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whatoncewas
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Young european self-directed investor currently establishing a growth and income focused portfolio. Long: ACN, BBL, BLK, GILD, GSK, KO, KORS, LVS, MCD, PEP, PSEC, RPG, SDRL, UL, V.
  • Paying A Dividend Is Efficient Capital Allocation 0 comments
    Feb 20, 2014 6:52 AM | about stocks: PG, CL, KO, XOM, BRK.A, BRK.B

    I believe that the payment of a dividend should be considered as a continuation of the concept of capital allocation.

    Any successful business generates profits. Ideally, firms will invest these profits in opportunities available to generate further profits. However, there comes a point in the life of any successful business when opportunities for growth become rare. If a firm begins to generate more capital than it can reinvest at a reasonable rate of return, there are several options open to management:

    a) It can hoard cash and short-term investments.
    b) It can reward management.
    c) It can re-purchase shares.
    d) It can pay a dividend.

    a) Hoarding cash does not seem to be rewarded by the market. Firms such as Apple, Microsoft and Cisco have billions of dollars on their balance sheets, none of which is contributing meaningfully to future earnings growth. Personally, this strikes me as indecisive behaviour by management.

    b) Excessive compensation for management, essentially for doing their job, has been a bone of contention in recent years and is generally not well received by shareholders.

    c) Other articles on SA have shown that, even with the best intentions, share buybacks frequently destroy shareholder wealth by repurchasing shares while overvalued, instead of while undervalued.

    d) Management can decide that releasing cash to shareholders is the only feasible option if they cannot otherwise create wealth for shareholders. Rather than building an obscene warchest, or destroying shareholder value, excess funds are allocated to the owners of the business. It is then up to shareholders to decide how to allocate this capital.

    However, by paying a dividend, management is realising the limitations of both the management team and the firm (for which it should be lauded) and making a decision with the best interests of shareholders in mind.

    Advocates of profit retention will point to Warren Buffet and theoretical models showing that paying a dividend reduces the value of a company. I don't disagree with theoretical models, but they are not always entirely applicable in the real world.
    Buffet is an anomaly. BRK can operate as a diversified conglomerate because Buffet is of the best allocators of capital of all time and is recognised as such. However, if the management of PG, CL, KO or XOM decided to stray from their core competencies and start allocating capital to purchasing railways or candy manufacturers, I daresay the market would punish them for it, and justifiably so.

    The payment of a dividend is an attempt by management to allocate capital in the most efficient manner, once other options have been examined and discarded.

    Disclosure: I am long KO.

    Stocks: PG, CL, KO, XOM, BRK.A, BRK.B
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