Why Big Dividends Are Bad News

Amid the generally gloomy mood in the financial markets, many dividend investors have never been happier. With many companies boosting their dividend payouts in recent months, shareholders have reason to celebrate. But higher dividend payments could actually be a bad sign for the overall economy.

New dividend payers
Most investors see dividend stocks as conservative, slow-growth stalwarts, and with good reason. Southern Company (NYSE: SO  ) , for instance, pays investors handsomely, but its future profit potential is largely limited by regulators. Regulation can also cover major capital investments, so utilities don't necessarily have the freedom to plow profits back into its business, even if they thought doing so would improve profits.

With other stocks in non-regulated industries, investors aren't surprised to see dividends rise, because the companies in question are mature businesses with few opportunities for additional investment internally. Philip Morris International (NYSE: PM  ) , for instance, has a worldwide tobacco empire, but there's only so much additional expenditures on marketing and publicity can do to boost profits. Eli Lilly (NYSE: LLY  ) can take some of its profits for use in research and development, but there's a point of diminishing returns for those expenses as well. At some point, investors recognize that these companies aren't supposed to do anything with the cash they generate, other than return it to them in the form of dividends.

Is growth going soft?
What does have the potential to disturb the market, though, is the fact that companies once seen as major growth drivers see no better alternative for their spare cash than to pay dividends.

Take Starbucks (Nasdaq: SBUX  ) , for example. Earlier this year, the coffee giant instituted a $0.10 quarterly dividend, giving the stock a current dividend yield of about 1.6%. With the stock projected to earn $1.23 this year, that's not a dangerous level to start. But it means the company is admitting that it no longer believes it can generate a better internal return by keeping the $300 million it will pay in dividends annually.

Viacom (NYSE: VIA-B  ) also recently started paying a dividend in the 2% range. Its $0.60 payout will divert $360 million from company coffers to shareholders each year. Again, one might think it would be able to spend the money better -- perhaps by improving its online content distribution strategy, for starters.

Nowhere to spend
You can see another sign of this reluctance to reinvest in businesses by looking at those companies that have accumulated large amounts of cash without paying huge dividends. While Cisco (Nasdaq: CSCO  ) and Apple (Nasdaq: AAPL  ) sit on huge stockpiles of available money, some have clamored for them to start paying a dividend.

But the implications of paying a dividend in this environment would be staggering. Essentially, by paying a dividend, growth companies are admitting that they no longer believe reinvesting profits in their own businesses is a worthwhile endeavor. They see no alternative but to return that money to shareholders.

And once you receive a dividend payment, you face the same dilemma. What should you do with the money? With savings accounts paying next to nothing, and even long-term bond rates heading lower, you don't have a lot of good options yourself.

Meanwhile, consider the things that companies aren't doing with the money they're paying out in dividends:

  • They're not hiring new employees.
  • They're not taking on new projects in an effort to expand their business reach.
  • They're not investing in new opportunities that would lead to the job creation the economy so badly needs right now.

In short, while getting a dividend check is nice for shareholders, it could be a symbol that companies are giving up on creating new hires or developing new projects. And while dividends most likely increase household wealth, which in turn could increase domestic consumption, it still may not be a great sign for the overall economy.

Be careful what you wish for
Clearly, it's better for a company to be able to pay a dividend than not. Dividends prove that a company has the financial resources to commit to an ongoing obligation to shareholders.

But with asset prices at relatively low levels, it's troublesome that companies aren't focusing on making profitable investments with their spare cash. As nice as it is to get a dividend check, corporate managers's inability to find better uses for their profits could bode ill for the health of the economy.

High-yield dividend stocks look great, but will they deliver? Selena Maranjian takes a second look at those attractive dividend yields.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

Fool contributor Dan Caplinger can always find something to do with cash. He owns shares of Philip Morris International and Starbucks. Apple and Starbucks are Motley Fool Stock Advisor recommendations. Philip Morris International is a Motley Fool Global Gains pick. Southern Company is a Motley Fool Income Investor selection. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy saves the best for last.


Read/Post Comments (8) | Recommend This Article (15)

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 July 02, 2010, at 12:25 PM, rd80 wrote:

    "Essentially, by paying a dividend, growth companies are admitting that they no longer believe reinvesting profits in their own businesses is a worthwhile endeavor."

    Letting massive piles of cash build also equates to admitting they no longer believe investing in their own business is worthwhile. Every dollar in a big cash stash is a dollar that could have been invested in the business, but wasn't.

