Friday, August 14, 2015

Should companies pay dividends?

As many of you know, I only invest my money in companies which pay dividends. I have made a lot of money that way, and I use dividends as a tool to measure my progress towards financial independence. Currently, I am on track to reach financial independence with dividends around 2018. We all know that dividends are more stable than capital gains. If I had to rely on total returns, and the stock market fell by 50% in 2018, I would have been in a lot of trouble. Since dividends are more stable however, I can ignore stock price fluctuations and focus on enjoying my life.

One of the fundamental questions I hear is whether companies should be paying dividends. The answer of course is that it depends on the company.

Mostly mature companies tend to pay dividends. These companies have an established niche in a market, and earn a lot of excess cashflow that they share with shareholders. Those companies have a lower risk of failure. A firm in the start-up phase will not pay dividends, because it needs all resources to grow or maintain the business. These types of companies are unproven, and therefore more speculative. We often hear about the successful companies that reinvested all profits and ended up being valued for billions of dollars. Google (GOOG) is one such example. The part for Google is that most profits are derived from online advertising. Any money allocated to other projects have not resulted in a meaningful return on investment for shareholders yet.



However, we never get to hear about the companies that reinvested all money in the business and failed, resulting in a complete wipeout for their shareholders. The sad truth is that most such companies end up failing, while only a tiny bit succeeds. An interesting example of a company that never paid any dividends is Advanced Micro Devices (AMD). There reason the company never paid any dividends is because it needed all cash merely to survive. The shareholders be damned.

Dividends impose a discipline on management, in the capital allocation process. There are constraints to growth. As a result, when management knows it has to pay a certain level of dividend income every year, they know they have to allocate their capital wisely, and only accept projects above a certain minimum rate of return. Investors in US equities have been conditioned to expect stable and growing dividend payments over time. Therefore, when management sets the dividend payment at a certain level, they are communicating that the company will be able to earn a sufficient amount of cash to pay shareholders. If a company is unable to pay a dividend, and has to cut it, this makes management look really bad. With share buybacks on the other hand, management has more flexibility to initiate with fanfare and then quietly cancel a buyback program.

One fear by investors is that earnings can be manipulated. But cash to pay a dividend cannot be made up out of thin air. Therefore, only a company with sufficient real earnings power can afford to regularly grows dividends for a long time. When a company like Coca-Cola (KO) pays you that 33 cents/share every quarter, I know that they can afford to do that, because they earn real profits. So you can see, dividends signal that the company earns sustainable profits.

Dividends are the only direct link for ordinary shareholders between a company’s performance and investor return. Dividends are set by managements. Share prices on the other hand are set by millions of investors, and they fluctuate greatly. A dollar of earnings can be quoted at any price, from 5 to 100 times earnings. Therefore, different investors will receive different amounts of money when they sell their shares. If a company like Coca-Cola (KO) paid a 33 cents/share quarterly dividend, this means that every investor of the company receives 33 cents/share every 90 days. As long as the company manages to keep selling beverages in 200 countries around the world, it will be able to keep earning money and pay a dividend to shareholders. Living off dividends is a much more sustainable way for retired investors to live off their assets, than relying on the fickle Mr Market for prices on their equities.

This is because dividends are more predictable than capital gains. For example, I am fairly confident that Coca-Cola will pay at least 33 cents/quarter for the next 12 months. The company might even increase that dividend at some point in the near future, as it has done every year for more than half a century. However, I cannot tell whether Coca-Cola shares will sell at $20 or $80 over the next 12 months. Those who think they will sell shares to fund their retirement are essentially speculating that they won't have to sell during the next long bear market. This is one reason why you have not heard about many index investors who retired in 1999 and then sold shares to live off their nest egg - they have all gone back to work when they ran out of money after the Global Financial Crisis.

One of my favorite argument to refute has to deal with the fact that Warren Buffett has never paid dividends on Berkshire Hathaway stock. He has managed to reinvest profits and buy more businesses and shares in publicly traded companies. This compounding of profits has catapulted Berkshire Hathaway's book value per share from $19.46 in 1964 to $148,133 in 2015. So if this worked so well for Berkshire Hathaway shareholders, why shouldn't all companies simply simply discontinue paying a dividend and reinvest all earnings back into the business.

