Dividends are BACK!

There was an interesting Blog post recently on the Economist's website discussing dividends, and how recent studies have shown that companies that pay dividends/have higher dividend payouts tend to generate higher future earnings growth.  This is somewhat counterintuitive considering we've heard for decades that "growth" companies must continuously retain earnings to fund future growth initiatives.  While this may be true for early stage companies, for more mature companies the retention of earnings may have the opposite effect.

For many companies, that large cash hoard may be burning a hole in their pockets, prompting some rather imprudent decisions, or worse, to decisions which actually destroy shareholder value.  Managing a large cash reserve may cause managers to engage in "empire building," wasting cash on expensive acquisitions that may not deliver the returns expected or add any economic value to investors.  There are countless examples of acquisitions gone wrong, resulting in divestitures, write downs and years of underperformance as managers seek to make their mistakes work out.  The cash hoard may also have an inflationary impact on salaries and benefits for senior managers as well, though this is probably just a coincidence.

So the question then becomes, is paying a dividend the right action for your company?  Well, it's a decision that ultimately only the Board of Directors can make, but here are some thoughts that may guide a well-warranted discussion.

First a point of clarification, we are really addressing only regular dividends, whether annual, semi-annual or quarterly, NOT special dividends.  Special dividends in my opinion are of questionable value to shareholders, it might provide a nice payday, but does nothing to ensure long-term performance, or enhance the value of the stock.

In an environment where T-bills yield zero return, or sometimes less, and the 10-year Treasury bond is yielding 2.2%, there is something to be said for paying dividends.  For most companies, not paying a dividend puts you at the same cash yield position as a T-bill, but without the downside protection.  If your company has a $10 stock and you were to implement a small dividend, say 5-cents per quarter, that’s $0.20 per year, and suddenly you have a 2.0% dividend yield which is comparable to 10-year T-bonds.  Some might say that such a small dividend is meaningless, but for yield investors, it doesn’t matter if it’s a 5-cent quarterly payout on a $10 stock or a 50-cent quarterly payout on a $100 stock, the yield is the same, and that is increasingly attractive to investors in the pitiful yield environment the Fed has created.

Beyond the yield argument, paying a dividend also opens up your company to a whole new segment of investors, income investors that look for growth or value companies, but require some sort of yield to meet their investment criteria.  There are a lot of growth and income funds or income value funds that simply can’t buy stocks that pay no dividends.

You are also providing a return for shareholders while not sacrificing share liquidity as you are in a buyback.  Many smaller companies today are jumping on the buyback bandwagon, hoping that will satisfy investors and boost their share price.  Buybacks have their place, but there are some drawbacks: 1) they drain trading liquidity, which is not good for low liquidity stocks; 2) they do not create discipline for management, you don’t have to buy back specific amounts each quarter, it’s merely a matter of convenience, unlike a dividend which has to be paid every quarter; and 3) the old argument about the buyback tide lifting the boat of share price, thus benefiting all shareholders is less compelling today – after all with capital gains tax rates and dividend tax rates being equal, there is little tax benefit to the buyback vs. dividend, and the increased valuation may occur anyway as investors start valuing the company on a yield basis as well.

Finally, dividends may also be used to promote increased share ownership.  Many companies offer dividend reinvestment plans which allow individual investors to reinvest dividends into additional shares (these used to be really popular back in the 1990s, but then dividends went out of favor).  Even without a company-sponsored plan, many brokers also have similar programs – I know in my personal account at TD Ameritrade, all dividends are automatically reinvested into shares every quarter, this increasing share ownership.  It's a small matter, but a potentially easy way to promote retail investor participation, an area often overlooked by management teams.  Perhaps it's time to take a new look at dividends at your company.