Why Dividends Are a Bummer

Am I a hypocrite?

On multiple occasions, I've highlighted exactly why I think investing in dividend-paying stocks is a great idea. I've also admonished companies that I think are cheating their investors by not paying dividends.

And now I'm saying that dividends are a bummer? Well, they are, and let me tell you why.

When a company pays a dividend, it's basically waving the white flag and saying that it doesn't have good opportunities to reinvest its earnings. And that's a bummer. If high-quality, blue-chip companies were able to continually reinvest their earnings at high rates, investors would be in line for some very impressive gains.

Check out what would happen if these companies could keep investing their earnings at the rates they currently earn:

Company

LTM Net Income

LTM Return on Beginning Equity

Theoretical Net Income in 5 Years

Microsoft (Nasdaq: MSFT  )

$16.3 billion

47.2%

$97.9 billion

Apple (Nasdaq: AAPL  )

$9.4 billion

40.8%

$57.5 billion

Coca-Cola (NYSE: KO  )

$6.8 billion

33.3%

$26.1 billion

Google (Nasdaq: GOOG  )

$6.5 billion

23.1%

$19.1 billion

Abbott Laboratories (NYSE: ABT  )

$5.7 billion

32.9%

$23.4 billion

Source: Capital IQ, a Standard & Poor's company and author calculations.

Theoretical net income in five years assumes all net income is reinvested at the same return rate as the LTM return on beginning equity.

To put some context to those numbers, we're saying that in five years, Apple will be making nearly three times what ExxonMobil netted over the past year and Microsoft's net income will equal to the current market value of Amazon.com and Nike -- combined. For shareholders of the companies listed above, the amazing growth listed above would almost surely mean incredible stock returns.

But that's listed as theoretical growth for a reason. None of these companies actually reinvest all of the money that they earn because they simply don't have enough high-return opportunities.

The next best solution
Boohoo, we don't live in fantasyland where big companies can forever reinvest their earnings at sky-high rates. So what do we do? One option is to eschew these hulking corporations altogether and focus on smaller companies that may still have enough growth opportunities to reinvest all of their earnings at high rates.

Another is to look for the companies that face facts and make the shareholder-friendly choice of using dividends to distribute earnings that they can't reinvest. Yes, dividends are a worse choice than reinvesting at high rates, but they're very often the best choice when those high-rate reinvestment opportunities start to dry up.

Why? Here's why.

1. Savings accounts are a bummer. Think dividends are a bummer? Well, stashing shareholder cash in a savings account can be a much bigger bummer. As I've pointed out in the past, Apple, which stashes cash instead of paying a dividend, earned a pitiful 1.4% on its cash balance in 2009. Had that cash been distributed to investors, I'm pretty sure that most of them would have been able to find a much better home for it.

2. Keeping management honest. When I was younger, I had a tough time keeping loose cash around. Inevitably I'd get that "burning a hole in my pocket" feeling, and voila!, my cash was spent on some random piece of junk. Many CEOs seem to have that exact same problem. Give them a balance sheet flush with cash and suddenly they feel like it's important to make business investments with questionable returns or go after "transformative" acquisitions. When a company pays out some of its cash in dividends, it cuts down on the cash that management has to work with and forces them to focus on the highest-return opportunities.

3. A bird in the hand. And of course there's always the time cost of money. If that dollar of yours (and as a shareholder it is your dollar) is just going to sit around gathering dust for the next three years, the company might as well pay it out. Unless there's a good reinvestment opportunity, a dollar today is worth more than a dollar tomorrow.

Not second-rate returns
While the idea that the companies in the chart above could continuously reinvest their earnings and become colossal beacons of capitalist splendor is theoretical, the idea that investors can score big by investing in companies that have resigned themselves to paying dividends is not.

In fact, stock guru Jeremy Siegel has identified cigarette-maker Altria (NYSE: MO  ) as the best performing stock over the past 50 years. And, yes, that's the same Altria that grows at a snail's pace, reinvests very little in its business, and has recently been paying out more than 80% of its earnings in dividends.

What's also not theoretical is the fact that the team at Motley Fool Income Investor has managed to best the returns of the S&P 500 since its inception almost seven years ago. By focusing on finding high-quality companies with strong dividend payouts, the team has scored big with stocks like Petrobras (NYSE: PBR  ) . Specifically, in Petrobras, the team saw a company with a huge competitive advantage in deep water drilling, plentiful reserves, and a stronghold on the Brazilian market -- all factors that make Petrobras a very reliable dividend payer.

If you'd like to check out what the team is recommending you buy today, you see their top stock picks with a free 30-day trial.

Fool contributor Matt Koppenheffer owns shares of Coca-Cola, but does not own shares of any of the other companies mentioned. Coca-Cola and Microsoft are Motley Fool Inside Value picks. Google is a Motley Fool Rule Breakers choice. Apple and Amazon.com are Motley Fool Stock Advisor selections. Coca-Cola and Petrobras are Motley Fool Income Investor selections. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.


Read/Post Comments (9) | Recommend This Article (23)

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 10, 2010, at 8:49 AM, EquityBull wrote:

    Good article.

    What are your thoughts on dividends next year if they are going to be taxed at ordinary income rates? For high net worth individuals they could pay 55% of the dividend payout received to the taxman.

    Maybe with the new tax laws they should buyback shares to limit the tax exposure to shareholders? Berkshire Hathaway has never done a buyback or paid a dividend and has no plans on doing either. Of course buffett always finds a way to deploy capital to earn higher rates of return on it.

