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I've been hearing a lot of arguments being tossed around about how dividend stocks are primarily the domain of passive/uneducated investors or weak companies, so I thought I'd write down some of my own thoughts on this issue. I understand where the anti-dividend crowd is coming from: I used to be one of them. A long time ago, I believed that dividend companies were for the risk-averse and elderly. Agile investors with a healthy appetite for volatility could crush the market only by aligning their fortunes with young companies growing like weeds, with the wind at their back and their best days still ahead. I wrote off dividend-paying companies as the stuffy old dinosaurs of the stock market. They were ancient, and gigantic by virtue of their age, but you're not going to get anywhere fast by riding on the back of one. I preferred to invest in cutting edge growth companies that made money fast and ate it up even faster, that were either going to shoot to the moon or crash and burn in a spectacular blaze.

I was wrong. I've moved far away from the days when I saw dividend stocks as exclusively widow and orphan concerns, though I don't count myself as an income investor just yet, especially in the current market environment where rock bottom bond yields have driven up the valuations of dividend equities to the point where few of them represent good bargains. But that's just a temporary state of affairs - I have my eye on a number of great, dividend-paying businesses, and I'm ready to pull the trigger as soon as valuations drop. As far as the concept of dividends is concerned, I've reached the point where I see them as a net positive when I'm analyzing a business, similar to large insider purchases or a strong balance sheet. I don't need a dividend to buy a company, but seeing one makes the investment opportunity more, not less attractive. A dividend shows management concern for shareholder interests, it forces managers to be more efficient in their capital expenditures, and it hedges against the depreciation of cash assets on the balance sheet. But most importantly, dividend stocks are not just for passive investors who prefer to take a hands-off approach to investment...in fact, it's the exact opposite.

The Origin of the Dividend

Before we get into that, let's talk about why companies pay dividends in the first place. Imagine the following hypothetical scenario. Roused by the capitalist spirit, I decide to start up a new publicly traded corporation, called Company X. As a young company helmed by an ambitious entrepreneur, the sky's the limit for Company X. My new company is short of cash and hungry for growth, so I eschew a dividend payout, choosing instead to plow all of my earnings back into the business to fuel an aggressive expansion. I'm a savvy and efficient operator, and manage to earn a 20% return on equity every year. Since I'm retaining all the earnings of Company X, the company grows book value by 20% per year, and its market value grows at a corresponding pace.

My shareholders are pleased...they are happy to sacrifice a quarterly payday for a 20% annual appreciation on their invested capital, which is much higher than the 9.5% return the stock market as a whole has averaged over the past 100 years. It's mathematically advantageous for me to retain a dollar of earnings rather than pay it out as a dividend. If I reinvest it into the business at a 20% ROE, I create a compounded annual revenue stream of 20 cents. If I pay it out to my shareholders, they would, on average, generate a compounded annual revenue stream of only 9.5 cents if they redeployed their dividends into other investment opportunities in the market. Clearly retaining the dollar is the superior option. Of course, there are some investors, such as retirees, who may prefer dividends since they're looking for money to spend, but such investors wouldn't be buying a young start-up like Company X in the first place.

As Company X grows larger, I begin to find that the opportunities to make outsized profits are beginning to become fewer in number. As my company grows bigger, so too does its anchor of size. Now, if I retained all of the company's earnings, I can only invest half at 20%. My best ideas are just as profitable, but they've diminished sharply in quantity, so now I have to resort to my second best ideas. These second-string opportunities offer me a return of just 10% on my invested capital. This is still higher than the average market return, so after much deliberation, I decide to continue the company policy of retaining all earnings.

On average, a dollar in my hands in still more valuable than a dollar in the hands of my shareholders. I know that some of my shareholders may be cunning investors in their own right, and if I paid out the less profitable half of Company X's earnings to them, they might be able to earn a better return than 10%. However, as the CEO, my job is to maximize value for all my shareholders as a group, not just a select few. I can't very well pay out dividends to those owners with a superior investment track record and withhold them from those without one. So I continue to retain all earnings. Company X's annual book value growth has slowed down from 20% to 15%, but my shareholders continue to be satisfied, since their investment is still growing faster than the market average.

Let's fast forward ten years. I've achieved enormous success as chief executive of Company X, and navigated it to become one of the largest companies in the world, a multinational enterprise that's a leader in its industry. I'm rich and famous, and the shareholders who got in on this ride at the beginning are now sitting on millions. However, the curse of success in the wonderful world of business is that the law of large numbers begins to work against you. The bigger you get, the more difficult it is to grow even bigger. I still spy many avenues for profitable expansion for Company X, but now, even my best ideas can only generate a return on capital of 15%. With my company's operations spitting out massive gobs of free cash flow, I can only deploy half of its earnings towards these opportunities. The rest, if I choose to retain them, will have to go to my second best ideas, which now earn a measly 5% return on capital.

