Dividend Is Not A Four-Letter Word

Includes: AAPL, BRK.A
by: Marc Gerstein

When did the world go crazy? When did companies that pay dividends find themselves put on the defensive?

Back in the 1970s, when I was in school, I remember having done a paper exploring the relationship between dividend payout ratios and P/E multiples and while I can’t recall what, exactly, I wrote, I can’t forget the overwhelming bias in the literature of the day against companies that didn’t pay dividends. Lately, though, an anti-dividend body of opinion seems to have emerged, at least on Seeking Alpha, such as was evident in a 1/10/12 article suggesting receipt or non-receipt of dividends is completely irrelevant to investors and another from 12/28/11 that tried to pass dividends off as being illusory. There have been many more; those are just the ones that are freshest in my mind.

I can understand investors finding reasons, lots of very good reasons, to want to own shares of non-dividend paying companies. There is no shortage of spectacular business and stock-market success stories involving companies that retained and reinvested every penny of profit they ever earned, ranging from the likes of Apple (NASDAQ:AAPL) and the products it created to Berkshire Hathaway (NYSE:BRK.A), which is known more for ordinary businesses selected through the superior capital-allocation skills of its legendary leaders. I get it. And in fact, given my affinity for small- and micro-cap stocks, especially at the smallest end of the spectrum, the ones I address in my low-priced stocks newsletter, I own lots of non-dividend payers.

But I also own many income stocks and find the disrespect being shown in some quarters for dividends and the companies that pay them to be just plain absurd.

Imagine a friend of yours is going into business, say a cafe, and needs a partner to contribute some capital. Would you be content to realize nothing – absolutely nothing, zero, zilch, nada – from your stake unless and until you sell out? Imagine the cafe does well. Your friend prospers. He’s the day-to-day manager and collects a salary from the closely-held corporation, and, perhaps monthly bonuses. The money going from the cafe to your friend appears on the corporate books as cost of goods sold, an ordinary expense. But you have a full-time job and don’t work in the business. So you get no salary. If the corporation doesn’t do the paperwork needed to declare a dividend, your friend will be making money hand over fist while you get nothing. You could sell. But that may destroy your friendship if he has trouble raising capital to buy you out and winds up having to close shop. Or perhaps you really want to hang on because you think the business has legs, perhaps even potential for a second or third cafe. All you want is to participate in the cafe’s financial success. You recognize that your friend, the guy who is there working all the time, should pocket a lot more than you. But isn’t it fair that you get something, at least as much and hopefully more than you could have received had you said no to your friend and kept your money in insured treasuries or CDs, if not on day one then at least starting at the point where the cafe is on solid ground. Is that too much to ask?

Dividends are meaningful; very, very meaningful.

The world of publicly-traded corporations is a bit different since money is not being divided among just you and your friend. In fact, you probably don’t know and may never get to see or talk to the people who manage the business day to day. But the key dynamic remains the same: Dividends enable owners to financially benefit from the profitability of the business without having to sell. The public arena introduces some distortions here, such as the greater ease with which those who run the business can get away with taking all their return in the form of salary and bonuses while leaving other owners high and dry and/or the fact that other owners rarely, if ever, get a say in how the company addresses questions relating to reinvestment of profits. The distortions are magnified when, as can happen, senior managers own just trivial stakes in the business, or in some cases, no shares at all.

I don’t need to preach chapter and verse the benefits of cash in hand to the many Seeking Alpha readers who have owned and/or currently own dividend-paying stocks. All they need do is look in their brokerage account records and tally up the money that’s there as a result of dividends. Less easy, but still worth thinking about, is the extra money they earned on dividends that were allowed to remain in the account. Interest-on-interest is extremely important in the field of fixed-income (and is used to calculate yield to maturity and duration). It’s a shame equity math does not do a good job of recognizing its parallel: return on dividends. But it’s there.

