An article recently appeared on Seeking Alpha arguing that dividends do not create value for shareholders and merely represent a transfer from a firm to shareholders. The argument of this article is based on the Modigliani-Miller theory of corporate finance (M&M), which states that the value of a firm in a perfect market is unaffected by how it distributes its earnings.
Hypothetically, if a stock trades at $100/share and pays a $1/share quarterly dividend, each quarter that stock will trade lower by $1 on its ex-dividend date. Furthermore, this will be exactly the same as if a hypothetical investor sold 1% of their holdings each quarter.
I do not dispute that this is true, in fact, it is important to educate investors that dividends are not a panacea for retirement. One cannot dial in 10% annual returns by buying a stock that yields 10%. However, I dispute that this means that dividends “don’t matter,” in fact discovering firms that pay sustainable and increasing dividends remains a wonderful investment strategy even though a dividend theoretically only represents your own money being paid back to you.
There are many other ways that a firm can reward shareholders, but I will argue that dividends are special due to their dependability, transparency and tax advantages. Finally, dividend investing also satisfies an important role in investor psychology. When an investor’s portfolio reaches a critical mass, dividends are more than abstractions on a balance sheet. For myself and many other successful investors, having steady dividend payments enough to cover expenses changes your mentality from one of a speculator, to a part owner of a business. I wrote a recent article about the 4% rule and using the Schwab U.S. Dividend Equity ETF (SCHD) to implement it. Dividends are not the “end-all” of stock ownership, but they are certainly important.
Reasoning by Analogy: Comparing Corporate Dividends to Personal Savings
No value is created when a company pays a dividend. Similarly, no value is created the moment that a saver deposits cash into their bank account. In both cases, a transfer of money has taken place, but the creation of value is not the instant that the cash is transferred, rather it is the process leading up to that moment.
For a saver, it is the process of earning more than you spend that creates value. No one would dispute that a self-made millionaire has created value by depositing their excess savings to a bank account every month, even though each visit to the bank did not create value. It was earning more than they spent that created value. Just like in the stock market, there are multiple ways that an individual can create value. Savings is one, but they could also pay off debt, acquire a business, improve their home or invest in the stock market. The key is that successful individuals, like successful companies, must make good capital allocation decisions to build financial wealth.
Similarly, a company’s dividend history is a record that each quarter the firm earned more than it spent and returned some of that excess to shareholders. Each dividend in isolation does not create value, but when a company is able to grow its profits year after year and prove that through its dividends, that is the hallmark of a successful business.
Many Ways for Management to Use Cash to Create Value for Shareholders
Dividends are only one way that a firm can use its excess cash to create value for shareholders. Occasionally, income investors focus on dividends to such an extent that management is dissuaded from investing in other ways, and in the extreme, this can be detrimental to returns. Other value creating investments include:
- Reinvestment in the Business (R&D or CapEx): A healthy business requires investment to remain profitable. If dividends come at the expense of R&D or CapEx, the sustainability of the business may be lowered.
- Mergers, Acquisitions and Partnerships (M&A): The firm can acquire or merge with other firms to fuel revenue growth. These can expand the firm into new marketplaces.
- Debt Reduction: The firm can use cash to pay down its debt.
- Share Buybacks: In principle, share buybacks are identical to dividends when they reduce the share-count, but are more tax efficient. In practice, shares must be sold, thus receiving a good price is essential.
- Dividends: Cash payments to shareholders reward them for their partial ownership in the business.
- Building Cash Reserves: Building a large cash balance can provide a buffer for the business and with cash yielding over 5% it can also provide a modest return.
Every one of the above can be done in a value creating or a value destroying manner. Therefore it is essential for an investor to understand how management deploys the firm’s cash in order to choose whether or not to invest.
Amazon: The CapEx Champion
Amazon (AMZN) is a champion of CapEx investment in its distribution network and Amazon Web Services. The company does not pay a dividend and throughout its history has reinvested its cash flow in the business to grow revenues. This has led over time to remarkable revenue per share growth, and over the past several years very extensive investment of above 12% of annual revenues bodes well for continued growth. Amazon is a good example of a company that has invested better in its business than returns available elsewhere. Thus, shareholders have been enriched more than if they had been paid a dividend.
Amazon is a great example of how investors should not limit themselves to judging their returns by income alone. You can miss great investments this way, even if income is a primary concern in your portfolio.
