Dividends Are Dumb

Question everything.

It's a good motto if you ever find yourself in a government-conspiracy movie. And it'll also serve you well any time money's involved.

The folks who question seemingly self-evident principles can make an absolute killing.

  • Ask the Super Bowl bettors who took the so-called suckers' bet of the Giants over an 18-0 Patriots team.
  • Ask hedge fund manager John Paulson, who made more than $10 million a day in 2007 ($3.7 billion total) because he figured out housing prices could actually fall.  
  • Or ask some guy named Craig who questioned the virtual monopoly that newspapers had on classifieds (yes, that's a Craigslist reference).

So when I heard the argument recently that dividends are actually a bad thing, I was willing to listen.

In fact, it's a more compelling argument than you may think.

These dividends are just dumb
Why do we invest money in a company? Ultimately, it's because we think that company can grow our money by using that money to invest in its growth.

When a company turns around and gives us that money right back (creating a taxable event in the process), it defeats the purpose. If we want out, we can simply sell our shares. And do so on our own timetables.

Hence, anti-dividend people maintain that even the modest dividends that companies like Visa (NYSE: V  ) , Activision Blizzard (Nasdaq: ATVI  ) , and Best Buy (NYSE: BBY  ) pay out are just plain dumb.

But hear them out. The case against dividends gets stronger, given the reason folks buy dividend stocks in the first place.

Frequently, investors who buy shares of companies that pay large dividends are seeking safety and stability. Why? Because a company that commits to a regular dividend payment is signaling exactly that -- safety and stability.

So it's ironic that a dividend can act like debt -- an obligation that makes the bad times worse. Although paying dividends is optional (while missing debt payments leads to bankruptcy), a company that chooses to cut its dividend signals weakness, often leading to a further weakening of its stock price. That's a double whammy no investor wants to face.

Yet I still heart dividends
So why am I still bullish on dividend payers?

I'll leave aside the empirical evidence that dividend payers have handily outperformed non-payers historically. Instead, let's look at a company's life cycle.

Early in a company's history, it feeds on cash like a baby sucks down formula. Investors don't care, though, because the company needs that capital to fuel its growth. Soon enough, that company either fails or becomes bigger and stronger.

At some point, it starts producing more cash than it's consuming. It can then build a war chest to ensure its survival through good times and bad.

But then what? If there aren't any compelling internal opportunities, a company has four choices:

  • Sit on the cash.
  • Buy back shares.
  • Make acquisitions.
  • Pay dividends.

When you look at all four options carefully, dividends make a heck of a lot of sense.

Dividends stand alone
Sitting on cash is safe, but it's a drag on a company's return on capital -- especially when interest rates are hugging 0%. Apple's chosen this path, hoarding nearly $40 billion. But few companies have the amazing innovation-driven growth that can hide this drag.

Buying back shares is almost like a dividend with no tax consequences. In fact, if a company can buy back its stock at low points, it can really juice returns to current shareholders. Unfortunately, most managements don't do a good job of timing. Even Goldman Sachs, the reputed master of the markets, made massive repurchases of its stock throughout the heady bubble years only to have to sell new stock to raise cash when its stock price was hammered.

Other financial pros including JPMorgan Chase (NYSE: JPM  ) , Wells Fargo (NYSE: WFC  ) , and Bank of America (NYSE: BAC  ) didn't do any better timing the market. Classic "buy high, sell low" behavior.

Acquisitions are the scariest of all. You see, management is often judged on its ability to grow the business, specifically earnings per share. That's why it'll buy back shares at inopportune times. And that's why it'll pursue ill-advised acquisitions and poorly conceived internal projects with such gusto. This growth at an unreasonable price helps management but hurts shareholders.  

Which leads to the reason I love dividends. The issuance of a regular dividend instills management discipline by removing some capital from consideration. You can't waste what you can't touch.

Meanwhile, as shareholders, we get a nice income stream ... the classic stock play that yields like a bond.

