I read a great article recently titled “Dividends: The Good, The Bad and the Ugly” by Joe Magyer from the The Motley Fool group and it makes for interesting reading.
Every investor in the world (especially Australia) loves receiving dividends, but Magyer’s article questions if paying dividends is always the best strategy for a listed company that you own shares in. Below I will share with you some of Magyer’s thoughts.
Dividends are an immediate cash payback on your investment which you can use however you wish. You can use the cash from your dividends for your own spending purposes, invest in other areas or re-invest into the same investment. During bear markets, dividends can at least provide the investor with some ongoing compensation. Australian investors can also benefit from the franking credits attached to fully franked dividends.
Australian investors place a high importance on companies which pay a strong fully franked dividend and for many of these shareholders, the regular dividends are their main source of their disposable income.
Paying out large percentages of profits to shareholders as dividends may result in companies missing out on reinvestment opportunities. Keeping the cash in the company, rather than paying it out may assist in making a company stronger, creating a monopoly position, developing new & existing products, expanding into new markets and investing in technology.
A great example of this is Warren Buffett’s investment company Berkshire Hathaway, which is listed on the New York Stock Exchange. In 49 years this company has paid out only one dividend. Because of this fact, millions of investors have steered away from purchasing shares in Berkshire Hathaway.
This has proved to be a terrible investment decision as the company has grown in value at a whopping 19.7% per annum in a 49 year period. That is a gross return of 693,518% (that’s right!!). When you compare this to the S&P500 over the same period, including dividends, the gross return has been 9,841%.
If Buffett had paid out his profits each year as dividends, the returns to shareholders would have been much lower.
So if a company is boosting its dividend payout ratio, this may not always be a good sign. It may actually mean they are running out of growth options.
This example usually stems from the strategy where a company continues to payout dividends to investors, whilst at the same time trying to raise new equity to fund growth opportunities. The costs involved with raising new equity are significant with lawyers, investment bankers and stock brokers/investment houses each taking a chunk.
A recent example of this questionable strategy is ASX Limited which paid out $313 million in ordinary dividends in 2013 and then raised $546 million in new equity. In many cases it may make more sense to just not pay a dividend (or reduce a dividend) to keep the cash within the company.
In summary, just remember, there are a number of factors you should be looking at when you are choosing a company to invest in. Dividends are just one (not the only one) so don’t get tempted without looking at the whole picture.