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:

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.