Dividends are an important criterion for investors who want a consistent recurring income stream; to profit from their investments without selling. They represent the distribution of corporate profits to shareholders. The larger and more established companies with greater predictable profits are often the better dividend payers. Paying dividends allows companies to share their profits with shareholders, thanking shareholders for their ongoing support via higher returns and encouraging them to continue holding the stocks for more dividends. Shareholders need not sell their shares to receive cash from their investments.
On the other hand, startups and other growth companies, such as those in the technology or biotech sectors, do not offer dividends. They are still focused on growth and re-investing their cash back to grow their business.
Bottom line: What are we investing in?
Investing > Dividends
We invest based on the quality of the companies and their earning potential — their ability to widen their competitive moat and grow. Dividends are one plausible outcome from their quality execution.
Some investors are myopic to focus just on dividends. It can lead them to neglect their evaluation of (a) the competitiveness and financial position of these dividend-paying companies and/or (b) high-quality with growth potential companies that offer high share price appreciation potential.
There are disruptions, innovation, competition and liberalisation of sectors happening:
- Online shopping has been affecting retailers and shopping malls. Some went on to create their logistics and new logistics service providers; challenging traditional postal service and courier service delivery.
- Companies implementing hybrid work arrangements affect office space providers.
- Electronic communication channels (emails, WhatsApp, Zoom, etc.) disrupt postal companies and telcos.
- Ride-hailing services affect taxi businesses.
- Airbnb affects hotels.
- Online news channels, blogs and social media affect newspapers.
- Netflix and YouTube affect national broadcasters and cinemas.
- Liberalisation of the sectors (telcos, banks, insurance companies, stockbrokers) as governments issue more licenses and welcome foreign companies’ participation to compete and provide consumers with better quality service.
The market cycles of products and services are getting shorter. The operating environment becomes less predictable, less stable and more competitive. Investors cannot assume that the companies’ moats are unassailable and that dividend yields and their payouts are assured.
Dividends ≠ Good
No dividends ≠ No good
Companies issue dividends when they have sufficient profits to cover operating expenses, debt payments and other obligations. Consistent and increasing dividends are viewed positively as a sign of strength that the management is confident about future earnings growth. It makes the company more attractive to investors, which helps to drive the stock price higher. It creates a clientele effect as it will attract income investors. Dividends can be addictive. Dividend cuts (when the companies are not doing well with poor cash flow) can easily cause their share prices to plummet.
Many well-established companies paid dividends when they were in strong market leadership positions (General Electric, Ford, General Motors, Intel). However, despite their deteriorating competitiveness, they continue to pay dividends (albeit lower). Some (such as BP as shown in the Exhibit below) are paying with future cash flow; believing they will get better. In other instances, some management continues to pay dividends because they are the business owners with sizable shareholding (not because of the financial ability of the companies). Over time, they were unable to sustain their dividend policy. The results can be:
- A sliding share price and a declining dividend yield because of a poor-quality business
- Asking for monies through rights issues taking back the dividends they have been giving (and maybe more) and placements; diluting existing shareholding
- Increasing its debts and reducing dividends as they need to pay for the rising interest expenses
Session 24: Dividend Closure and First Steps on Valuation
On the other hand, young startups, challenging the status quo, compete aggressively to out-win the incumbents with their capital and cash flows. The shareholders investing in these companies do not expect dividends as they want them to keep growing—for example, Tesla versus Ford and General Motors. Dividends become a handicap for the incumbents against the young growth companies.
| Tesla | General Motors | Ford | |
| Revenue growth for 2022 | 51% | 23% | 15% |
| Operating margin | 16% | 6% | 4% |
| FCF margin | 9% | -3% | 4% |
| ROIC | 24% | 6% | 4% |
| Dividend yield | – | 0.81% | 10% |
Beware of dividend traps
A dividend trap is a stock that pays a (high) dividend yield but does so at the expense of its long-term health. These companies are often in decline, and they may be using the dividend to attract investors while masking their problems. The financial health is not able to sustain the dividend payouts over the long term.
Profits ≠ Dividends
As discussed earlier, companies do hoard cash as they want to reinvest to grow, a buffer for rainy days and the right opportunities for acquisitions. When a company pays a dividend, it has less capital to reinvest. Dividends are leakage; an expensive luxury for shareholders. The company could have grown faster and better by having more capital and not declaring dividends. Hence, when the company keeps (a) growing revenue and free cash flow and (b) can reinvest that money at a high rate consistently (high ROIC above its WACC) over a long period, it can grow much faster. We have to trust the companies that they can maximise returns with the cash position for shareholders and keep growing. Many companies have been growing very well; multi-baggers and they give little or no dividends.
Refer to the last section below on why Berkshire Hathaway does not give dividends and its approach to capital allocation.
2 components of dividend stocks: Dividend growth stocks
Great dividend growth stocks are those that:
- They can keep growing consistently (albeit slowly).
- They are cash-generating machines. They have a strong moat. They can generate very good free cash flows and they do not need all the money generated to operate and invest for growth. With the excess cash, they can afford to give and increase dividends and occasionally, special dividends.
