposal on a regular basis. I can't control what others are willing to pay for a share of a stock, but I can look to companies that pay ever-growing streams of cash dividends-when I start trying to use investments to meet my living expenses, I'd rather be at the mercy of Coca-Cola executives to continue a half-century policy of paying rising dividends rather than be at the mercy of Mr. Market to be trading shares of a company at a desirable price so that I could sell shares for income.
When Benjamin Graham wrote The Intelligent Investor, he asserted that the primary focus of stock ownership was for firms to pay out profits to shareholders in the form of dividends. This attitude towards stock ownership gels well with the notion of long-term investing and an ownership mentality. At some point, I want to enjoy the fruit of my labor and investments. If I am indifferent about whether or not a company pays dividends, then I expose myself to the prospects of asset depletion that comes in the form of having to surrender to Mr. Market. But if I forge an alternate path and treat dividends as the heart of my investing strategy, then I can regularly reap the fruits of my investment in the form of quarterly cash payments without having to sell my holdings at a price dictated by the marketplace.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.