Friday Reading

The Dividend Dilemma

If there’s a subject that seems to get people talking, it’s dividends. Those semi-annual payments seem to be a gift from the heavens for some investors, a tangible reward for holding assets whose returns are otherwise extremely volatile. On the other extreme, in a more textbook academic argument, is the point that dividends are basically a semi-liquidation of a company you put your money into because you believe it can earn greater returns on that capital than you can – and, since dividends are still horribly tax-inefficient, it’s simply a lose-lose game to placate (irrational) investors. I’m somewhere in the middle. I’m wary of those who hunt for dividend yields as a primary objective, but I would probably say that, ceteris parabis, I’d prefer a stock yielding 5% to one yielding 2%.

What got me thinking about the topic, then, is a great article on Stockopedia – and an equally great tree of (as of writing this!) 34 comments. As with much of writing on investment, the article starts with the base premise being that of a sort of efficient market concept – that dividends are fundamentally inefficient, and that in a rational world they shouldn’t be paid. It then goes on to list several examples of where dividends may be a sort of rational choice, given a number of explanatory factors. I should state at this point that, if the tax laws work so as to make capital gains more advantageous than dividend payments, I don’t think there’s any advantage of dividends over share buybacks, barring those fluffy psychological ones – people prefer them, for some reason. If we’re talking about share buybacks vs. dividends, then, I’m in the camp of returning money to shareholders the most efficient way. Owning a stock, in my book, implies that you think a share buyback is more efficient than a dividend. You are saying you prefer to have the stock of the company than the equivalent amount of cash. Hence – no matter what the P/B or P/E, you should prefer to increase the percentage of the company you own (through a buyback) than your cash (through a taxed dividend).

I think the argument has sort of morphed, though, from being one of ‘dividends vs. share buybacks’ – which is a valid concern, since if companies are returning money in an inefficient way, it only hurts shareholders – to an argument about what level of cash should be returned. On that, I only have two points to make beyond what it a pretty comprehensive discussion at Stockopedia. I’m probably stepping on other commenters’ toes slightly with them, but still!

Firstly, I think the most important factor – bar none – is that there cannot be a blanket application of whether returning cash to shareholders is appropriate or not. It is entirely dependent on the operational structure of the business, the balance sheet, and the growth opportunities. I like Tullett Prebon returning cash to shareholders. Their business model requires little investment for growth, and so the alternative to them giving cash back to shareholders is leaving it on the balance sheet to be put to no productive use. I worry slightly about Dairy Crest giving back so much to shareholders, given their debt pile and their slightly wobbly balance sheet. I emphasise entirely with Plastics Capital paying a basically non-existent dividend. They are a consolidator, they are small, and they have growth opportunities – they’re also in manufacturing, so it’s logical that growth requires heavy capital expenditure.

Secondly, I also worry about the use of dividend yields as a ‘one-off’ tool for assessing the level of dividends. Dividend yields are inappropriate because they factor into the equation the volatile share price – a more accurate measure, to me, would be to use the percentage of net profit that’s being paid out year on year, the payout ratio – the inverse of the dividend cover. In actuality, the accusation that many ‘high-yielders’ are paying too much in dividends could probably be levelled at many large firms. Many pay out high proportions of their earnings – it is just that, because their share price is not depressed, their dividend yields are not high.

I don’t screen for high dividend yields, but in most cases I do like it – unless I see a good reason they shouldn’t be paying one, like in a case of high debt or obvious growth opportunities they could be exploiting. Large dividends, I think, likely speed up a reconciliation with intrinsic value – since it’s difficult for a stock yielding 7% to stay that way for long if the dividend looks sustainable, for instance. A stock with the same level of earnings/assets which is not paying a dividend, I think, will take longer. That’s just a hunch, though. Time will tell if I’m right!

4 Replies to “Friday Reading”

  1. John Kingham

    Hi Lewis,

    I think I put in a couple of comments early on in that thread – didn’t realise it had grown that much now! I think your points about Tullett Prebon and Dairy Crest really get to the heart of the matter. These are two wildly different businesses with different cash needs.

    If TB were to hold on to all their cash they’d have to reinvest it into more brokers and try to expand. But what if they can’t expand that fast? Or they go sideways into something else and open a bank, or a supermarket or what?

    If they can’t profitably reinvest the money above a reasonable rate (15% says Mr Buffett) then they should give the money to me (as I own TB) and I can then reinvest it as I wish, seeing as it’s my money anyway.

    Dairycrest is exactly the opposite and I didn’t buy them recently because of that debt pile. They shouldn’t be paying any cash out because interest on that debt is eating profits already and of course the debt is a big risk.

    Sorry for repeating your points but they bare repeating!

  2. Batholemew

    Hey Lewis,

    A thought. Why is a stock that will never have a dividend worth anything?
    if you know for a fact that the stock will never pay out then what gives it any value? how is this different from buying a pebble and hoping that someone else later on will think it has more ‘intrinsic value’ later on?

    I would argue that stocks only have any value because they have the potential to pay out dividends, this is not true if you are looking to buy the whole company or control the board, but as a small investor the fact that stocks generate money has to be the key reason to hold them.

    That said most of this is academic since even a stock that does not pay dividends can pay dividends. I would agree that share buybacks are often better, as you say by owning the stock you are implicitly believing that it is valuable. However the worth of share buybacks come from the increased percentage of the companies earnings that remaining shareholders are entitled to and thus the potential dividend yield they could theoretically be given.

    • Lewis

      Thanks for the comment,

      Agree with your first paragraph. A stock that will never pay dividends is surely worthless!

      Also agree with your final paragraph, though – the point is academic. All stocks can pay dividends at some point in the future – all viable investments, anyway. The real question is whether the business can more profitably invest its money in itself – by keeping its cash flow – in exchange for giving you a larger dividend in the future. If a small cap is earning 30% return on invested capital, for instance, I don’t want a dividend now – if it can invest that money in itself to earn 30% on a bigger asset base, please do it!

      Your final paragraph makes my head hurt a little, but makes sense. At some point down the line there has to be a ‘conventional’ payout method – be it a liquidation or a dividend.

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