When Dividends Are Dumb

• Email
• Share
• Print

Most of us in the financial press treat the desirability of dividends as self-evident -- just like life, liberty, and the pursuit of higher returns.

Now, don't get me wrong -- I love dividends, and I've taken the time in the past to distinguish those that I consider safe from those that I consider not so safe.

But, believe it or not, sometimes companies that pay dividends are doing you, the investor, a disservice.

No dividends, no problem
When a company pays a dividend, it's essentially saying, "Here's some of your money back. We have no better use for it."

You see, a company can do three things with its earnings (or cash flow, if you want to get technical):

• Reinvest in the company
• Buy back shares (or debt)
• Pay a dividend

The opportunity to reinvest is why growth companies rarely pay dividends. When a company is planning projects on which it expects high returns, it would be counterproductive to give back some of its capital.

This is why some very large, fairly established companies -- like new-economy powerhouses Amazon.com (Nasdaq: AMZN), Google (Nasdaq: GOOG), and Apple (Nasdaq: AAPL) -- don't pay dividends. Meanwhile, when Microsoft (Nasdaq: MSFT) started paying a dividend earlier this decade, it signaled the end of its high-growth phase.

But even companies that are out of the high-growth phase can do a disservice to shareholders by paying a dividend.

When dividends are dumb
Look at Warren Buffett's Berkshire Hathaway (NYSE: BRK-A). Buffett famously refuses to pay a dividend because, as my colleagues Brian Richards and Tim Hanson have explained, he can invest the capital better than you can. In such a case, paying dividends to shareholders would actually destroy value.

More recently, we had big banks paying hefty dividends despite taking government bailout money. Before the TARP bailout last October, banks arguably had to maintain the tricky game of depleting their capital by paying dividends or, ironically, risk experiencing the next bank run due to lack of capital.

But with the post-TARP government "too big to fail" stamp, banks could slash their dividends and claim fiscal responsibility instead of impending death. Yet, instead of taking the opportunity to immediately slash dividends, big banks like JPMorgan (NYSE: JPM) and Wells Fargo (NYSE: WFC) continued their normal dividends into the next year. When they finally got smart and slashed dividends to a nominal level, their share prices actually rose.  

When companies that need capital (for growth or safety) pay out dividends, it's a dumb move. Raising capital through stock or bond offerings usually costs them much more than they would have paid by repurposing their dividend money -- which both JPMorgan and Wells Fargo learned the hard way over the last year.

When dividends are smart
So why do I love dividends? I've shown you some strong exceptions, but I love dividends because they're a great tool for reining in management.

If you've ever been part of a company's budgeting process (I have), you know that managers will generally use all the resources they're allocated. When there are real opportunities for the company, paying a dividend takes away management's ability to execute.

But when opportunities are scarce, you often get movement for movement's sake: Acquisitions to "diversify" the business; share buybacks at all-time highs; a new, ill-conceived product; excessive management perks. A properly formulated dividend takes away that excess capital and enhances efficiency.

That's why a company saying, "Here's some of your money back. We have no better use for it," is not necessarily a sign of management weakness. In fact, more often than not, it's a sign of management strength.

What to look for
So when you're on the prowl for a dividend play, don't just trust a big dividend yield and a smile. The same rules apply to dividend payers and non-dividend payers alike: We're looking for companies that make the best use of their capital. Sometimes that means reinvesting in the company. Sometimes that means buying shares back when the market is mispricing the company's stock. And, yes, often it means paying a nice, fat, sustainable dividend.

If you're looking for those nice, fat, sustainable dividends, you've got company. Our Motley Fool Income Investor newsletter service is, too, and our analysts focus on companies that are paying dividends for the right reasons. In the universe of dividend-paying stocks, only six have made their cut as "buy first" stocks. To see them all, click here for a free 30 days.

Already a member of Income Investor? Log in at the top of this page.

Anand Chokkavelu owns shares of Berkshire Hathaway and Microsoft. He loves to quote Clark Gable: "It is an extra dividend when you like the girl you've fallen in love with." Google is a Motley Fool Rule Breakers recommendation. Apple, Amazon.com, and Berkshire Hathaway are Stock Advisor selections. Berkshire Hathaway and Microsoft are Motley Fool Inside Value picks. The Fool owns shares of Berkshire Hathaway. The Fool has a disclosure policy.