Dividends: Do Your Investments Know Who the Real Boss Is?

charles_headshotI like getting paid in cold, hard cash. And frankly, who doesn’t?

But stock dividends are more than just a quarterly paycheck. They are a way of doing things. I would go so far as to argue that they are a philosophy of life (or at least of business).

They are a way of correctly conducting business for a healthy company. A sound business philosophy begins with dividends…

That might sound a little kooky at first, but hear me out.

In the Wolf of Wall Street, Leonardo DiCaprio playing Jordan Belfort says that money does more than just buy you a better life; it also makes you a better person.

OK, so that’s debatable.

But I can assure you those dividend payments, that extra money, definitely makes for a better company.

This is why:

1. Dividends prove who the real boss actually is. It is important to remember that the bespoke CEO running the company is not the owner. He, or she, is just an employee, no different from a common assembly-line worker… aside from that obscenely engorged paycheck. We, the shareholders, own the company. Management lets us know they understand and respect this by regularly paying us, and by raising the quarterly dividend.

2. Dividends kill needless empire building. Listen, corporate CEOs aren’t any different from politicians. At the end of day, they’re spending other people’s cash on often wasteful projects that add zero value. Because growth – any growth – offers more power and control.

A regular dividend forces discipline on management. If half-corporate profits pay out as dividends, remaining cash will fall to growth projects chosen much more selectively. CEOs will have to focus on the most profitable and worthwhile and, by necessity, pass on the marginal ones.

3. Dividends foster more honest financial reporting. At one point or another, many (if not most) companies will… ahem… perhaps, be a little less than honest in their financial reporting.Outright fraud is rare, but accounting provisions allow for a decent bit of wiggle room in how revenues and profits hit the bottom line. Even professionals have a hard time figuring out what a company’s true financial position is if the numbers are fuzzy enough.

Incidentally, our resident forensic accountant John Del Vecchio has an entire trading service dedicated to uncovering accounting shenanigans. John lays out step-by-step how investors are getting taken for a ride while “blue chip” companies hand out multi-million dollar bonuses to executives, make foolish and ultimately worthless acquisitions and spend lavishly on expensive perks.

Well, while dodgy accounting can obfuscate revenues and profits, it’s a far-sight harder to fudge the numbers when it comes to cold, hard cash.

For a company to pay a dividend, it has to have the cash in the bank. So, while paying a good dividend is no guarantee a company isn’t being over-aggressive with its accounting, it definitely acts as an additional check/balance.

4. Share buybacks – the main alternative to cash dividends – never seem to work out as planned. Companies always buy their largest share repurchases when times are good, they’re flush with cash, and their stock is sitting near new highs.

But when the economy hits a rough patch, sales slow, and the stock price falls… the buybacks dry right up. And another (frankly insidious) motivation for buybacks is to “mop up” share dilution from executive stock options and employee stock purchase plans. The net effect is that a company buys their shares high and sells them back to employees and insiders low.

Call me crazy, but I thought the whole idea of investing was to buy low and sell high, not the other way around. A better and more consistent use of cash would be the payment of a cash dividend.

5. And finally, we get to stock returns. I’m not particularly excited about the stock market at today’s prices. Based on the cyclically adjusted price/earnings ratio, the S&P 500 will deliver annual returns of virtually zero over the next decade. But if you’re getting a dividend check (or two…) every quarter, you’ll still realize a respectable return, even if the market goes nowhere. And that return is real, in cold hard cash, and not ephemeral like paper capital gains.

Hey, not every great company pays a dividend. And younger companies struggling to raise capital to expand have no business paying out precious cash as a dividend, not when it might need to keep the lights on next month.

Seriously… for the bulk of your stock portfolio – the core positions that really make up the heart of your nest egg – look for companies that have a long history of paying and raising their dividends.

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Charles Sizemore

Editor, Dent 401K Advisor

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About Author

Charles Sizemore is a research analyst with Dent Research. His primary research focuses on income, retirement strategies and fundamentals.