  • Report this Comment On July 02, 2010, at 12:37 PM, PeyDaFool wrote:

    rd80,

    Maybe you're right, or maybe sitting on a pile of cash is a smart way of ensuring the company will still be around if s*it hits the fan.

    As a shareholder, I'm happy with the amount of cash AAPL is sitting on. Of course, I wouldn't complain if they started started paying me a dividend, but either scenario means the company has a chance to survive and grow during hard times. Without any cash reserves on hand, or the equivalent of an "emergency fund" for an individual investor, the future becomes fairly uncertain.

  • Report this Comment On July 02, 2010, at 1:17 PM, TheDumbMoney wrote:

    I think the Fool has a calendar tickler, and when it goes off every few months, they make one of their writers write one of these "dividends are good" / "dividends are bad" articles, because the Fool knows it will rile up blowhards like rd80, PeyDaFool, and me. rd80 is right. I would go even farther: the fact that AAPL is sitting on tons of cash (more, PeyDaFool, than it needs to stay solvent through a reasonable recession) is ALREADY an admission, Mr. Caplinger, that it cannot grow its business by investing that money -- in my view. Recall, MSFT also sat on a huge pile of cash for years, before it faced reality and decided to pay out in 2003ish; of course, it still sits on a huge pile of cash anyway, too. Also, to avoid dividend stocks is nuts. Something like 40% of the return of the S&P over the last 80 years has come from dividends. So you look for ones that have some growth, too, and some dividend growth. And, Mr. Caplinger, again, likely to rile a blowhard like myself up, also does not mention all of the bad things companies do when they instead "reinvest" that money: they overpay for their own shares in ill-timed buybacks, they overpay in acquisitions to fund "growth," they "diversify" outside of their area of expertise and waste tons of money doing so, and in the process of the latter two scenarios, they also tend to increase bonuses to top executives for doing such a terrific job "growing" the company.

    The fact is, every company, just like every country, will one day be run by an idiot. Dividends are like constitutional checks-and-balances: the discipline of having to pay and increase that dividend does a small something to help prevent the idiots who eventually will take over the company one day from buying companies they should never buy and then paying themselves big bonuses for doing so.

  • Report this Comment On July 02, 2010, at 5:51 PM, Stocklovr wrote:

    Why can't a company grow unless it sits on ALL of it's cash and gives it's shareholders NOTHING? That is, in my opinion, ridiculous. Maybe Starbucks decided to actually reward their shareholders for holding a stock that did nothing from 2005 until recently? Further, it's possible they decided that the shareholders could actually spend a little of that money in lieu of their empire building. Companies don't always spend their cash hord judiciously. If they did, Starbucks, for example, whould not have had to close so many stores over the last two years. How much did shareholders make when SBUX took those losses?

    If an investor wants to ever get paid for buying stock in companies that do not pay dividends, then they have to become ex-shareholders, i.e., sell some or all of their their shares which means you better be good at timing the market so you can get a good price.

    Slvr

  • Report this Comment On July 02, 2010, at 7:36 PM, busterbuddy wrote:

    Your comment about Southern company and being concerned about regulators is just a uneducated one. The regulators don't do anything to the dividend that the notsmart people in the White House. The utility regulators in most of Southern Companies region base their regulation on a return on investment. They control salaries and advertising cost. So not investing in Southern company because of regulators is just causing you to lose money. Be smart or being really Foolish its up to you.

  • Report this Comment On July 02, 2010, at 8:33 PM, atum2002 wrote:

    You have two choices when talking about expenditure of capital: having the money in your hands or having a promise that it will be carefully managed by the people who are supposed to be stewards of it for you. Given what's been going on for at least the past 15 years I'll take the former.

  • Report this Comment On July 03, 2010, at 5:27 PM, goalie37 wrote:

    Let's put your argument another way. If I owned 100% of a business, would I be worried that my company was so profitable that I could pay myself some of the profits?

  • Report this Comment On July 06, 2010, at 2:42 PM, sinedo wrote:

    I too believe this kind of article is just designed to generate noise from "Fools". Like most of the responders, I would rather have dividends from my investments, whether I run them or just invest in them. I also feel that Management that can keep a nice hoard of cash, will have it when the general economy throws many valuable assets out on the Market to raise cash. Aggressive Managers too often leverage their Companies into a hole and can't make debt payments, so they have to sell the "family jewels" to keep solvent. Being there with cash to pick up those jewels is smart, if they're not too scared to act.

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