Throughout stock market history, dividend-paying stocks have made a huge difference in investors' returns. Yet while the positive benefits of stocks that pay dividends are well-documented, recent experience paints a much different picture of their performance.
Lately, a rash of companies have had to cut their dividends dramatically. Many, including Wells Fargo
For these companies, it's tough to argue that dividend cuts are a good thing. With their businesses endangered and cash at a premium, these companies are doing what it takes to survive -- even if it comes at the expense of hurting their shareholders' short-run prospects.
But a much different group of companies are considering smaller payouts for a much better reason -- one that may make you want to think twice about dividend payers in general.
Going on a buying spree
Traditionally, companies that have paid large dividends run mature businesses that produce substantial amounts of cash. Because businesses in mature industries don't necessarily have a lot of growth prospects, there's little reason for companies to hold onto that cash or try to reinvest it into their business operations. So the companies use excess cash to pay their shareholders, gaining a following of loyal dividend-seekers in the bargain.
The falling stock market, however, has brought with it some huge opportunities for opportunistic companies looking for ways to expand their reach. Pfizer
Of course, people disagree about whether these are smart acquisitions or not. But the question that income investors should ask of these and any stock they own is this: Are these companies making better use of their cash than I would if they paid it out as dividends?
Smarter use of cash?
If you're relying on dividend income, then it doesn't really matter why a stock stops paying a rich dividend -- you won't like it.
But for most investors, dividend stocks serve two purposes. First, they represent stable investments in companies that typically have long histories of profitability and fiscal responsibility. Second, some dividend-paying companies still have growth potential -- growth that could boost payouts in the future.
When companies don't have a better use for their cash, it makes sense to pay it out to investors who can then make their own decisions about where to put the money. However, if companies can make use of their cash in a way that will eventually produce greater shareholder returns than most investors could find on their own, shareholders should happily give up their quarterly payments and cheer them on.
The no-dividend retained-earnings model is one that many companies have used -- including Warren Buffett's Berkshire Hathaway -- to enable them to take advantage of opportunities as they arise without curtailing their ability to get outside financing or access capital markets. Right now, cash-rich companies like Berkshire have commanding leverage in negotiations with struggling businesses seeking liquidity.
To me, the prospect of greater returns down the road makes it worth suffering through the initial negative reaction to a dividend cut. So if you own a stock that cuts its dividend, check and see whether it has good plans for that money. If it does, you might be better off holding on than selling at fire-sale prices.
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Fool contributor Dan Caplinger has high hopes for his dividend-paying stocks, even though they haven't helped him out much lately. He owns shares of Berkshire Hathaway. Berkshire Hathaway and Pfizer are Motley Fool Inside Value recommendations. Berkshire Hathaway is a Motley Fool Stock Advisor selection. Pfizer is a former Motley Fool Income Investor pick. The Fool owns shares of Berkshire Hathaway and Pfizer. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy always pays dividends.