The buzz term for investing nowadays seem to be income investing as evidence by the increasing popularity of terms such as Dividend Aristocrat and Dividend King. In fact, there is a part of me that now thinks many investors associate good companies with steady dividends. Just check out websites such as simplysafedividends.com by Brian Bollinger.
Dividend stocks are amazing. For one, they provide a steady stream of income. It is even better in countries like Singapore where dividends are not taxed, unlike countries like the USA.
However, there is a case to be made for greater investor discretion when it comes to investing in dividend stocks. There is even a case to be made for more people investing in companies that pays $0.00 dividends – companies such as Warren Buffet’s Berkshire Hathaway and John Malone’s Liberty group of companies. If you were to have a look at my portfolio, I guess you can say I am biased!
But first, let’s talk about why people invest in companies that pays out dividends. I see two main reasons for this.
- Dividends are an important marker of company quality. Companies that pays out dividends are usually companies that are able to generate stable cash flow. Think about companies such as Coca Cola, Wells Fargo and IBM. They are all fantastic companies with strong capacity to generate cash.
- A good dividend policy indicates and ensures Capital Discipline within the company. By retuning capital to its investors, management is able to ensure judicious us of capital generated from daily operations.
Point 1 explains why dividend stocks are favourites of investors, especially for those near retirement. The strong ability of companies such as Coca Cola to generate cash indicates an intrinsic strength (moat) that allows companies to tide through difficult times, and all the while providing investors with steady income.
Point 1 is fairly simple to understand. However, I find Point 2 more interesting. A good dividend policy indicates capital discipline. But what does it mean to have a good dividend policy? Are there instances where no dividend policy is a good dividend policy? Of course there is!
As point 2 asserts, dividend payout is an indicator of capital discipline. A company should only retain as much earnings as is sufficient for its investment needs. Companies with too much capital on hand will lead to inefficient use of capital. Occasionally, we will end up with a company that spends too much money on random projects with limited accountability (like Google for example although they are improving). This happens when the company runs out of further opportunities to invest in its own business. When this happens, investors will be better off when the companies returns capital in the form of dividends. (Companies can also return capital through share buybacks but that’s another story.)
There is a big problem with dividend payouts though. With the returned capital, investors are now stuck with a reinvestment decision. Of course they can use the returned capital to supplement their income, but if they want to reinvest the money, the responsibility of finding new investment opportunities is now back in their hands. So much for passive income!
This leads me to my next and final point.
There are rare occasions when you have an excellent capital allocator as a company CEO. These CEOs have a knack for spotting excellent opportunities to deploy capital generated by their companies. When you have such a CEO at the helm of the company, investors can and are better off if they are relieved of capital re-allocation decisions. With a CEO that has a strong track of good capital allocation decisions, investors are much better off with a zero dividend policy. You can trust that the CEO will do a much better job than you at reinvesting the money generated by the company’s operations. In his 2012 letter to shareholders, Warren Buffet wrote a segment explaining this in greater detail.
You know whats better? Such companies are apparently rare and extremely precious gems in the investing realm. In his book, the Outsiders (I am doing a book review on it), Thorndike discovered that such CEOs generated the best returns for their investors. Warren Buffett stands out as among the best of this elite group of CEOs.
This perspective has influenced my investment decisions tremendously. Over the past year, I have begun to favour companies ran by CEOs that have strong capital allocation track records and modified my portfolio allocation accordingly. I have since allocated 35% of my portfolio to comprise Warren Buffett’s Berkshire Hathaway and another 35% to John Malone’s Liberty group of companies. Both are top notch CEOs with strong track records of capital allocation.
In case you haven’t realised, I belong to the group of investors who would rather do without reinvestment decisions. It is not easy, and neither is it my full time job, to find new investment ideas to put the returned capital to good use. Hence, as much as possible, I rather have someone make those decisions on my behalf. This led to my preference to invest in companies with low dividend payout ratio, favouring instead companies with a CEO that has a strong track record of capital allocation (Neither Buffett nor Malone’s companies distribute cash dividends). This way, I don’t have to worry about reinvestment decisions, or in other terms new ideas to make my money work.
At the end of the day, people have different objectives for their investments and dividend stocks do meet the needs of certain investors. However, with the great fanfare for dividend stocks today, I thought it might be helpful to share a slightly different perspective on investing here. Hopefully, you will find this sharing helpful.