As CEO of Company X, I am now faced with a dilemma. I have two options available to me. The first: I can retain all earnings and achieve, on average, a 10% marginal return on equity. This is still higher than the average market return, and would likely be sufficient to placate my shareholders. The second option is to retain the half of Company X's earnings that I can deploy at the higher 15% rate, and distribute the other half as dividends. Down which path should I tread?

If I was an unscrupulous executive who's only looking out for number one, I would no doubt choose Door #1, because my compensation is contingent on the size of Company X. The bigger the company that I manage, the bigger my paycheck. The most effective way to grow a company is to retain all earnings, including the portions that can be reinvested at a mere pittance. Even if I increase earnings by only one cent on the dollar, that's still one cent more than I would have if I had paid that dollar out to shareholders. Clearly it is in my best interest to withhold all earnings from the owners and keep it all inside the company vault. Either that, or spend it all on share repurchases in order to jack up the value of my options.

On the other hand, what if I was an executive who's committed to doing the job I was hired to do, which is to maximize value for my shareholders over the long term? Then I would instead choose to adopt a 50% payout ratio and retain only the portion of earnings that I can reinvest at a return superior to the market average. The rest I distribute to my shareholders, who can reinvest their payout into an index fund and earn a 9.5% return - far superior to the 5% return I can generate if I had kept those earnings on the company's balance sheet. From the perspective of the shareholder, the better prize is behind Door #2. With half of the earnings of his company compounding at 15% and the other half at 9.5%, he would be pulling in a 12.25% marginal return per year, which is materially superior to the 10% he would be earning had Company X retained all of its profits. Furthermore, since I'm also investing half of the company's profits at a high rate of return, the income stream represented by the stock's dividend payouts will increase over time.

A Case Study: Procter & Gamble (PG)

This is why companies begin to pay dividends as they reach maturity, because they've grown so large that it becomes impossible for them to redeploy all of their profits at an acceptable rate of return. After passing a certain milestone in their lifecycle, initiating a dividend payout policy becomes the most effective way to generate enduring shareholder value. For a case study, let's examine Procter & Gamble, a great American business that's a core holding in many dividend portfolios.

Looking at one year trailing data for fiscal year 2011, Procter & Gamble sports a return on equity of 17%, and a payout ratio of 51%. Had the company retained all of its earnings, it would almost certainly be unable to maintain a 17% ROE. In truth, the payout ratio understates the percentage of its cash flows Procter & Gamble returns to its shareholders. One must also add in all the money the company has spent on its share buyback program, which is another vehicle for returning profits to owners. The reality is, the portion of profits that is actually reinvested back into the company, the part that is compounded at 17% is a very small sliver of Procter & Gamble's annual cash flows. Indeed, rather than growing incrementally, book value for Procter & Gamble actually dropped $8 billion between fiscal year 2008 and fiscal 2010.

Does this mean that Procter & Gamble is a bad company? Absolutely not (in fact, it's one of the companies on my own watch list). It just means that the company should be viewed as a cash machine rather than a growth machine. As a mature company, its primary function is to deliver cash to shareholders, not to help shareholders compound their cash, though of course it does that very effectively as well (otherwise it would be sporting a much lower P/E). The unique characteristic of cash machine companies is that their value does not remain constant between different owners. If I own 100 shares of Procter & Gamble and you own 100 shares of Procter & Gamble, even though the market values of our holdings are the same, my stock may be worth more than yours, or vice versa. The reason for this phenomenon is that only half of the value of cash machines is contingent on the size of the cash flow delivered to shareholders. The other half hinges on how effectively the recipient of that cash can compound it.

What Dividend Investors Can Learn From the Oracle of Omaha

One dollar in the hands of Warren Buffett in 1970 was worth far more than one dollar in the hands of Joe McCitizen. Analysts of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) will immediately notice that the company's equity portfolio is comprised almost entirely of dividend-paying blue chips like Procter & Gamble and Kraft Foods (KFT). In curious contrast, Berkshire itself pays no dividend, even though it's larger than most of the companies it owns.

Buffett has said that Berkshire will continue to eschew a dividend as long as he can redeploy earnings at a higher rate of return than shareholders can if they were forced to reinvest those earnings themselves. As a conglomerate that controls subsidiaries in a vast multitude of different industries, Berkshire possesses the advantage over other large caps because it has a much more massive universe in which to invest its funds, whereas companies like Kraft are forced to invest within the bounds of their own industries. While horizontal expansion does occur, it's generally fairly limited. Kraft might decide to move into a new kind of snack product, but it isn't going to suddenly start selling, say, carpets. If an enormously lucrative opportunity arises in the carpeting industry, Kraft won't be able to take advantage ... but Berkshire can (one of its subsidiaries is Shaw Industries, the world's largest carpet manufacturer). As such, Buffet's decision to retain Berkshire's earnings is the correct approach when the goal is to maximize total return.

