Island Investing: On Dividends

Q. How much do dividends matter?

A. While some research indicates that dividend stocks outperform the market, those studies are by definition backward-looking and far from practical. Academic research is often intellectually interesting but practically useless when creating a pragmatic investing strategy of your own.

Instead of relying on studies, let’s think like a business owner to answer this question. You as an investor are an owner in a company you hold shares in, and as such, a small percentage of the leftover cash that the company produces every year technically belongs to you. What would you like your company to do with it?

The company has six options for that cash. It could do nothing and let more cash accumulate, but investors that don’t earn much on their share of earnings tend to get ornery.

The company could use that cash to either make acquisitions or reinvest it in additional capital projects. If you’re like me, however, you may not be a fan of someone else spending your money on things you may not like. In most cases I’d rather stick to owning companies that don’t grow by acquisition or require a lot of capital.

That leaves three options for what you’d like a company to do with your cash. I’d argue they are each pretty similar. Whether a company pays a dividend, repurchases its own stock, or reduces its debt, it is creating value for you the owner. Whether you realize that value in the form of a dividend or see your equity stake increase “in the books,” each option has a different economic significance.

Dividends represent a bird in the hand, and some place a high value on that. However, companies that pay dividends are also signaling they are returning cash to their shareholders because they are unable earn high internal rates of return on it. That may not be the case for companies paying down debt or buying their own shares back.

So while dividends can be important, they might be less important than debt paydowns or share buybacks when it comes to maximizing returns.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
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3 Responses to Island Investing: On Dividends

  1. Kirk Kinder says:

    What do you think about the argument that share buybacks or debt repayment only helps the corporate executives increase their stock option value? Why pay dividends when the corporate execs won’t receive that money through their options so they take other measures to boost the price. Do you think if the corporate execs really had most of their wealth tied up in the company they might opt to pay dividends?

    • Cale Cale says:

      Yes, to be clear on stock buybacks – only a positive so long as a buyback is not a veiled way to make up for dilution from option issuance to management. And assuming positive intent on the part of management in general is also part of the equation. That assumption may be debatable – and the ability of management to allocate capital should always be examined closely – but I suppose I’m thinking more about companies like Berkshire Hathaway then the folks who run, say, First Solar.

      There are certainly plenty of companies who attempt buybacks to boost short-term value, but because debt paydowns impact the firm’s capital structure, I think those decisions are generally made more rationally. If management is doing things to increase long-term value of the firm…and they’re accounting for options properly (or, like Google, that expense is basically immaterial to earnings power)…then whatever increases their option value increases my equity value, too – a plus, assuming that “positive intent” thing. Key is whether or not they’re throwing long-term holders under the bus to boost short-term earnings.

      And the personal stake/dividends thing is an interesting question. I’d like to see most management teams with a much bigger personal stake in the companies they run – and not because it’s given to them. Probably a case by case basis as to how they’d think about dividends then. Buffett may be a counter-example.

      Always thought this was intriguing, too. In theory execs could receive dividends by just exercising their options and holding. Most exercise and immediately sell, though, of course. There are still plenty of companies that both award options and pay divvies, so the question is why don’t we see more exercise-and-hold? I suppose that they’re conscious of signaling…more specifically, there might be a big outcry if shareholders saw these guys pulling out millions in cash from dividends on exercised-but-not-sold options as the stock tanked. But that seems a minor downside at best. It’s still hard to think about and not come out a bit more cynical about those options, unfortunately…

  2. Kirk Kinder says:

    Great follow up…thanks. Right now, IRS guidelines require incentive stock options be held for at least two years before being sold (essentially from grant date). I would love to see that extend to 10 years. That would force corporate execs to be longer term investors. Could ensure they use cash optimally. I also think they should require the execs to front the cash to buy the stock, rather than offer cashless exercises. Get some skin in the game.