Today, in a final post in a long series, I show you how to put what you have learned about dividends into inaction 😛
But, to wrap up this important series, first it might be nice to go “all the way way to the beginning” with some history on dividends, courtesy of our friends over at Everything Warren Buffett:
During the first half of the 20th century, dividend income made up all of the 5.3 percent return U.S. stocks delivered to investors, data compiled by the London Business School show.
At the time, companies paid out most of their earnings to shareholders, compelled by a Treasury Department rule that established penalties for “improper accumulation” of income, according to the sixth edition of Benjamin Graham and David L. Dodd’s “Security Analysis.” The book laid out the principles of value investing followed by billionaire Warren Buffett, the chief executive officer of Berkshire Hathaway Inc. and the world’s most successful investor.
“The prime purpose of a business corporation is to pay dividends to its owners,” Graham and Dodd wrote.
Between 1980 and 2000, investors increasingly sought price gains as dividends contributed 25 percent of returns. The shift occurred as companies such as Cisco Systems Inc. and WorldCom Inc. increased profits by using excess cash for expansion and acquisitions. In the five-year bull market that ended in 2007, cash to shareholders as a percentage of earnings fell to a record low of 31 percent, based on data compiled by Yale University professor Robert Shiller, as profit growth juiced by borrowed money outstripped dividend increases.
Returning money to shareholders prevents managers from wasting it on investments that may not prove profitable, according to Bahl & Gaynor’s McCormick.
“It forces companies from empire building, stupid acquisitions and nefarious activities,” he said. “You can’t fake the cash.”
The last sentence pretty much summarizes the pro-dividend position: it stops companies from making mistakes with their cash …
… but, my perspective on that is simple: who is better placed to invest my cash? Me (Mr Ordinary Investor) or, say, Warren Buffett (Mr World’s Richest Man)?
In fact, at the 2000 Berkshire Hathaway Annual General Meeting, Warren Buffett was asked about the dividend policy at Berkshire, to which he said:
We will either pay large dividends or none at all if we can’t obtain more money through re-investment (of those funds). There is no logic to regularly paying out 10% or 20% of earnings as dividends every year.
Given my somewhat ambivalent stance on dividends – I can take ’em or leave ’em 🙂 – it was interesting to see this recent and nicely coincidental article in Motley Fool:
… it’s important not to focus on a dividend yield alone, as recent happenings in the stocks below make clear:
Problem With Dividend
General Electric Either must cut dividend or lose AAA rating, according to analysts. Gramercy Capital Company forwent its fourth quarter dividend. Education Realty Trust of Memphis Cut its dividend in half.
Even in a bear market, growing companies that pay dividends can be too good to be true — so be sure to do your research.
You see, the decision to pay dividends is a somewhat arbitrary decision of the board of directors … only loosely tied to the actual profit (better yet, cash flow) performance of the underlying business.
Profits are related to the internal performance of the business.
Dividends are related to the external relationship of the company’s management (as represented by it’s board of directors) to its owners (i.e. its shareholders).
So, when you invest in stocks, you should simply remember that you are buying a small share of a big business: and like any other investment, you should make sure that it makes a decent – and, steadily increasing – profit (called ‘earnings’) and produces strong – and, increasing – cashflows that management uses wisely.
This means that you will EVENTUALLY get your money back in some combination of two ways:
1. The share price will eventually rise to reflect increases in profits and/or
2. The board of directors may choose to distribute some of the profits as dividends.
So here are your Buy For Income INVESTING strategies if you do decide to choose stocks as an investment vehicle:
You will probably be investing in a low-cost Index Fund and holding until you reach your Number; the fund will usually collect any dividends and reinvest them automatically for you. All you will see is a long-term increase in the total value of the fund (appreciation + reinvested dividends) … frankly, this is all you really care about right now.
If the urge to invest in individual stocks strikes, you will probably purchase 4 or 5 undervalued stocks (i.e. where the current price does not fully reflect the current and/or future earnings of the company … notice, I haven’t mentioned dividends here) and hold them. You will probably reinvest the dividends into buying more of the same stocks as they probably still represent excellent value. You will keep doing this until you reach your Number (or decide to cash out for a ‘better investment’).
You will talk to your accountant about the tax advantages of withdrawing any dividends v reinvesting v selling a small portion of your portfolio every year to live off … other than that, you won’t care if you make your yearly ‘retirement’ income by selling stock, withdrawing some/all of the dividends, or any combination of the two.
Think of it this way:
Dividends are what you MAY get if you speculate on some stock (i.e. a piece of paper) …
… Profits are what you WILL get if you invest in a solid business.
If you invest well, eventually the stock price PLUS the dividend (it’s not terribly relevant in what proportion) WILL rise to meet the steadily increasing profits … Warren Buffett has averaged a 21%+ annual return by this simple assumption.
Suffice it to say that I have NEVER (yet) bought a stock for (or despite) its dividend … how about you?
Adrian – Another timely and relevant post as always.
In reading Buffettology, I’m coming to the conclusion that when you search for excellent businesses, NOT paying a dividend might very well be one of the criteria you SHOULD look for.
The reason being that the company could use the retained earnings to grow (i.e. earn more in the future which will increase the company’s value) and that you forgo the ensuing tax bill that would come from the dividend payout (assuming you’re investing in a non-tax advantaged account).
What do you think?
I agree it ideally shouldn’t be a big difference if profits come from dividends or share appreciation. However, I can think of a few good reasons that you may want the flexibility of dividends:
#1 The market doesn’t always seem to realize the value of good companies. Wouldn’t it make sense at the 301 stage to have dividends to give you the option to not have to sell at prices you believe are too low?
#2 Buying and Selling shares has a transaction cost. If I want to add a new investment and there are no dividends then I have to sell shares and pay transaction costs in order to have the cash to buy something else.
#3 Increasing share prices instead of paying dividends can lose some of the profits to management as they typically have large numbers of stock options.
Jeff, I wouldn’t immediately rule out all dividend paying stocks- consider See’s Candies. This is one of the companies Buffet loves BTW- it doesn’t really have growth potential, so investing more in it’s business isn’t likely to be a great investment. However, it is a wonderful cash cow- and Warren has used that cash to invest in other businesses. If you can find such a gem and they distribute profits as dividends why shouldn’t you invest in them?
@ Jeff – I agree; if you were to invest in a dividend-paying company (and why not? If it’s a GREAT company that happens to pay dividends?) you would want to take a MACRO view and ensure that they aren’t sacrificing future profits just to appease current shareholders with some ‘dividend cotton candy’.
@ Rick – Thanks for your comments; I agree with your #1, but I think you can do even better:
IF you can reuse dividends to make other great investments, then more power to you … it’s a GREAT strategy, as this two part series from Phil Town demonstrates:
It may be true that a company is capable of investing in its main line of business, but there is nothing to show that managers are competent to invest in other companies or other lines of businesses. There is evidence that buying markets rather than growing them costs more. Many managers make mistakes about buying businesses, they pay too much, can’t merge the operations, etc. Berkshire is not a good example, because it is a holding company which is designed to invest in other companies.
Just because you’re buying a company for dividends doesn’t mean that you can’t research it just as well as someone buying for future share growth.
@ Bob – Thanks; you are right … I have seen many companies buy, but not integrate well.