How Dividends Keep Companies Honest and Investors Wealthy

dividends

For all the reasons to own dividend stocks, this one might be the most important.

Dividends are taskmasters. They force management to focus on its most important function: to maximize shareholders’ long-term wealth.

This concept of dividend-as-taskmaster came to my attention a few years ago after reading a series of published lectures by the great value investor Benjamin Graham. Graham noted the tendency for companies to accumulate equity capital instead of paying dividends. This, in turn, lead to lower returns on invested capital.

When capital accumulates, management gets sloppy. Discipline wanes and focus shifts to empire-building and away from maximizing return on each dollar invested.

It can’t be any other way. Money is a good, and like all goods it has a diminishing marginal utility. This means the next dollar received is perceived as less valuable than the previous dollar. Concurrently, the next investment project will likely be of lower value than the previous project.

I’m sure you understand the conundrum: the more dollars there are, the more dollars that will chase lower-return investments.

We see this value-destroying paradigm at work repeatedly in the mergers-and-acquisitions market.  An influential 1999 study by KPMG found that 83% of mergers and acquisitions among large companies failed to increase shareholder value. Money that should have gone to shareholders as dividends was squandered instead.

Most investors view the world differently. They assume most companies – growth companies in particular – continually reinvest retained earnings at a high rate. Therefore, dividends equate to low growth and lower returns, while retained earnings equate to high growth and high returns.

Life frequently works to the contrary. A study published by Robert Arnott and Clifford Asness, titled “Surprise! Higher Dividends = Higher Earnings Growth,” for the Financial Analysts Journal found future earnings growth was higher when current dividend payout ratios were high and lower when payout ratios were lows.

This makes sense when viewed from Graham’s perspective, which is predicated on the reality that management frequently destroys wealth, not compounds it. It also makes sense from an economic perspective.  If you have a proven record of creating value, capital will always be available at favorable rates. There is no need to hoard cash and deprive investors of a vital component of overall return – dividends.

High Yield Wealth recommendation Icahn Enterprises LP (NYSE: IEP) amplifies my point. The company pays nearly all its earnings to its investors. It yields over 5% as I write. Since it was first recommended in July, it has returned nearly 60% to the High Yield Wealth portfolio. Though Icahn Enterprises retains little of its earnings, it’s able to continually raise capital at favorable rates because of its proven ability to generate value for its investors.

Hoarding excessive cash diminishes company value over time; foregoing dividends deprives investors of an important source of wealth-generating return. From the end of 1929 through 2011, reinvested dividends provided almost half of the S&P 500 Index’s total return, or a 9.4% annualized return versus a 5.2% return for price appreciation alone.

So three cheers for dividends and quality dividend-paying stocks. You have to appreciate a policy that keeps management focused on allocating capital efficiently and enables you to maximize investment returns at the same time.

Published by Wyatt Investment Research at