Companies Under Fire for Not Paying Dividends
Common stocks paying dividends was an idea that never really made sense, although some are now waking up to this reality more. Proponents of dividends just don’t get it though.
One of the first things you encounter when you learn about stocks is that there are two main types, common stock and preferred stock. Common stock is by far the most widely issued, and what we normally refer to when we speak of a company’s stock and its stock price.
Common stock and preferred stock serve two different purposes. Preferred stock functions more like a bond than a stock, with the goal being to realize an income stream through dividend payouts over time, like a bond pays out interest payments.
With preferred stock, you do own a piece of the company by virtue of the shares that you own, as opposed to bonds where all you own is the debt and income stream. Should the company fail, bondholders get paid off first, and then preferred shareholders, and if there is anything left, common shareholders collect, although there may not be and it can be challenging enough just to take care of the bondholders given that a bankruptcy generally involves a bond default, meaning that they can’t meet their obligations and are in real trouble just on this end of things.
Both preferred stock and common stock can pay dividends. Preferred stock needs to, as this is the reason people buy these shares, and they really don’t move up and down in price very much and this is where the money is made with this form of stock.
With common stock, the company can distribute its profits several ways, by paying out a dividend, by paying down debt, by using the profits to expand the business, to buy back their own shares, or even to just hang on to the money for future use. Given that there is a choice with common stock, we want to make the right one.
A company benefits when it increases its access to capital, provided that it is profitable, as this allows them to leverage this money to make more money down the road. This is the reason why we make capital investments, to grow our capital.
Paying dividends divests capital by paying it out. This does not serve to benefit the company’s fortunes at all, and while it is claimed to benefit shareholders, it actually harms them, and one of the ways it does is due to their being worse off just having the money handed to them rather than keeping it invested and allowing it to grow.
The idea of dividends with common stock dates back to the early days of stock investing, and it has persisted because we’ve either just took it for granted and haven’t thought about it very much.
One of the hallmarks of today’s stock market is that many companies, and some pretty big ones as well, have questioned this model and come to the correct conclusion that this is not an efficient or wise way to distribute company profits. It is clearly neither in the interest of the company or its shareholders, yet it still persists with most companies today.
The companies that don’t pay dividends have managed to set themselves up for more growth and especially more growth in their stock price, yet they come under criticism for this from those who really don’t understand the opportunity cost of dividends. While we can rightly say that shareholders are entitled to these payouts if they wish, whether they should be wishing for such a thing is left relatively unexamined.
The confusion here stems from people trying to treat common stock like it is preferred stock, and invest in common stock primary for dividends. If we want income, we need to invest in income investments such as preferred stock and bonds. Viewing common stock as an income investment or even primarily one is a big mistake.
Capital Gains are More Efficient Than Distributions and This is Not a Matter of Just Preference
The first problem that we run into is the fact that the majority of income earned by investing in common stock comes from capital gains, realized as the price of the stock rises and you sell it at a gain. Seeking to subdue these gains in favor of income will produce a lesser return, because you are taking out money out of the company, promoting divesting rather than investing, and foregoing the leverage that this money could have provided to further the company’s fortunes as well as that of their shareholders.
In addition, when we seek to invest for income with a common stock, capital gains and losses will still carry the day mostly, with capital gains being muted, and the risk of capital losses being ever present and actually increased by a company focusing on dividends.
Dividends, given that this is de-investing, puts down the value of a stock and its price going down is where the risk is. Dividends therefore hurt a stock two ways, by limiting the upside on a net basis and by also increasing the downside risk.
Dividend investors will tell you that they don’t like risk, although they willingly take on quite a bit and this tends to be well in excess of their risk appetite, which they reconcile by trying to ignore the risk involved and basically pretend that this is a preferred stock where price movement isn’t an issue. Closing our eyes and investing don’t go together so well though.
If common stocks no longer paid dividends, this would help make the process more transparent to these so-called dividend investors. Investing always needs to be understood in terms of total return, which includes any income as well as any capital gains or losses. This is the case with bonds as well, and investors often do not account for capital gains and losses or the risk that these capital losses involve even with these investments.
If a company still wants to pay dividends, in spite of this not being beneficial to either the company or its stockholders, they do have a right to do so. However, in order to make an informed decision, they need to understand that dividends distribute income to them in a less efficient manner than capital gains do, and that retained earnings promote capital gains where dividends do not and actually reduce total return.
What is curious and even annoying is how some people who mistakenly think that they understand how this all works and then try to advise companies who have chosen not to pay dividends to start paying them.
There isn’t even any sort of rationale used to support this view other than things like they could pay dividends so they should. You also read things like more people are looking for dividend stocks since yields with bonds are so low so companies should pay dividends to pander to the misunderstanding of these investors. They might want them, but whether they should or not is the real question.