The problem with this thinking is that it ignores the realities of doing business in the real world. There are constraints to growth, which impact incremental returns on investment. For example, if you want to dig a hole, it would take you a long time to accomplish the task. If you have two or three helpers, you will do the task faster. However, if you have 100 people helping out, you will likely have too many people, which will likely lead to a halt to the hole digging process.

The reality of the situation is that Buffett is an outlier. I know this because there is only one Buffett, but over 100 dividend champions.

We have previously discussed that while Buffett doesn't like paying out dividends to shareholders, he likes receiving them from subsidiaries and equity holdings he owns through Berkshire Hathaway. This is why I believe that he is a closet dividend investor, who just like you and me, likes to receive those dividends and reinvest them in his best idea of the moment.

It is extremely difficult to keep reinvesting money in your business to grow, as you enter a point of diminishing returns. If McDonald's or Wal-Mart (WMT) simply doubled the number of locations they had, they would not automatically double sales and profits. In fact, they would probably go bankrupt, as opening thousands of expensive new stores would likely cannibalize sales of existing stores. and also it would take time to find suitable locations, build the store, and then attract customers to shop there on a recurring basis. Building a store, stocking it with merchandise and employees is a costly process which would lead to losses if there aren't any customers to shop there. In fact, McDonald's almost got in trouble in 2002, because the company was simply focusing on increasing number of stores, without paying attention to same store sales for example. It is much easier to grow rapidly if you are Shake Shack (SHAK) and have 63 locations worldwide. However, if you have to invest in it at 210  times expected earnings for the year 2016, chances are that the growth is already fully priced in the stock. If something goes wrong with the expansion plan, chances are that this investment may not deliver a reasonable rate of return. If investor appetite for the stock sours, investors will lose money because of the multiple contraction.

In addition, companies cannot simply merge with competitors or buy unrelated businesses in order to grow. Integrating business systems , different products and cultures can be extremely difficult, time consuming and costly. Most acquisitions don't work and fail to deliver the synergies expected. Also, regulators do not like too much concentration in industries- case in point the acquisition of T-Mobile by AT&T a few years ago, which was blocked by the FCC.

Of course Buffett is a genius, who has managed to leverage float from his insurance operations in a way that enables him to invest borrowed money in stocks at an effectively negative margin interest rate.  Other insurance companies have tried to replicate this model, but for whatever reason only Markel (MKL) seems to be able to copy it.

Full Disclosure: Long MCD, WMT, KO, BRK/B

Relevant Articles:

Dividends versus Homemade Dividends
- Why I am a Dividend Growth Investor
- Dividend Growth Stocks - The Best Kept Secret on Wall Street
The Warren Buffett Argument Against Paying Dividends
The Most Successful Dividend Investors of all time

20 comments:

  1. Good post. Is there a link to your current portfolio balance and holdings?

    ReplyDelete
    Replies
    1. HI Hieu,

      The list of holdings is available to subscribers to my free newsletter.

      My net worth numbers should be of no importance to you.

      Best Regards,

      DGI

      Delete
  2. A timely article, DGI as I've been thinking about this lately. This idea may seem too simplistic and even naive given to my recent conversion to the DG world, but I think all companies should pay a dividend. I say this because when I invest in a company, I"m essentially loaning them money. A return on that loan, even by way of a small dividend, would add a level of accountability to investors. Yes, new companies need all the case they can get when starting out. At the same time, they have taken on loans that have to repaid. An investor buying shares of a company is the same thing.

    ReplyDelete
    Replies
    1. As an investor, I like the discipline that a dividend imposes on management. I also see a dividend as a signal that the company is stable and mature, so it can provide me with income. Then I have to do the digging to see if that is truly the case or not.

      I also like the fact that my returns are diversified between dividends and capital gains. I do not want to have my success dependent entirely on stock price gains - noone can predict stock prices. Dividends are easier to predict

      Delete
    2. Stan,
      I think of corporate bonds as loans to companies. When I buy shares on in company, I see myself as buying a small piece of it. The dividends, in my view, are just my share of the excess profits.

      Delete
  3. DGI, I expected this to be your shortest article ever. "Of course."

