Why Dividend Investing Works

March 11, 2014

4 minute read

Why Dividend Investing Works

"The prime purpose of a business corporation is to pay dividends to its owners. A successful company is one which can pay dividends regularly and presumably increase the rate as time goes on". – Security Analysis, Graham and Dodd

To defenders of the efficient market hypothesis and "rational" markets, dividend-focused strategies can seem to be irrational and an anomaly. Some behavioral economists even chalk dividend strategies up to investor biases such as loss aversion, regret avoidance, and an inability to delay gratification.

Two articles (here and here) by the BAM Alliance's Larry Swedroe from this week summarize these criticisms quite nicely and are worth reading. (If anything, it's important to challenge your beliefs now and then by seeking contrary opinions.)

Yet somehow dividend investing works and has worked over generations and across markets, as investment adviser Tweedy, Browne shows in its papers "The High Dividend Yield Return Advantage" and "What Has Worked in Investing". I've also personally seen it work for many individual investors and in my own portfolio.

Haters gonna hate

In his 2012 letter to shareholders, Warren Buffett made a compelling case as to why Berkshire Hathaway doesn't pay a dividend. Dividend critics often point to Buffett's comments as support for their argument.

What these critics miss, however, is that Buffett was only referring to why his particular company doesn't pay dividends. Berkshire doesn't pay dividends, Buffett reasons, because he thinks he can manage the capital better than shareholders -- and most would agree with him.

Buffett certainly doesn't mind receiving dividends from his portfolio holdings, with most of his largest holdings (Coca-Cola, Exxon, Sanofi, etc.) paying very ample dividends each year. That's because he takes the dividends and reinvests them where he sees the best opportunities.

The fact is that few management teams allocate capital as effectively as Buffett does. As such, they should only have capital they need to reinvest in value-enhancing projects. All extra cash should be returned to shareholders. In addition, by having a certain amount of earnings earmarked for dividends each year, management teams need to focus on investing the remaining capital in an efficient manner.

Indeed, a 2003 article in the Financial Analysts Journal by Arnott and Asness even found a counterintuitive-but-positive relationship between earnings growth and dividend payout ratios:

The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low....Our evidence contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is consistent with anecdotal tales about managers signaling their earnings expectations through dividends or engaging, at times, in inefficient empire building.

By investing in firms that pay out a meaningful portion of earnings each year as dividends, then, investors are reducing the risk that management will mis-allocate the capital toward empire-building or value-destructive acquisitions and buybacks.

As Benjamin Graham noted in Security Analysis, "a dollar is worth more to the stockholder if paid him in dividends than when carried to surplus [by the company]." I'd much rather have some of the firm's earnings in my pocket each year than leave it all in the company's coffers. If that money is going to be subsequently misspent, I'd rather it be my own fault than someone else's.

Show me the money

Further, when you invest in a firm that doesn't pay dividends, the only cash flows you can see are the ones the company's accountants says it has. Problem is you can't actually touch any of that cash. Dividends, however, need to be paid in cash and can't be faked. At least for very long.

Firms that are able to consistently generate enough cash to commit to a dividend and are confident enough to raise their payout each year are probably doing something right. A progressive dividend policy also shows a company's shareholders that it views them as partners in its prosperity.

Finally, it may be irrational by traditional finance standards, but focusing on the income return naturally shifts attention away from the short-term price volatility that often causes investors to trade too frequently -- and usually at precisely the wrong time. If focusing on dividends helps investors bear through difficult markets when they would have made emotional trading decisions and racked up high transaction costs in the process, well, I don't see much wrong with that.

Don't get me wrong, total return (capital gains plus income growth) should be the primary long-term objective, but if you can consistently identify quality firms that can grow their payouts each year and buy them at a good-to-fair price, the capital gains should take care of themselves.

Bottom line

You won't find this in any finance textbooks, but dividend investing works precisely because it encourages investors to think like investors -- that is, focus on buying good companies (poorly-run companies can't sustain high dividend growth for very long) at good-to-fair prices and hold them patiently.

Sure, you could do the same with a strategy that doesn't include dividend-paying stocks and sell partial stakes to generate "dividends" as needed. That's much easier said than done, of course, as it requires nerves of steel and a high level of trust that the companies are allocating your capital better than you can.

Dividend investors may indeed be irrational, but I'm content being the irrational guy patiently letting my dividends roll in from well-run companies that I bought at a good price.

What do you think? Please let me know in the comments section below.

Good reads this week

Paul Scott's daily UK small cap report (I highly recommend this - and it's free) - Paul Scott via Stockopedia
An interview with behavioral investing expert Michael Mauboussin - Motley Fool
Tim Cook doesn't care about "Bloody IRR" - Aswath Damodaran
Millennials and the new death of equities - A Wealth of Common Sense
Charlie Munger on governance - 1 Raindrop

Quote of the week