Why, then, does Berkshire choose to buy companies that pay dividends rather than investing in companies that retain all earnings, much like itself? The answer is the same: Buffett believes that if a company he owns streams its earnings to him, he can compound it at a higher rate of return than management at that company can if left to its own devices. Considering Berkshire's long term performance relative to the average company in the S&P 500, this is a credible claim. Not only is a dollar in the hands of Warren Buffett more valuable than a dollar in the hands of Joe McCitizen, it is also more valuable than a dollar owned by Joe McInvestor, and a dollar held by Joe McManager. Even if I owned the exact same stocks as Buffett in the exact same quantities, Buffett's portfolio would be worth far more than mine because he can redeploy those dividends way more effectively than I can.

Putting It All Together: Rethinking Dividend Theory

What does this mean for you, dear reader? As part owner of a portfolio of dividend-paying companies, you are Warren Buffett. You may not be the man, but your role as high overseer of capital allocation is the same. Like Buffett, you, too, have a boundless universe in which you can invest. While each company in your portfolio is restrained to the opportunities available in their own industries, dividends paid out to you can be deployed into any company in any industry. In your position of owner, there are avenues of profit available to you that are closed off to your managers.

The conventional school of thought that dividend stocks are for passive investors is thus turned on its head. A passive investor would find a so-called "growth" company with zero yield far more suitable for his interests, because he can lay off the entire responsibility for compounding the company's earnings on his management. In contrast, when you buy a dividend company, you are assuming partial responsibility for earning an acceptable return on capital for the portion of earnings your company sends your way.

When it comes to the dividend investor, his real return depends on how effectively he can compound his dividends. There will be a sizable performance gap between an investor holding 100 shares of Annaly Capital Management (NYSE:NLY) who parks his dividends in a savings account paying 0.5% interest, and an investor with 100 Annaly shares who feeds his dividends into the stock market and earns a 9.5% annual return (or reinvests them into the company and earns whatever yield it's currently paying). If Warren Buffett bought 100 shares of Annaly and compounded its dividends at the same 20% he's historically achieved at Berkshire, his Annaly stock would be even more valuable to him than to our second investor. For a mortgage REIT like Annaly, which is required to pay out at least 90% of profits to shareholders by law in order to reap special tax benefits, managing the dividend becomes an even more important concern. mREITs generally don't experience very much organic growth except through secondary stock offerings, so the burden of putting his money to work falls almost entirely on the investor.

Inexperienced investors need not eschew dividends, because as Benjamin Graham said, it requires little ability to produce average returns in the stock market. Less knowledgeable investors, or those who wish to allocate only a minimum amount of time to stockpicking can see acceptable returns simply by investing their dividends into an index fund or buying more shares of the companies they already own through a DRIP program. Or they can simply utilized the tried and true method of buying companies that have been raising their dividends consecutively for many years, which includes such stalwarts like Procter & Gamble and Altria (NYSE:MO), though some new hands to the dividend game like Intel (NASDAQ:INTC) are quickly catching up. If you're planning on spending the dividend, then you don't even need to worry about reinvestment.

However, investors who have the ability to consistently choose best-in-breed businesses will find that dividend stocks are far more valuable to them than to their more defensive compatriots. Dividend-paying companies allow them to leverage their capital allocation skills beyond the initial selection process of assembling their portfolio. Now, they must also use their ability to decide how to profitably deploy the earnings their companies upstream to their cash account, to buy not only dividend stocks in general, but the right dividend stocks at the right time at the right price - a welcome responsibility for those who can translate those dividends into a superior total return or a larger income stream, depending on their goals.

As it turns out, dividend stocks are no plodding dinosaurs. Instead, they are strategic assets with intrinsic values that scale with the investment ability of the shareholder. One may be able to make fast money with a collection of high growth stocks like Amazon.com (NASDAQ:AMZN) and Chipotle Mexican Grill (NYSE:CMG), but a dividend portfolio that's strategically designed, carefully cultivated, and effectively managed can produce long term returns that are equally impressive.

Therefore, when you think of dividend stocks in the future, think not of widows and orphans. Instead, think of Warren Buffett and the billions he's made and will continue to make from his dividend portfolio. And think of the dividend investor not as a passive owner who just collects dividend checks, but as an active partner of his managers who's taking his destiny into his own hands and sharing the fiscal responsibility of reinvesting the company's earnings. As the pilot of a dividend portfolio, you are sitting in the captain's chair. While adequate results can be attained by activating the autopilot, exceptional results are in reach for those who grip the throttle tight and fly towards the stars.

Disclosure: I am long BRK.B.

Source: Debunking The Myth: Dividend Stocks Are Not Just For Passive Investors