Dividends Are Dumb

Question everything. It's a good motto if you ever find yourself in a government-conspiracy movie. But it'll also serve you well any time money's involved.

The folks who question seemingly self-evident principles can make an absolute killing:

• Ask the Super Bowl bettors who took the so-called suckers' bet of the Giants over an 18-0 Patriots team.
• Ask hedge fund manager John Paulson, who made more than $10 million a day in 2007 ($3.7 billion total) because he figured out that housing prices could actually fall.
• Or ask some guy named Craig, who questioned the virtual monopoly that newspapers had on classifieds. (Yes, that's a Craigslist reference.)

So when I heard the argument recently that dividends are actually a bad thing, I was willing to listen. To my surprise, it proved a more compelling argument than you may think.

These dividends are just dumb
Why do we invest money in a company? Ultimately, it's because we think that company can grow our money by using that money to invest in its growth.

When a company turns around and gives us that money right back (creating a taxable event in the process), it defeats the purpose. If we want out, we can simply sell our shares. And do so on our own timetables.

Whereas dividend advocates see the sub-1% dividend yields of Hewlett-Packard (NYSE: HPQ), MasterCard (NYSE: MA), and Oracle (Nasdaq: ORCL) as just a start, anti-dividend folks maintain that even these modest dividends are just dumb allocations of capital. Dividend-bashers might question why HP wouldn't spend even more than the billions it already spends on capital expenditures and research and development to grow its business. MasterCard went public just a few years ago, so these anti-dividend folks might question why it got an infusion of capital, only to quickly start returning it. As for Oracle, they'd likely prefer that the serial acquirer kept acquiring.

Each of these companies generates high returns on the capital they invest in their business -- that's why we invest our money in them in the first place. Wouldn't it make sense for them to invest more capital to generate more of those high returns?

You may already be writing off these arguments, but hear them out. The case against dividends gets stronger, given the reason folks buy dividend stocks in the first place.

Frequently, investors who buy shares of companies that pay large dividends are seeking safety and stability. Why? Because a company that commits to a regular dividend payment is signaling exactly that -- safety and stability.

So it's ironic that a dividend can act like debt -- an obligation that makes the bad times worse. Although paying dividends is optional (while missing debt payments leads to bankruptcy), a company that chooses to cut its dividend signals weakness, often leading to a further weakening of its stock price. That's a double whammy no investor wants to face.

Yet I still heart dividends
So why am I still bullish on dividend payers?

I'll leave aside the empirical evidence that dividend payers have handily outperformed non-payers historically. Instead, let's look at a company's life cycle.

Early in a company's history, it feeds on cash like a baby sucks down formula. Investors don't care, though, because the company needs that capital to fuel its growth. Soon enough, that company either fails or becomes bigger and stronger.

At some point, it starts producing more cash than it's consuming. It can then build a war chest to ensure its survival through good times and bad.

But then what? If there aren't any compelling internal opportunities, a company has four choices:

• Sit on the cash.
• Buy back shares.
• Make acquisitions.
• Pay dividends.

When you look at all four options carefully, dividends make a heck of a lot of sense.

Dividends stand alone
Sitting on cash is safe, but it's a drag on a company's return on capital -- especially when interest rates are hugging 0%. Apple's chosen this path, hoarding nearly $40 billion. But few companies have the amazing innovation-driven growth that can hide this drag.

Buying back shares is almost like a dividend with no tax consequences. In fact, if a company can buy back its stock at low points, it can really juice returns to current shareholders. Unfortunately, most managements don't do a good job of timing. Even Goldman Sachs, the reputed master of the markets, made massive repurchases of its stock throughout the heady bubble years only to have to sell new stock to raise cash when its stock price was hammered. That's classic buy high, sell low behavior!

And if Goldman (and most of the other large banks) mistimed buybacks, you can be sure other major companies did as well. For example, Kraft (NYSE: KFT), IBM (NYSE: IBM), and Comcast (NYSE: CMCSA) all conducted large buybacks in 2007 before their stocks tanked in 2008. Shareholders of these three companies were thus subject to a terrible use of capital. Since then, buybacks have been cut back drastically, though as shares are on the rise again, so are buybacks for Comcast and IBM. And all three of these companies (like many others that engaged in the same practice) still have the same leadership largely in place.

Acquisitions are the scariest of all. You see, management is often judged on its ability to grow the business, specifically earnings per share. That's why it'll buy back shares at inopportune times. And that's why it'll pursue ill-advised acquisitions and poorly conceived internal projects with such gusto. This growth at an unreasonable price helps management but hurts shareholders.

Which leads to the reason I love dividends. The issuance of a regular dividend instills management discipline by removing some capital from consideration. You can't waste what you can't touch.

Meanwhile, as shareholders, we get a nice income stream ... the classic stock play that yields like a bond.

With 10-year Treasury bonds currently yielding just 3.74%, dividend stocks are that much more attractive. Because of this, let me share three dividend plays that the dividend hounds at our Motley Fool Income Investor newsletter have identified and recommended.

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This article was originally published Feb. 26, 2010. It has been updated.

Anand Chokkavelu doesn't own shares of any of the companies mentioned here. Paychex, Philippine Long Distance Telephone, and Southern are Motley Fool Income Investor recommendations. Paychex is a Motley Fool Inside Valueselection. Apple is a Motley Fool Stock Advisor recommendation. The Fool owns shares of and has written puts on Oracle. The Fool has a disclosure policy.