Jun 212011
 

Dividends have been said to be the only free lunch in investing. For many investors, getting their quarterly dividend cheques is almost the best part of investing in a stock. These type of investors tend to be long term buy and hold types, rarely selling their positions. Some of them even have blogs, touting the glorious dividend every opportunity they get. I imagine these people would be boring dinner party guests.

I make fun of dividend lovers, but I’m basically one myself. I enjoy getting a dividend off my investments. As Benj Gallander says, dividends allow me to be stupider, longer. As a contrarian investor, I can often hold investments for years while I wait for the fundamentals of the business to turn around. Getting paid to wait is a nice bonus while killing time for that catalyst that’s needed to increase the share price.

Even though I like dividends, they aren’t a mandatory thing for me. I’m happy to hold a company that doesn’t pay a dividend. I’m usually investing in beaten up names, companies that may not be terrifically profitable for whatever reason. I’m much more interested in the condition of the balance sheet than the condition of the dividend. I’ve invested in companies that have recently cut their dividends. What I care about is whether the company’s balance sheet is strong enough to whether the hardship that any contrarian investment is going through.

Saying that, I understand that most investors don’t invest like me. For dividend investors, they like the stability of putting their money in stable companies that have been around for a long time. These companies have predictable earnings and dividends. A lot of time though, even mature companies have better things to do with their money than to pay out dividends. Let’s look at a few.

Pay Down Debt

When I’m screening names to put on my watchlist, I’ll often come up with a couple hundred that pass all the criteria. Out of these couple hundred, 10 or 15 names may make the list. Companies will get eliminated from consideration for all sorts of reasons, but one reason stands out from the others: debt.

A company will often pay a dividend for years as it begins a slow demise. General Motors did. So have all sorts of others I can’t think of right now. This dividend money could be much better spent on paying down debt, yet it’s given out to shareholders. Even though the dividend might not be in the best long term interest of the company, management knows that the share price will get hammered if the dividend gets cut.

Usually a company will eventually cut the dividend. By that time though, the market has clearly priced in a dividend cut. The bottom line is a company with lots of debt shouldn’t be paying a dividend. They should be using that money to improve the balance sheet.

Better Opportunities

In many situations, it’s better for a company to reinvest any money they would have paid out in a dividend back into the business.

If a company pays a 3% dividend, investors like it. But if a company doesn’t pay the dividend, they can reinvest that back in the business. If the business can generate a return on equity of say 10%, then the company can grow the earnings over time simply by reinvesting the dividend.

That 3% dividend might represent 25 or 50 percent of total earnings. This reinvestment can create a significant compounding effect quite quickly.

As a bit of an aside, one area I generally don’t like companies spending money on is acquisitions. Some work out quite well. Others fail miserably. This crapshoot is one reason I don’t really like companies to do them. The other is companies are usually pretty bad at buying underpriced assets. They’ll pay fair price and then some for a competitor that often does things very differently, meaning the synergies are weak at best.

I Don’t Hate Dividends

Dividend lovers sometimes forget that all of a company’s earnings belong to the shareholders, whether those earnings are paid out in the form of dividends or whether they stay with the company in the form of retained earnings. Each of these has value. The value of each depends on all sorts of factors, from the investor’s point of view or the company’s point of view. My Dad should view dividends more positively than I should, since his portfolio should be more conservative, as an example.

I like getting dividends just as much as the next guy. If a company is mature, has minimal debt, and doesn’t see any glaring opportunities to spend all of their capital, then by all means they should pay a dividend. There are many companies out there that should be much more aggressive in paying out dividends, like major tech players. Others though, like Yellow Pages, really have no business paying out such aggressive dividends.

And just maybe, some of those dividend investors will buy something that doesn’t have a dividend.

 

Tell everyone, yo!

  One Response to “Should Investors Care About Dividends?”

  1. Some good points. Some people get way to caught up in dividends and think of them value created out of thin air. That being said, I like how dividends from a strong company can help provide some returns when general market pessimism is holding back the stock in spite of strong earnings. 

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