Dividends, part I

I have decided to move a question from the comments section to the main blog because of its importance. Here we are talking about dividends, and thanks to Gary, who asked.

When investing in a financial asset (e.g. stock, preferred stock, bond, money market, mutual fund, etc.) there are two ways to make money: capital gains and income. Capital gains are when the value of your investment rises in value and you sell that asset for more money. So, for example, if you bought a share of stock in a business at $50 per share and the price of that stock rose to $60 per share, then your capital gain is $10 [$60 – $50 = $10]. Is that clear? The other way to make money is for the business you have invested in to pay you a portion of its profits to you in the form of a dividend.

These dividends rightfully belong to the owners of the business. However, the payment of dividends is at the discretion of the Board of Directors, who are elected by the shareholders at the company’s annual shareholders’ meeting. However, in practice, the Board responds more to the whims of the Company’s management than they do to shareholders. The reason is that for most publicly traded businesses the management team occupies the most important Board seats, including Chairperson. Also, Boards have personal contact with the managements of business, and so therefore have personal relationships. Most shareholders do not know their board on a first name basis, and the reverse is certainly true.

OK, so back to dividends. The huge advantage of dividends over capital gains is that they are cold, hard cash paid to you by a business, not some ephemeral quasi-return that exists only on paper, such as capital gains. You can only realize capital gains by selling the asset, thus losing all possibility of future return. And that may not be your long-term strategy. Unfortunately, most companies do not pay dividends. Why?

There are several predominant reasons why businesses do not pay dividends to shareholders:

• Dividends are tax inefficient
• Companies have better uses of that cash than you do

The first reason, tax inefficiency, is actually a legitimate concern, and for this reason it serves as a smokescreen excuse for the second. So what in Heaven’s Name is tax inefficiency?

Tax inefficiency comes about because when a corporation pays you a dividend, your dividend is most likely going to be taxed as income to you. The thing is that the corporation has already paid income taxes on the monies paid to you because the cash came from their profits (i.e. net income). In other words, the dividend monies are taxed twice in the end. Your only recourse to avoid paying the taxes is if the asset that paid you the dividend is housed in a tax friendly account (i.e. IRA, SEP IRA, 401 (k), etc.). Otherwise, you get the IRS whammy. Dividends are also considered tax inefficient because the tax rate on dividends is higher than that on realized capital gains.

However, I doth protest at the supposed purity of this argument. But how could I disagree with this bit of quantifiable wisdom? I disagree because most companies don’t pay much in the way of taxes anyway. Businesses, even more so than individuals, have numerous deductions that they can take that massively minimize the amount that they pay in the form of taxes. Secondly, I protest because many individuals are primarily invested in the stock market in tax favored accounts, such as company 401(k)s, and so taxation is avoided by individuals, too. Yet, most companies provide the arguments I named above as the excuse for not paying dividends and further use it as a smokescreen for the second reason named above, too.

That brings us to the second excuse given: Companies have better uses for cash than you do. This is pretty straightforward, businesses compare the assumed rates of return on the internal business projects that they would like to spend money on to what the assumed average rate of return is to the generic investor (i.e. you). Most businesses feel that their internal projects are likely to earn them 10-40%. The wide range is because high growth businesses have higher growth rate projects. In comparison, the businesses assume that you are only going to be able to take the cash paid to you from the dividend and re-invest those dollars at about 3%! I am not kidding you. Most businesses assume that you are going to stick those monies in the bank, spend the dollars, or do something that will earn you less money than they could earn if they kept the money and invested it for themselves. Quite clearly this is faulty thinking. Why? Because you can take the dividend, excess profits, that are paid out to you and invest those monies anywhere you choose to or in anything that you choose to. You could invest them in GeeWhiz WhizBang, Inc. that is growing, growING, groWING, grOWING, GONE, if you wanted to. So you see there is some arrogance to the second reason. Businesses know better than you do. They can take care of money better than you can. You should let them do it. To say nothing of the fact that there is value in just having the cash in your hand, right? After all, when it is in the Company’s hands only they have discretion, but if they pay it out to you in the form of a dividend, then you have the power of discretion and decision. To me that is very valuable in and of itself.

That is enough for now. I will return to this topic tomorrow to talk about how to tell if a business can continue to pay its dividend to you if that is your primary interest in buying shares of stock in a particular business.

Ciao for now!

Jason