Skip to Content
US Videos

In Defense of Dividends

Though dividend-payers won't shoot to the moon, they can compound a lot of value and wealth for investors over time without the wild ride.

Mentioned: , ,

Jeremy Glaser: For, I'm Jeremy Glaser.

Not everyone loves dividends quite as much as Morningstar DividendInvestor editor Josh Peters. We're here with him today to see why he likes them and why some detractors are wrong.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: So, Andy Kessler had a quote few years ago, where we said that, "Dividends are just a bribe to get you interested in slow growing companies that can't be bothered to reinvest their earnings in something useful."

Josh, why do you think he is wrong?

Peters: Well, I actually like to pull out a different quote. I think Mr. Kessler is a very witty guy, a very good writer. He can certainly turn a phrase, but if I want real investment wisdom, then I think I am going perhaps turn the pages of Graham and Dodd.

So, I have my own quote I'd like to read. This is from Security Analysis, considered the original tome of fundamental security analysis, appropriately titled enough.

"The prime purpose of a business corporation is to pay dividends to its owners."

Certainly, those are two competing visions on exactly what stocks are supposed to do, what companies are supposed to do with their earnings, but I really have to ask the question, if you own a share of stock, and you put money into the company or you've given money to buy an existing share from somebody who long ago put money into the company, doesn't that share of stock have to give you some money back in order to justify its worth at some point?

Glaser: But isn't the point that he is trying make is that instead of returning that money to shareholders, they should be reinvesting it, they should be finding things to do with that money to increase the value of their shares over time?

Peters: Well, there are two answers to that question. One is still, you have to have a terminal value somewhere. A fantastic company--let's say Google, take that as an example, it certainly developed an amazing business in online search. They may not pay a dividend today, may not pay one tomorrow, may never have paid one, but in order for that share of stock, literally that stock certificate, to have some real value, eventually it's going to have to provide cash return in some way. If it's not a dividend, could it be somebody comes along and buys them for cash? They are a pretty big company to be swallowed that way. Will they liquidate? Well, if they liquidated, and just paid out whatever their resources were at the end of the business, that's probably not going to wind up be very profitable. So, at some point there has to be that dividend component to the company story in order to establish real financial value for the share of stock.

The second point is, companies can only reinvest so much, and Apple and Google are examples of this, piling up cash. In the case of Google, plowing money back into all sorts of businesses that are unrelated to its original search business, and you kind of wonder, are these really creating value? Does it create value for Apple to be sitting on tens of billions of dollars in cash that probably will never have a profitable way to spend and enlarge the company and generate that much more cash as a result? Or would it be better for that cash to actually be given back to shareholders, since Apple, all they need to do in order to grow is just invent new products--that means hire some smart people, give them some office space. All the manufacturing is done overseas, anyway. I think those are kind of companies that actually could grow, could expand, could create new products, employ new people and pay big dividends. Why they don't I think is really just a matter of bias that, like Mr. Kessler's, I don't think really has much basis in fact.

Glaser: But certainly sounds like, a lot of fast growing companies don't pay dividends, so investors certainly see a lot of dividend paying names as ones that might be a little bit slower, that aren't going to have those kind of eye-popping returns you might get from a young company that's still really innovating.

 How do you know that if you're buying an income-paying stock you're not going to be stuck with a turkey in the total return department?

Peters: The matter is that turkeys are everywhere, but I like to think--and I think that the actual historic record bears this out pretty well over time--Yes, it's true that smaller companies tend not pay dividends. If they pay them, they tend to be very, very small--yields often 1% or less, not really a big piece of the total return, but what people buy those stocks for is growth, growth, growth.

Well, a new business doesn't have an established track record, doesn't have well connected customers or employees necessarily. It could be that it's going to fail. A lot of new businesses fails. A lot of companies that even get to the point of going public turn out not to be successes in the long run, and if that businesses crashes and burns then the shareholders loose whatever they put into it.

When you do find those companies that have made the decision that we're grown up, we're mature, we're comfortable with our competitive position, comfortable with our financial security, now we can start paying generous dividends, 3%, 4%, 5% to shareholders, that's generally a much tighter range of potential outcomes.

Take the regulated utility industry, bankruptcy is very, very rare. I mean utilities almost have to go out of their way to mess up in order to land in bankruptcy or have to slash their dividends to zero or something like that. They're not going to go to the moon, either, but if you can earn 8%, 9%, 10% a year, 3%, 4%, 5% dividend yield, 3%, 4%, 5% type of growth, those can build a lot of value, a lot of wealth for you, a lot of income for you over time compounded without those wild rides and without the high failure rates.

So, that's actually one thing that I think is a plus. If every company out there paid a dividend, the signal that you get from having a nice dividend might not be as strong. As it is, when you see a Procter & Gamble or somebody like that paying a yield over 3%, intuitively you know they should be a pretty steady business. A dividend like that tells you that that's going to be a big component of how they make return for shareholders.

Glaser: So investors should be wary of companies that don't pay dividends in general, or they should just give it a little bit of extra scrutiny before jumping in there?

Peters: I think it's fair to say that you should be wary. You should ask yourself very carefully what it is that you're expecting to get--because the company could grow its earnings, but the market might not reward that with the higher P/E. The P/E might contract, the stock might go nowhere. A company without an investor base that is used to getting a reliable dividend check, all they've got is just the capital gains chase. A big earnings miss, or even a small earnings miss, you could get hit pretty hard. That kind of framework is just a very different kind of investing that I think doesn't lend itself well to reaching long-term real world portfolio goals.

So, I would say that nobody has to own a stock that doesn't pay a dividend. There is no must-own stocks out there like that. And if you look at the stock that doesn't pay a divided, you might want to just ask yourself, why or why not? Why aren't they paying a dividend? When would they pay a dividend? Where does the cash come from on the share that I am buying to justify the amount of cash I am spending to acquire it?

Stocks that pay more meaningful dividends, you may not have that problem, you don't have that logical issue to work out, and you can actually, again, in the case of a Procter & Gamble or something like that, you can look at that record of seeing that cash continue to grow being paid on that share. That gives you a much better sense that there is a lot of value there and that it should continue to increase over time.

Glaser: Josh, thanks for your thoughts today.

Peters: Thanks, Jeremy

Glaser: For Morningstar, I am Jeremy Glaser.

Jeremy Glaser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.