Investors have a lot of good reasons for liking stocks that pay dividends. But dividend-paying stocks have one advantage that many people don't always realize. Paying a dividend ensures that the cash a business generates goes toward a legitimate purpose: paying back shareholders for their investment in the company.
Becoming a solid dividend stock doesn't happen automatically. Companies have to commit to adopting the mindset of paying a consistent and growing dividend before they ever see it come to fruition. But with all sorts of corporate excess running rampant, investors now recognize that the way of thinking about corporate capital that comes from paying a dividend also helps reinforce the responsibility that management teams have in safeguarding shareholder assets.
Too much cash on their hands
Yesterday's news of Microsoft buying Skype is only the latest example of the ongoing battle between the paradigms of dividend income versus internal growth. Microsoft argues that even a lofty $8.5 billion price tag for Skype isn't too much, given the twin goals of incorporating the company into its suite of Internet-based products as well as keeping it out of the hands of competitors. But skeptical investors like the managers of the high-performing Yacktman Fund argue that the cash-rich company is essentially squandering hard-earned money -- money that could instead go to shareholders.
The debate over how much cash a company needs has gone on for years. With many companies, especially tech giants like Microsoft, having built up huge 11-figure cash hoards, shareholders are largely at the mercy of corporate management not to make big mistakes in capital allocation. Having a lot of ammunition to bag an elephant acquisition may sound good in principle, but many worry that in practice, companies often pay elephant prices for buyouts that never deliver the goods.
Why dividends rule
The situation is entirely different at companies that pay a substantial percentage of their income in dividends. There, company executives get a reminder each and every quarter that their first duty is to shareholders, to produce the dividend that they count on for their living expenses or to reinvest, either back into the company or into other investments.
In essence, it's the mirror image of what smart savers do. Just as you "pay yourself first" by setting aside a certain amount from every paycheck toward your savings, companies pay their shareholders first with a dividend policy that demands steadily growing payouts over time.
That isn't to say that every penny of earnings needs to go to pay dividends. In fact, that can be dangerous in its own right: It leaves no margin of safety during tough times when earnings fall, and it doesn't give managers any flexibility in allocating capital back into the business without taking more drastic measures like issuing debt or making secondary stock offerings.
As I see it, though, the best dividend stocks find an appropriate middle ground, making sure shareholders get their fair share through dividends but also reserving enough cash to make strategically smart moves from time to time. Setting the "sweet spot" at 50% to 60% of earnings, the following stocks were the ones with the fastest-growing dividends out of the 14 S&P 500 stocks that passed the test:
10-Year Dividend Growth Rate
Source: Capital IQ, a division of Standard & Poor's.
With yields of 3% or more and consistently higher payouts over the past decade, none of these companies have strained to meet their obligations to shareholders. Yet with 40% to 50% of earnings still available for internal reinvestment or strategic moves, company managers aren't hamstrung by their dividend policies. That seems like a reasonable compromise to make everyone happy.
Demand your dividend!
Unfortunately, shareholders often have no recourse but to vote with their feet when a company whose stock they own makes a move they don't like. But with companies collectively sitting on so much cash right now, it's more important than ever to make sure that money gets back to you -- rather than going for something of far less value.