Cisco: Acquisition of Splunk Counters Tepid Growth
Cisco (CSCO) announced earlier this year that they would be acquiring Splunk. Cisco paid $28 billion for the company, a significant premium considering Splunk’s TTM revenue was $3.98 billion. While Cisco pays a dividend and repurchases shares, management choose to use substantial cash to fight against declining revenues in its core business.
Cisco is an example of a company that is cheap, but I question the returns that will be possible when management is forced to pay very high prices for acquisitions in order to plug revenue declines.
Kinder Morgan: Too Much Debt and Extended Deleveraging
Returning cash to shareholders generally is evidence of sustainable value creation, but it is important to note that this is not always the case. Take, for example, Kinder Morgan (KMI), which loaded up on too much debt to pay an overextended dividend. It is nearly ten years hence, and a painful period of deleveraging has left the dividend substantially lower than in 2015.
Kinder Morgan is a warning that investors cannot look at a dividend yield in isolation. Instead, the cost of debt and CapEx must be compared to the business’ free cash flow. Dividends are not a free lunch and while they are generally a positive for shareholders, they can be a negative if substantial debt needs to be added to pay them.
AutoZone: The Buyback Champion
AutoZone (AZO) is an example of a buyback champion that has substantially lowered its share-count over the years through scrupulous repurchases. The company currently trades on the high end of its historical P/E range, which has traded between 12x to 22x. Over the previous 10 years, AutoZone has repurchased nearly half of its shares.
While this has been a great boost to EPS growth, AutoZone has increased its long-term debt in order to repurchase shares so aggressively. Overall, earnings have grown faster, but this and the company’s high present valuation likely mean that future returns may not be as robust as those in the past.
It should be noted that while repurchases can be more tax advantaged, allowing an investor to compound gains without realizing taxable gains, there is the disadvantage that the stock must be sold to realize a gain. M&M theory posits that a perfectly efficient market will make cash removed from the balance sheet by a dividend indistinguishable from repurchases that lowers the share count. However, the valuations that stocks trade at can vary widely; thus there is some risk that realizing profits in the business may require selling at an inopportune moment.
Altria: MO Dividends No Problems
Altria (MO) is a great example of a dividend champion stock that has passed its growth years and returns its earnings to shareholders with a robust dividend. Generally, stocks with falling revenues are not great investments, but at a greater than a 9% yield recently, Altria was too cheap to ignore.
Incredibly, the dividend rally of 2017 took Altria to a 3% yield, while the growth fueled market recently brought the company into deep value territory at $40/share. As such, buying the stock just for the dividend was a poor strategy, but buying a deeply undervalued dividend paying stock can reap excellent returns.
Dividends in the Past have Predicted Strong Returns
A study by Hartford Funds has shown that dividends contribute strongly to overall returns. Over time, reinvesting dividends has provided a major component of the S&P 500’s returns.
S&P 500 With and Without Dividend Reinvestment (Hartford Funds)
Furthermore, dividend yields have correlated in a positive manner with total returns. First and second quintile stocks (those that paid in the top 40% in terms of dividend yield in the S&P500) outperformed stocks that paid the lowest in terms of dividend yield. The highest quintile stocks paid the highest dividend yield.
S&P 500 Total Returns by Dividend Quintile (Hartford Funds)
It is important to note that these were S&P 500 stocks, which are among the strongest and largest companies in the world. Thus, simply picking a high-yielding stock is not a good strategy based on this data. However, it can be argued that these stocks give greater total returns because management, through paying dividends, focused the remaining earnings of the company to generate the highest returns.
Conclusions
Thinking about dividends requires investors to consider the wisdom with which a firm reinvests its profits. If you are buying a stock and becoming a part owner in a business, these are your profits. Dividends are merely one piece of a larger puzzle, but they are the most transparent and in my opinion the lowest risk way of returning capital.
As outlined above, every manner of returning cash to shareholders presents some risk, even leaving cash on the balance sheet can encourage management to spend money poorly. Dividends do matter for total returns because ultimately decisions must be made about how to employ cash from the business.
A long and growing history of dividend payments does not represent a magical creation of value, however, it can prove that management has skillfully deployed capital over time and remains a key metric in evaluating most companies.
As shown above, Altria (MO) has used this created value primarily to pay dividends, resulting in phenomenal returns for long-term investors. AutoZone (AZO) has done the same with share repurchases, and Amazon (AMZN) has done so through aggressively reinvesting in its core business. My purpose in writing this article is to broaden the conversation and remind investors to question how the value created from their profits is being returned to them.
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