With 10-year Treasury bonds currently yielding just 3.87%, dividend stocks are that much more attractive. Because of this, let me share three dividend plays that the dividend hounds at our Motley Fool Income Investor newsletter have identified and recommended.

Company

Description

Dividend Yield

Paychex

America's largest payroll processor for small and medium-sized businesses.

4.0%

Clorox

Maker of Clorox bleach, Glad trash bags, Kingsford charcoal, and Pine-Sol.

3.1%

Philippine Long Distance Telephone (NYSE: PHI  )

The Philippines' leading fixed and mobile telecom provider.

5.1%

One of the companies above is a "buy first" recommendation -- and only six companies get that nod from the Income Investor analysts. If you'd like to find out the names of all six and gain access to all their recommendations and research, access is yours free for 30 days. Click here to start. There's no obligation to subscribe.

This article was originally published Feb. 26, 2010. It has been updated.

Anand Chokkavelu owns shares of none of the companies mentioned here. Best Buy and Paychex are Motley Fool Inside Value recommendations. Apple, Activision Blizzard, and Best Buy are Stock Advisor picks. Clorox, Paychex, and Philippine Long Distance Telephone are Income Investor picks. Motley Fool Options has recommended a synthetic long position on Activision Blizzard. The Fool owns shares of Activision Blizzard and Best Buy. The Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 01, 2010, at 4:15 PM, rsenn wrote:

    No, dividends are good. Every company eventually dies. If it never pays a dividend the shareholder effectively gets nothing for his shares.

    Imagine the Great British Wool Sock Company, founded in the year 1000. An enteprising shepard invests 1 pound for 1 share. Over the years the company does well, expanding from wool socks, to uniforms, and sails for the British navy, and so on. The stock price soars and becomes worth 1,000,000 pounds. The shepard (or his heirs) hang on to the share, but never does the company pay a dividend.

    Eventually the company suffers reversal and in the year 2000 goes out of business, having never paid a dividend.

    What did the shepard and his heirs get? Nothing. In fact, they lost a pound (or more if you consider alternative investments).

    Dividends are essential.

  • Report this Comment On April 05, 2010, at 3:37 PM, jrod87 wrote:

    Like the way you put it. My top to picks are ATVI and NLY I had invested in ATVI before the Dividend, this is my reward for being a loyal investor. Growth and Collapse happen but you’re able to hedge your bet with a dividend that can be placed (in my mind) 2 places. A.) Reroll it back into the stock and let it compound. B.) Put it into a tax-exempt whatever and let it compound. Key here is there are more ways to gain the growth you desire With Dividends compared to No dividends.

  • Report this Comment On April 07, 2010, at 5:46 AM, seagull2912 wrote:

    Being a fool's which speaks the true to the kings ( your readers) you should and must mention about biggest problem most dividend paying company have is that they cut those dividends unexpectedly most of the time as well as expectantly resent time.

    On the positive side (you have not mention this either) the dividend ply a a major roll/factor for growth of S & P 500 I don't remember exact number but it something about 40% !!!

    Nevertheless the criteria to sort those company out has been established and it is the most important factor for your readers :

    The S&P 500® Dividend Aristocrats index measures the performance of large cap, blue chip companies within the S&P 500 that have followed a policy of increasing dividends every year for at least 25 consecutive years.

    http://www.standardandpoors.com/indices/sp-500-dividend-aris...

    So you are not as fool as you are trying to say you are.....

  • Report this Comment On April 15, 2010, at 11:06 AM, AppleAnnie100 wrote:

    Your brief assessment of the four options companies have for using spare cash justly points to the perils of options 2 and 3 and the positives of option 4. Here is an addition to option 4. Other than dividends, the way we profit on our investment in a company is by selling our shares for a higher price than we paid for them. The notion of an ever-rising share price flies in the face of reason, but the equation of "shareholder value" with today's share price - an assumption that has the status of received truth - seems to me chiefly responsible for the overwhelming focus on short term results - and that in turn prompts all but the most steel-nerved CEOs to countenance ever-increasingly innovative accounting manipulations to show those results. It seems to me that a periodic healthy dividend is another important metric for shareholder value.

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