Why Companies Can Shun Dividends

Macro Super-Fool (and uber-interviewer) Morgan Housel's recent column on why companies should pay dividends begins with this statement:

Some investment rules are so powerful they can't be rebutted with a straight face. That companies with higher dividends tend to outperform those with lower dividends is one of them. ... Countless academic studies show that dividends are typically the best way companies can reward shareholders.

Oh really, Morgan? I beg to differ. Them are fightin' words. And my face is as straight as the Bonneville Salt Flats. 

Here's why. 

Correlation is not causation
Morgan claims that dividend payers have historically outperformed nondividend payers.  This is absolutely true. I do not dispute this. (Don't worry...the article isn't over.)

What I dispute is that these companies outperformed because they paid dividends, and that therefore managements are putting their shareholders in "peril" by not paying more in dividends. Morgan's academic studies prove that dividend payouts and outperformance are correlated, not that dividend payouts cause outperformance.

And there is a huge difference between correlation and causation in practice.

It's been noted, for instance, that ice cream consumption and crime are strongly correlated. Does this mean eating ice cream causes crime?

No, of course not. It's more likely that there is a third variable at the fact that criminals might prefer to work when windows are open and people are out and about, which happens to be during the summertime when people consume ice cream. 

So banning ice cream wouldn't lead to less crime (just more unhappy children).

Similarly, it does not follow that paying more dividends will cause a company to outperform. There could be a third variable at work that explains why dividend payers outperform. 

And I think there is. 

Companies that pay dividends
Think for a moment about the kind of companies that pay consistent dividends: They're often leaders in their field, possess durable competitive advantages, and have strong and ethical managements.

In short, all characteristics Berkshire Hathaway's (NYSE: BRK-B  ) Warren Buffett looks for in a company

I'd argue that it's these Buffett-like characteristics -- and not the dividend policy itself -- that causes dividend payers to outperform. Having the free cash flow to be able to pay consistent and increasing dividends is often indicative of a great Buffett-like company. I think this is the real reason why dividend payers outperform.

After all, there is no rational reason -- all else equal -- why changing the dividend policy should lead to outperformance. As I've written about many times, a stock's price falls by the amount of the dividend payment when the stock goes ex-dividend. 

To put it another way, giving Research In Motion Cola-Cola's dividend policy won't make it perform like Coca-Cola. Nor will it change the fact that Research In Motion is in trouble (though I think RIM is undervalued and is therefore still a CAPScall). 

Similarly, giving Coca-Cola RIM's dividend policy won't change the fact that Coke is an excellent company (and is also a CAPScall). And assuming Coke managed the company in the same way, it won't change the total return given to shareholders. (Er... OK, it would a little bit -- by eliminating double taxation of dividends it would boost after-tax performance.)

Morgan's excellent P/E comparison
My hypothesis -- that dividend payers outperform because they're better companies, not because they pay dividends -- is further validated by Morgan's observation that stocks with higher dividend payout ratios have higher P/E ratios: We know that companies with higher P/Es tend to be better quality names. 

Morgan of course has a different conclusion: For the majority of companies, there's a clear trend: Pay higher dividends, and the market will reward you with a higher P/E ratio.

One of the examples Morgan gives is Consolidated Edison (NYSE: ED  ) . Morgan points out that ConEd has a higher P/E than Microsoft (Nasdaq: MSFT  ) despite obviously having a lower growth rate. He concludes it's because ConEd has a higher payout ratio. 

The problem with this is that earnings growth is just one side of the P/E equation. The other is how risky those earnings are. And all else equal, a regulated utility like ConEd is a lot less risky than a software company like Microsoft. Therefore a higher P/E isn't so weird. I also think that Microsoft is a bad example because it's simply undervalued right now (it's been a longtime CAPScall of mine). 

The same is even more true of Morgan's comparison of AT&T (NYSE: T  ) to Apple (Nasdaq: AAPL  ) . Yes, it's true that Apple's growth rate is far greater, but AT&T's business model is also a heck of a lot less risky (which is part of why, you guessed it, it's also a CAPScall). Therefore a higher P/E than Apple is not as crazy as it initially appears, and is consistent with my hypothesis. 

Why I fight
Some of you may be wondering why I fight so hard, in so many columns, against dividend evangelism when I clearly like a lot of dividend-paying stocks. Heck, Vanguard Dividend Appreciation is my largest holding and a CAPScall.