    I'm somewhat surprised to see you own BRK.B. Doesn't the lack of dividends violate your investment philosophy? Recently, I started selling off stocks that don't pay a dividend including PNRA, CELG, and GOOGL. The only exception is that I kept 5 shares of CMG that I bought to get my youngest daughter interested in investing (it's her favorite restaurant and we are in at less than $300 per share).
    All the best,
    Keith

    ReplyDelete
    Replies
    1. Hi Keith, I own 1 share of BRK/B. I think I talked about it last year when I wrote this article:

      http://www.dividendgrowthinvestor.com/2014/02/warren-buffett-is-now-working-for-me.html

      I also own 1 share of Buffalo Wild Wings... Google is the company I understood well, but never bought because I already earn advertising revenue through them.. So I thought it would be too much risk concentration. Plus, I doubt they will pay a dividend - they are focusing on far flung projects that may not have commercial viability. Lucky for them, they have online advertising, which will grow for a while.

      I like to own 1 share of a bunch of companies, since that allows me to monitor them easily. For example, I bought one share on UNH recently to monitor it.

      Best Regards,

      DGI

      Delete
  4. DGI - thank you for the great article. I find that it was well written and descriptive of the approach to market growth vs. dividend investing. Thank you for taking the time to write it up!

    ReplyDelete
  5. MKL is a great company. I have done well with my position there. BRK is overpriced, IMO.

    ReplyDelete
    Replies
    1. I was very close to breaking my rules and buying MKL in 2013, after reading their annual report. The management probably has a good 10 - 15 years left to do their magic ( until they get to Buffett/Munger age)

      Delete
  6. I just finished reading "The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success" by William N. Thorndike. One main characteristic of these outsiders, who achieved outsized returns, shared with each other is that none of them believed in paying dividends. Not to diminish dividend investing, but this is an interesting read for those who want to look beyond dividend investing groupthink. Warren Buffett is one of the CEOs featured in the book.

    ReplyDelete
    Replies
    1. Hey, if you can identify and share with me who the "next" Outsiders are going to be, that would be awesome.

      Problem is, the book might have been based on survivorship bias, since those outsiders are tough to spot in advance. And many others who followed the exact same formulas ended up not doing very well. Remember when Eddie Lampert and SHLD were supposed to be the next Buffett and Berkshire?

      Check those articles: http://y0ungmoney.blogspot.com/2014/08/great-capital-allocators-who-ultimately.html

      http://y0ungmoney.blogspot.com/2014/05/book-review-outsiders-by-william.html

      Best Regards,

      DGI

      Delete
    2. Good point about identifying the next one.

      Delete
  7. Sir when you achieve financial independence will you still write these wonderful articles for us (your regular readers?)

    ReplyDelete
  8. Great article as always! What are your views on dividend income through dollar cost averaging on SPY? You get market performance and consistent dividends with relatively low risk to principal

    ReplyDelete
  9. Nice post, DGI. Dividend companies do have a number of benefits for the investor which--for those already converted--are certainly hard to argue against.

    The Buffett argument against it is very common. However, as you point out, he does himself rely very heavily on dividend companies and for good reason. There is a certain irony that he, in fact, does not pay any. I wonder whether post-Buffett Berkshire will change tack in this regard. I suspect it will, but I am sure there are plenty of people who would disagree.

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  10. DGI,

    Thank you so much for the content you put out everyweek. I have your blog bookmarked and try and learn as much as possible. I am very young and follow a similar goal of being able to live off dividends in the near future. I am trying to figure out ways to accelerate the process of generating more capital to buy stocks. I wanted to see if u can maybe write an article on leverage investing at a young age. My strategy would more or less focus on leveraging with cautious until a certain point than begin deleveraging after a certain positive cashflow can be avhieved.

    Thanks.

    ReplyDelete
  11. Great post DGI!

    I have been a regular reader of your posts for quite some time. I always try to measure porfolio by the stream of dividend income, I try not to look at networth fluctations. Dividend cash flow is the king maker. Thanks for the inspiration!

    Take care

    Dividend Freedom

    ReplyDelete
  12. Great Article! I think Buffets' methods are great, but getting paid at in dividends is the whole reason why we bother "risking" our money buy stocks.

    ReplyDelete

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