It’s interesting, especially after reading investing history, to live through period of “irrational exuberance”. I’ve been investing throughout the dot-com boom, the subprime meltdown and the continued Canadian real estate bubble. One enthusiasm, which seems to be limping towards an end, is the wild enthusiasm for dividends.
What Is A Dividend?
Equities – stock you buy – represents a fractional ownership of the company. If you have 100 shares of Disney stock, you own a tiny fraction of a percent of the company. The company operates on its own, and the value of the stock is what the market – other buyers – would be willing to pay to own part of that company.
As a company makes money, they pay their bills. In addition to things they have to pay for, they may choose to pay more money to try to make their company better. For example, they might buy a new machine that will streamline their production, pay down debt or open a new animation studio. In some extreme circumstances, they might buy another company and absorb it. The money used for all these things is called retained earnings.
Any money that they don’t use to pay their bills or expand their company is returned to the investors. The message being conveyed is that this money belongs to the investors, but the company doesn’t have anything important to do with it so they’re giving it to then. This money, being passed to owners of shares of the company, is called a dividend. Many large, established companies, called a blue chip, will regularly pay dividends. This indicates that the company has more than enough money coming in to pay its bills, but doesn’t see any opportunities to invest in making themselves bigger and more profitable.
What’s a Dividend Cut?
A dividend cut is simply when a company that has been regularly paying a dividend stops paying it or pays less.
What About Companies That Don’t Pay Dividends?
When a company doesn’t pay a dividend, it’s saying that either it doesn’t have enough money coming in to afford it or that it has better opportunities to invest the money than investors probably do. If Apple was going to pay me a $500 dividend, but the CEO felt that he could get a 20% return on that money by developing a new product with it – I’d much rather he grow it by $500 than give me the cash. I don’t have any opportunities to easily grow my money by 20%.
All else being equal, we should expect companies that pay less in dividends to grow faster than companies that pay more.
A Fetish For Dividends
Many investors have developed a great affection for companies that pay dividends. They have wild enthusiasm for companies that have been able to pay a dividend for an extended periods of times, sometimes decades or more, and in the best cases a continually increasing dividend.
This is never guaranteed. I bought a bunch of Bank of America, which at the time had been paying a dividend for over a century. They cut their dividend.
Investors, such as Derek Foster or Geraldine Wise, feel that dividends are one of the most important metrics that can be used to evaluated a company. Sending a check with cold hard cash to investors can’t be faked, and the ability to do so on a continuing basis is an indicator of a strong company.
The central fallacy with these views is that dividends aren’t magically conjured out of thin air. It’s money that’s being taken out of the company. Companies that pay lower (or no) dividends will have more money available to grow and develop. For every company that squanders retained earnings there can be a dividend paying company that could have invested the money better than shareholders can.
One of my mother’s friends announced in conversation that she “couldn’t survive without her dividends!” In fact, she could, and simply selling off an equivalent portion of a portfolio of broad-based index funds would amount to much the same thing.
Dividends aren’t good or bad and they certainly aren’t magic the way some investors treat them. Hopefully management will make the right dividend policy based on the business’ needs and future outlook – not to manipulate investor sentiment.
I went through a period where I was quite enthusiastic about dividends. I read an amazing series of blog posts by Dan Bortolotti at Canadian Couch Potato which changed my outlook. For anyone thinking about investing in individual stocks (especially with a focus on dividends), which I don’t recommend, I heartily suggest reading his entire series:
Dividend Myth #1: Companies that pay dividends are inherently better investments than those that don’t.
Dividend Myth #2: Dividend investors are successful because they select excellent companies and buy them when they are attractively priced.
Dividend Myth #3: Dividend-paying stocks are a substitute for bonds in an income-oriented portfolio.
Dividend Myth #4: You can beat the market with common sense: just focus on blue-chip companies with a competitive advantage and a history of paying dividends.
Dividend Myth #5: It’s easy to build a well diversified portfolio of Canadian dividend stocks.
Dividend Myth #6: Investors who follow a dividend growth strategy will eventually beat the market on yield alone.
Do you invest in dividend paying stocks? Have you read Dan’s series? What failed to convince you?