    If Apple paid out a dividend on that cash hoard next year investors would get slammed on the taxes unless held in an IRA or tax sheltered vehicle.

    The dividend story grows muddier next year for investors with the impending tax changes.

  • Report this Comment On April 10, 2010, at 8:50 AM, EquityBull wrote:

    Good article.

    What are your thoughts on dividends next year if they are going to be taxed at ordinary income rates? For high net worth individuals they could pay 55% of the dividend payout received to the taxman.

    Maybe with the new tax laws they should buyback shares to limit the tax exposure to shareholders? Berkshire Hathaway has never done a buyback or paid a dividend and has no plans on doing either. Of course buffett always finds a way to deploy capital to earn higher rates of return on it.

    If Apple paid out a dividend on that cash hoard next year investors would get slammed on the taxes unless held in an IRA or tax sheltered vehicle.

    The dividend story grows muddier next year for investors with the impending tax changes.

  • Report this Comment On April 11, 2010, at 1:35 PM, ockhamsrazor wrote:

    talk about shooting the messenger.

    it is a *fact* that companies can't reinvest earnings ad infinitum at their peak ROE. it's so obvious a fact that i sound like a dullard for pointing it out. issuing a dividend doesn't cause this effect, and neither does a dividend make it "more true".

    a "real" distribution is management of a good company acknowledging reality, and responding in a rational, shareholder-friendly way. a distribution is a "real" one, if it is paid for from operating cash flow and not financing activity. as the previous commenter pointed out, the relative merits of buybacks vs dividends are always worth considering. buybacks are sometimes excellent and sometimes "meh", but a dividend is always a good thing.

    here i do not really mean "dividends" as exclusive of buybacks.

  • Report this Comment On April 11, 2010, at 1:36 PM, ockhamsrazor wrote:

    er, ignore that last line. reworked the post and didn't edit that part out.

  • Report this Comment On April 11, 2010, at 7:19 PM, TLassen wrote:

    "When a company pays a dividend, it's basically waving the white flag and saying that it doesn't have good opportunities to reinvest its earnings. And that's a bummer. If high-quality, blue-chip companies were able to continually reinvest their earnings at high rates, investors would be in line for some very impressive gains"

    To paraphrase Simon Cowell, this statement above and most of the rest of the article is complete and utter nonsense.

  • Report this Comment On April 12, 2010, at 2:59 PM, TMFKopp wrote:

    @EquityBull

    Good question.

    First of all, I'm not sure where you're coming up with that 55% figure. As far as I've seen the maximum the highest earners would pay next year is 43.4% (39.6% tax bracket + 3.8% from the new healthcare bill). And of course that's only those making over $384,000.

    However, that's only the outcome if Congress doesn't jump on the issue and the Bush cuts on dividends are simply allowed to expire. What seems likely is that they will push up rates to 20% for the highest earners (but still + the extra bit from healthcare) and keep it at 15% for everyone else. But with the government these days, who knows.

    Certainly the best way to deal with the situation is to make as much use as possible of tax advantaged accounts. Then (in most cases) it doesn't much matter what dividend tax rates are.

    As far as substituting buybacks for dividends to avoid tax consequences... I'm not all that much of a fan of buybacks. They can definitely be done well and give shareholders a much lager benefit than a dividend of a similar size. However, all too often they aren't done well. Just think about the number of companies doing massive buybacks in 2007 versus the lonely few that were buying back shares in early 2009. In fact, there may have been more companies issuing shares at the lows in 2009 than there were buying back shares.

    Matt

  • Report this Comment On April 12, 2010, at 3:27 PM, mobil4 wrote:

    Could have been a good article,had he mentioned more of the small cap stocks. For example, sun industries, plum creek, ainv,ftr,line (linn) and I could go on and on.

    Regards

    Mobil 4

  • Report this Comment On April 12, 2010, at 7:29 PM, busterbuddy wrote:

    This whole idea of investing for Growth etc is great but you have to sell and buy at the correct time. And the last years have shown that is not easy to do.

    But investing in good paying dividend stocks is a much better way to invest. You is the true picture of the company by its dividend pay out. And if you reinvest those dividends you grow your value.

    Even the Great Hedge fund managers and pension plans have solid dividend stocks as their core investment strategy.

    Buy backs. What a stupid strategy. Boeing was buying back stock at over $85 a share because some one as the CEO why he wasn't doing it during one quarterly report. But Boeing wasn't buying back at $32 a share. Because it had cash issues.

    All through the last ten years mergers and buyouts showed quarterly growth returns and speculation of ROE just magically showed up. And everyone ran to buy. What another Stupid idea!

    So be stupid or be solid in an invest in companies that pay out a good dividend. Cash is always king be in interest or dividends. Everything else is just smoke and mirrors of a balance sheet that FASB has allowed to lie, cheat and steal. Every looked at Berkshire hathaway's stock holding??? Da, don't look like alot of Growth stuff there. Looks like alot of Cash flow companies.

  • Report this Comment On April 17, 2010, at 8:35 PM, truman1987 wrote:

    Dividends are ok. What is really bad is repurchasing company stock. That means that of all the investments, the Board decided that their own stock was the best place to put their money. Arrogance or laziness?

    Run an analysis, it wouldn't surprise me to see companies that buy their own stock back underperforming the market over the next few years. Could be a sell signal.

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