There are two reasons why I fight. 

The first is that this belief that dividends are manna from heaven is dangerous for investors. I can't count the number of times I've seen investors hold on to bad companies simply because they think their dividends confer magical outperformance powers. Think of the shareholders who held on to old GM or the financials late last decade. 

The second is that dividend policy is ultimately a distraction for investors and management. Fools should concentrate on buying the best businesses at the best price, dividend or no dividend. And managements should focus on making their companies worthy of a Fool, dividend or no dividend. Dividend policy does not make a bad business good, nor a good business bad

Fool contributor Chris Baines is a value investor. Follow him on Twitter, where he goes by @askchrisbainesChris' stock picks and pans have outperformed 92% of players on CAPS. He owns shares of Berkshire Hathaway and Vanguard Dividend Appreciation. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy

Read/Post Comments (5) | Recommend This Article (9)

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  • Report this Comment On January 18, 2012, at 5:45 PM, Hawmps wrote:

    First of all, I very much enjoy reading two very different perspectives from Fool writers. You make some good counter points to Morgan's opinions on dividends and dividend payers, but one thing that is often overlooked (perhaps by both you and Morgan) is the effect that the reinvestment of those dividends has on the company that paid them. More often than not, a dividend is paid and that cash is turned around and put right back into the company it came from via a DRIP plan or other re-investment strategy. Yes, the stock price goes down after ex-div but very soon after a significant % of that payout gets re-invested right back into the company. Thus there is an increase in demand for the stock because investors are reinvesting their dividends.

  • Report this Comment On January 18, 2012, at 6:33 PM, cbaines2 wrote:

    Both are excellent comments that deserve a response. I'll try to be as brief as I can while addressing these (surprisingly) complex issues:

    Hawmps, as a value investor I'd argue what you should care about are things that effect the intrinsic value of a company...not what may temporarily drives up the demand for a stock. In the long run the share price will come to reflect the intrinsic value of the company, dividend or no dividend. And - at least in theory - arbitrageurs should sell or a short a stock that becomes "overpriced" due to any unjustified demand from dividend reinvestors.

    Addressing truthisntstupid (whose comments recall from prior articles and are always fun to address), I am sympathetic to the fear that management will squander cash. But I'd argue the fault there lies squarely with management's investment policies and not with the dividend policy.

    Contrary to popular belief, a company does not need retained earnings to make poor investments. It can almost as easily pay out earnings in a dividend, issue shares of stock, and then use the proceeds from the issuance to finance stupid investments. (This is mathematically equivalent to retaining earnings.) As matter of fact many companies - like old GM - did/do just this. Heck, old GM paid a a huge dividend even when they had $0 or less in earnings.

    The bottom line is, if management is making dumb investments what is needed is a regime change in management. Dividend policy won't neccessarily stop the stupidity.

    As for the second paragraph, I agree 100% with Buffett that companies increase intrinsic value when they repurchase under-priced shares. But that is only if the shares are under-priced and the business is wonderful. And again, Buffett's concern points more to bad investment policy than dividend policy.

    Thanks for reading,

    Chris Baines

  • Report this Comment On January 18, 2012, at 8:12 PM, Hawmps wrote:


    I was referring the context of the article... the fact that many dividends are reinvested back into the company is something that is rarely touched on and it absolutely has some sort of affect on the business because capital is returning to the company that paid it out that it can use all over again. The term "overpriced" is an opinoin of the one that views the whatever it is as overpriced. It may very well be priced right for someone else.

  • Report this Comment On January 18, 2012, at 9:12 PM, cbaines2 wrote:


    When you reinvest your dividends capital is not returned to the company. Your money goes to paying whoever you're buying the shares from.

    Whenever you buy a share of stock someone else is selling it to you (or vice versa). That someone else is not the company unless it's an IPO or they're doing some other kind of equity offering.

    Thanks for reading,

    Chris Baines

  • Report this Comment On January 18, 2012, at 11:20 PM, cbaines2 wrote:

    Yes with DRIPS the proceeds go to the company because you are buying from the company.

    This doesn't really matter in terms of corporate finance, however. The dividend and the issuing of shares paid for by that reinvested dividend cancel each other out, making it mathematically equivalent to just retaining the earnings.

    Having said this, I don't have any problems with DRIPS or investors using them.

    Thanks for reading,

    Chris Baines

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