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.

This entry was posted in Island Investing and tagged . Bookmark the permalink.