Is There Danger In Dividends

Recently, a friend of mine, Leo, was discussing his portfolio. He said he only invests in companies paying dividends and asked what I thought.

On the surface, the question is simple. A dividend is a “cash bonus” shareholders receive from company’s sharing part of their profits. That certainly sounds good. However, like many things in the world of finance it requires additional thought.

Regardless of the industry, the job of every business leader is to make optimal decisions. As such, they are the Chief Capital Allocator. Any business leader must assess cash flowing through a business and determine what to do with the profits.

A capital allocator can pay a dividend, buy back their own stock or pay down debt. They can reinvest into internal operations or use profits to make strategic acquisitions. Or they can keep profits in cash reserves as a buffer or to invest in future opportunities.

As I discussed those options, Leo realized there is more than he had considered. However, he said, “Isn’t it true that dividends are paid by more stable companies?”

Sometimes this is the case. However, a more mature company has trade-offs.

Before a company pays a dividend, it must earn a profit. This is hard enough as capitalism is brutally competitive. After earnings fall to the bottom line, they must pay income tax at the corporate rate. In the U.S., this is usually 21%.

If it pays a dividend, then the shareholder pays tax a second time. And then you must find a worthy investment. As such, it bears taxation and reinvestment risks.

But it also signals something about future growth prospects of the business. If a business pays dividends, they are effectively telling the world the growth opportunities for reinvesting profits back into the company are not as good as they once were.

Yes, it may be more mature and stable. But it comes at a cost of slower growth.

I elaborated to Leo that a dividend is a loss of capital to a business. It is a defacto partial liquidation. Why would you conduct a partial liquidation if you had strong growth opportunities in front of you?

Some people, most notably Warren Buffett have built a cash war chest of $350 billion inside of Berkshire Hathaway. He is patiently waiting for opportunities to deploy capital. Therein lies the dilemma. Buffett is looking out decades, while most investors can’t look out 12 months.

That’s not to say that dividend paying stocks can’t be profitable. However, you must buy them cheap enough to offset the tax inefficiencies and the drag associated with slowing growth of a company or an entire industry.

More curious, Leo said, “Is this true of companies always paying the same or higher dividends each year?” Again, it depends.

Large tech companies like Microsoft and Apple manage strong growth and pay dividends. But simply looking at the dividend is not enough.

Take for instance AT&T. For years this was considered a “set it and forget it” company. However, innovation meant phone companies no longer had a monopoly. This led to more efficient wireless competitors. Now, rarely do people have a “landline.”

Despite this change in the competitive landscape, AT&T prided itself on paying fat dividends. From 2010 through 2021 AT&T paid a dividend that increased every year. However, many of those years it didn’t earn enough to cover the dividend payout.

As I said this Leo asked, “If they didn’t earn enough to fund the dividend, how did it get paid?” Great question. AT&T kept loading up on debt. During this time frame, AT&T nearly tripled their long-term debt.

Not only wasn’t AT&T covering the dividend, they paid it with borrowed money. In the process, AT&T became a risky asset to own.

All investors must understand if dividends are the top priority, management is telling you they lack opportunities to produce sizable returns from internal operations. Quite possibly, they are in a very competitive industry such as oil and gas, tobacco or coal.

As the chief capital allocator of your own finances, do you want to invest in a stagnant industry? Capital allocation is about opportunity cost. Does management truly understand capital allocation? Running a successful business is about return on capital, and not just the return of capital.

Dave Sather is a CERTIFIED FINANCIAL PLANNER and the CEO of the Sather Financial Group, a fee-only strategic planning and investment management firm.