Are Dividends Always Good?

Foreword from ShareInvestor

This article “Are Dividends Always Good?” by Jason Low was first published in The Business Times on 19 May 2008 and is reproduced in this blog in its entirety.

Shareholders could be better off if excess cash could be used in other ways to enhance value, writes JASON LOW

With the bears coming out to play for the past few months, investors have increasingly been looking out for safe harbours to put their money into. Inevitably, high dividend yielding stocks readily come to mind, as investors look to them for security and the potential double rewards that it may bring – dividend income and capital gains. The question then is: Are dividends always good?

To answer the question, we probably have to understand some basics.

Dividends are usually cash paid back to the shareholders as a share of returns that the business or company made in the last financial period. The dividend yields paid out by companies vary across the different industries. The best dividends usually come from companies that create their own products.

Altria, formerly Philip Morris, famous for its world’s best selling cigarettes brand, Marlboro, was also very well known for its high dividend payments to its shareholders. A sum of US$1,000 placed in Philip Morris back in 1957, with its dividends reinvested, would have grown to almost US$4.6 million today, according to Jeremy Siegel’s 2005 book, The Future for Investors.

The good Reinvesting the dividends paid out by the companies not only enables an investor to increase his holdings but also to compound his returns.

In his book, Mr Siegel said: “Long term investors who reinvest their dividends will find that the bear markets not only are easier on their portfolio but also can enhance their wealth.”

He continued: “If the price of the stock falls more than its dividend, and this almost always happens during market decline, then the dividend yield will rise. And a higher dividend yield is a ticket to higher returns.”

Investors who reinvest their dividends and accumulate more shares during the bear markets will eventually recoup the price loss because the lower price allows them to own more shares than they would be able to buy if the stock had not declined. Consequently, the value of these extra shares will surpass the magnitude of the stock price declines, making these investors better off overall.

For example, assuming one buys Wal-Mart at US$58 per share and thereafter, during a market correction, Wal-mart shares trade lower at US$42. With the dividends being reinvested at the US$42 price, it enables the investor to accumulate almost 30 per cent more shares than he would have had the price not declined.

In the long run, if the investor consistently reinvests the dividend he receives from Wal-Mart and in the process accumulates more shares, the value of his additional shares obtained will more than make up for any stock price declines the company suffers and greatly enhance future returns when the market recovers.

Hence, dividends not only give the investors constant liquidity and cash inflow, it also protects the investor in a bear market and enhances his potential returns during market recovery, given that the investor reinvests his dividends.

The bad for large growth companies like those in technology and medical sectors, however, investors might generally not prefer to receive dividends since pursuing growth requires money and the availability of funds has a direct impact on the scale of the growth projects the company can pursue. If a company does not expect to grow and has excess money, it makes sense to pay dividends to its loyal shareholders. However, a company pursuing growth and expanding its empire will want to use the money in its coffers to continue its dominance and therefore should not be expected to pay out any dividend.

Another worthwhile place that the excess money can go to is in the repurchasing of the company’s own shares. Using earnings to buy shares instead of paying them out as dividends will reduce the number of outstanding shares of the company, thereby adding value to the remaining shares. Earnings per share will correspondingly increase and this will usually drive up share prices.

Instead of paying out its excess funds as dividends, companies may want to use them for reducing its debt. This is mainly because the company is constantly incurring interest expense on its debt. Therefore, it may serve the company’s shareholders better if the company were to reduce its debt and correspondingly lower its interest expense incurred.

Another scenario when dividends are bad news stems from the belief in a stock-market timing model called the Dividend Dip Indicator. This model recommends avoiding stocks when corporations are raising the dividends.

Consider two companies, each paid $1 dividend per share. The next year, one company leaves it unchanged while the other raises its dividend to $1.40 and then cuts the dividend back to $1 the year after. The latter company’s shareholders would seem to be better off because over the three year period, they received a higher payout than the shareholders of the former company. But in reality, the shareholders of the latter company are likely to suffer as the market in general will be likely to be taken aback by the dividend reduction and as a result, the company’s share price is likely to drop.

It is common knowledge that the management of companies only raises dividends if they are certain that they are able to sustain it in the long run and that the increase in their profits is not temporary. Consequently, the number of dividend increases tends to rise only after the economy has been in good shape for a considerable period.

Chances are that by the time the management acts on dividends, the market has already discounted the good news of the economy. And since the economy is cyclical, a good time to sell is usually when all the good news is absorbed by the market, that is, when companies raise their dividends. Thus, it is apparent that based on this counter intuitive model, dividends may sometimes be bad news for the investor.

So it’s not always good to head for dividend-yield stocks. Investors should always weigh all pros and cons before making their investment decisions.

A company pursuing growth will want to use the money in its coffers to continue its dominance and therefore should not be expected to pay out any dividend.