Companies will stand their ground here as well as trying to educate these people, but the knowledge gap is a pretty big one and a few remarks from a CEO, however pithy, don’t seem to narrow it very much. Their investors may understand well enough but this falls short of educating the critics. The real problem is that a lot of people see dividends apart from total return and think that they can somehow focus on this and have bigger dividends make a common stock more attractive, even though that’s a completely misinformed view.
Warren Buffett and his $128 billion in cash these days has a particularly big target on his back, as people wonder why he doesn’t pay at least some of this out. This is actually an extreme case, as companies don’t have anywhere near this much cash and even a modest dividend would take up most of the profits that a typical company generates, but even in Warren’s case, it still doesn’t make sense to pay it out, any of it.
Buffett is even against share buybacks, and this part is highly questionable, but he at least has the correct view about dividends. His company has not paid a dividend since 1967. In 2012 he told investors that “our shareholders are far wealthier today than they would be if the funds we used for acquisitions had instead been devoted to share repurchases or dividends.”
How Dividends Hurt Total Return Net of Taxes in All Cases
The choice over these years would have been between putting the money in your pocket or letting Warren in his prime keep investing it for you, and the reason why you invested with him in the first place is to see this happen. If someone really wants to take some money off the table, this should be left to individual investors to decide, and Buffett tells people to sell some of his shares if that’s what they want.
Given the performance of Buffett’s stock lately, taking it all off the table may be the best move, as he should be putting a lot more of this money to work, but he does get an A for not doing something even worse and the money is at least still on board. We might have to wait for him to retire but someone eventually will wake up all these horses and get the cart moving again.
There are three negatives for investors when they collect dividends, with the first one being that if they take this money out, it can no longer be used to increase the value of their shares. The second is that by withdrawing, they are liable to declare this as taxable income now, instead of waiting. Thirdly, the tax rate that they will pay on dividend income is higher than with capital gains.
Even holding mountains of cash like Buffett has decided to do is still preferable to paying dividends even though this money earns an extremely paltry return. This doesn’t help the company, but it might down the road, but it won’t help investors to be forced into paying more taxes on their gains, which is all a dividend would do.
While this $128 billion is still on the books, it is part of the value of the stock, but once it’s paid out, it becomes removed from the equation. If he paid all this out now, Berkshire Hathaway would be worth at least $128 billion less and that would be reflected in the stock price, and the stock price would actually go down more than this amount because the current stock price does presume some benefits from this massive fund at some point.
If we pretend that dividends don’t affect a company’s stock though, it all becomes easy, as we then just decide whether we want money from heaven or not, and if we don’t get it, we become cheated by the tightwad company. This is at the crux of the misunderstanding, and if people understood enough about the pros and cons of dividends, they would change their minds.
Growth companies generally don’t pay them, and the reason that they don’t is because they’d rather use the money to grow. Even when a company is struggling to grow, or even to keep their earnings from getting smaller and smaller, with Kraft Heinz for instance, they will tend to pay dividends.
Kraft Heinz was paying 67.5 cents a quarter up until the crash of their stock, and with their profit projections looking thinner and thinner, they need to do something to get things going again. This is a case where it should be all-hands-on-deck but they instead are still choosing to pay out 40 cents a quarter, money that could be put to much better use than no use at all really other than punishing the poor souls that are still on board with greater tax liabilities, and in some cases, ones that they need to pay even though they may have suffered huge losses, like Buffett himself has.
The 40 cents a quarter represents two-thirds of the company’s profits, and they are not in a situation where they can afford to waste this much of it. Even using this to help pay down their $30 billion in debt would be preferable, as this would at least materially improve the company’s fundamentals, but if they really want to pass this through to investors directly, they could just use this extra money to take some of their stock off of the table and increase the value of the shares that people hold proportionately without requiring a distribution.
Dividends with common stock is a bad idea no matter how well or poorly your company is doing, and if there are no more growth opportunities, they can just buy back their stock, which at least captures the value of the profits in the stock price and helps the stock grow at least.
Even keeping the money in cash is better than just giving it to investors, as this retains its potential for growth and also avoids all the negative tax implications for investors. Mutual funds have no choice due to their structure, and must pay dividends every year, and this is one of the big reasons why so many are moving away from them and into ETFs.
The only valid reason to prefer a dividend is if the company is run by clowns that will do something stupid with the earnings that could have been paid out. If this is the case though, or even if we are just worried about this, we need to get out of the stock entirely, not quibble about dividends.
Dividends are just a bad idea all around with common stocks, and the last thing we should be doing is trying to persuade companies to do the wrong thing, and while this probably won’t work, this promotes more misunderstanding among readers where we should be looking to reduce it.
Editor, MarketReview.com
Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.
Contact Robert: robert@marketreview.com
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