I would, however, like to stick with the corporate governance/quality issue. Apple is an often-cited example of a company that has done well by reinvesting its profits. (There is controversy as to whether that should continue in the future, but the past is unmistakable.) Guess what: Not every company is Apple. Most companies do not have nearly as many promising reinvestment opportunities. And when such opportunities are questionable, management can choose one of two paths: Pay profits to the co-owners and let them consume or reinvest as they see fit (just as you might want to do if your friend decides to share the cafe’s wealth with you), or take pot luck by pushing new products the world doesn’t really need or want or making acquisitions which definitely benefit the lawyers, accountants and definitely the investment bankers but may or may not help the business. Decisions around reinvestment tend to be at the core of good governance versus bad.

This definitely is one of those warm and fuzzy issues. The question, though, is whether it also means something in terms of dollars and cents. I turned to my stock screener to investigate a bit.

I confined myself to non-financial companies included in the S&P 500 and ran two screens; one to identify companies that paid dividends and a second to identify companies that have not paid dividends. I confined myself to the S&P 500 in order to focus on larger well-established firms, the ones you’d think would be most likely to be expected to pay dividends. I eliminated financial firms because those have had many exceptional and well-known problems in recent years. I backtested both screens back to 1/1/04. Figure 1 shows the results of these two S&P 500 subset portfolios.

Figure 1

The trends you see here include the impact of dividends paid and assume the receipts are being reinvested back into the portfolios. Obviously, this is a non-issue for the red line, since the companies in that portfolio don’t pay dividends. And we’d expect the blue line to be higher since it includes dividend receipts – or not. The anti-dividend crowd carries on about how dividends don’t help shareholders, and the 1/10 article in particular claims dividends don’t make any difference at all. If they are correct, the non-dividend companies should have been able to use the retained-and-reinvested cash to generate at least as much wealth as that which the dividend-payer portfolio produced. That didn’t happen. The extra corporate wealth retained by the non-dividend payers did not find its way into the market values of the companies. Where did it go? I’ll be darned if I know.

One might argue that by focusing on S&P 500 companies, I rigged the test. It might be suggested that aside from a few flukes like Apple, growth companies, those that most ought to be retaining and reinvesting all their profits, tend to be smaller. OK. I’ll bite. Figure 2 shows backtest results for comparable screens created for non-financial companies included in the Russell 2000.

Figure 2

So where is the shareholder wealth created by reinvested profits? I’ll be darned if I know.

Bear in mind that to make it onto either dividend payer screen, the company just had to pay something. A minimal payout and a yield of 0.01% would have sufficed. So it would probably not be accurate to see this as a study of the mathematical impact of dividends on shareholder wealth. View it instead as a study of the impact of one aspect of corporate governance; a recognition of the legitimacy of dividends as way to deal with corporate profit. The dividend-payer lists include many firms that reinvest quite heavily: But these are firms that are more likely to reinvest based on thoughtful assessments (which sometimes turn out right and other times, wrong) of reinvestment opportunities, as opposed to perpetual knee-jerk refusals to consider dividends.

The differences here are not vast but they are meaningful. If the anti-dividend crowd is right, the red lines should be at least equal, in height, to the blue lines and depending on which dividend-hater you ask, it might even be reasonable to expect the red lines to be higher. If a company hangs onto all of its profit paying zero to owners, it ought to be able to reinvest profitably enough to at the very least put owners on an even keel with where they might be had they received some payments. If company can’t accomplish that, something is wrong.

This doesn’t mean you should avoid zero-dividend companies. As noted, I own shares in many such firms. But my decisions were based on case-by-case fundamental analysis and a belief that they face the kinds of opportunities that warrant re-investment. I also own many income-oriented stocks. There’s plenty of room in the world, and in the portfolios of many investors, for both kinds of firms. What needs to be eliminated is doctrinaire nonsense such as we’ve been seeing lately from the dividend-haters. Or if we can’t eliminate it (which, actually, is the case since we value free speech), at least I encourage readers to develop intellectual armor to refrain from allowing such gibberish to influence their investment decisions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.