It is a difficult feat to do both. Only the best can do it.
Total shareholder returns = Capital gains (i.e. rising share price) + Dividends (i.e. rising dividend per share)
A consistent dividend payout is only as strong as the business that supports it.
Very few companies can do both consistently over a long period especially when the operating environment is competitive, evolving and difficult to predict. These companies tend to value higher with low dividend yields and high price-to-earnings ratios (based on current trading prices).
We have to focus beyond their ability to churn out dividends to their growth capabilities as well as ROIC for their ability to generate profit from invested capital.
Investing criteria of companies that give and increase dividends consistently
| 1. Operating in stable and established sectors | The companies can grow consistently for a long time. |
| 2. Strong moats | Examples: strong brands, monopolistic powers (utilities, stock exchanges, supermarkets), and high-quality assets (high-traffic shopping malls, prime location commercial buildings). |
| 3. Steady revenue and earnings growth | The revenue and income growth are consistent and their margins remain stable. Erratic revenue growth and fluctuating earnings are not good. |
| 4. Cash machines | Through their revenue and earnings growth and low reinvestment requirements, the businesses are capable of generating good free cash flow yield consistently. |
| 5. Consistently high historical ROIC/ROCE | A high historical ROIC/ROCE are indicator of well-run companies that are generating strong profits relative to their invested capital. They suggest that the companies have competitive advantages and effective management. |
| 6. Supportive dividend policy | The companies are interested in giving dividends. |
| 7. History of dividends increase | It is a good sign if the company can keep increasing its dividend per share. |
Stability and consistency over a long period are important criteria within each criterion. They are important hallmarks of high-quality companies to be able to grow, give and increase dividends consistently over the long period.
Note: The companies can have debts. The businesses have to be robust enough to generate good returns from their debts in different operating environments (high interest rates, economic downturns). The debt position is manageable and will not threaten its competitiveness. Do take note of their ROIC/ROCE on how efficiently they use debts and equity to generate returns.
An illustration
| Coca-Cola | McDonald’s | Starbucks | Visa | |
| Capital gains | 68.9% | 187.3% | 256.3% | 434.8% |
| Average dividend yield | 3.9% | 4.6% | 4.3% | 2.2% |
| Dividend yield dividends collected in 2013 with the share price on 2 January 2013 | 2.97% | 3.4% | 1.6% | 0.89% |
| Dividend yield dividends collected in 2022 with the share price on 2 January 2013 | 4.6% | 6.2% | 7.2% | 4.1% |
| DPS CAGR | 5.38% | 11.1% | 13.6% | 18.3% |
| Total Shareholder Returns (TSR) | 108.15% | 233.24% | 299% | 456.9% |
| TSR CAGR | 7.61% | 12.8% | 14.8% | 18.7% |
| % of dividends to TSR | 36.29% | 19.7% | 14.3% | 4.9% |
| Revenue CAGR | -0.85% | -1.51% | 9.28% | 10.89% |
| Net income CAGR | 1.06% | 1.23% | 9.02% | 11.63% |
| Return on Capital Employed (ROCE) | 17.5% | 23.5% | 26% | 31% |
The table above shows that with higher revenue and profit growth together and a higher ROCE consistently and over a long period, dividends per share can grow at a faster rate and more capital gains; delivering good total shareholder returns.
While some companies can consistently meet the above criteria with supportable dividend yield, we cannot predict their sustainability. Dividend investors may care more about their dividends, but capital gains can make up more than 60% of TSR over the long term as shown in the table above. Conversely, a not-so-good company will distribute more dividends as a percentage of its TSR because its share price does not go up or worse, goes down to the extent that its TSR is lower (a dividend trap).
Focus on high-quality companies that can give and increase dividend payout with rising share prices. Buy well, buy cheap and keep validating to hold long.
Efforts are required to learn investing and identify these great companies.
Warren Buffett and Coca-Cola
Buffett started buying Coca-Cola in 1988, not long after the Black Monday crash in 1987. Since then and together with 2 stock splits, Berkshire has 400 million shares. The cost basis is $1.299 billion. At $62.44 per share (27 July 2023), Berkshire’s investment in Coke is worth $24.98 billion. That leaves an unrealized gain of $23.68 billion on the investment.
The gains are even larger when factoring in dividends. From 1995 to 2019, it earned about $7 billion in dividends from its Coke investment. In 2022, Berkshire received $704 million in dividend income from Coca-Cola. On an original investment of $1.3 billion, that amounted to a yearly return of 54%!
Use of dividends by shareholders
There are two uses for dividends:
1. Provide recurring income to spend
The lot size is getting smaller; more brokers are offering fractional share trading. These will allow shareholders to trim their positions to spend. These can reduce the importance of dividends.
2. Re-invest the dividends for better returns
It can be re-invested into the same investment through scrip dividends or invested in other companies offering better returns. The Exhibit below shows the differences in returns with McDonald’s Corporation between dividends reinvested and dividends not reinvested. High-quality companies are worth reinvesting in as they compound our money well.
Additional consideration: Tax implications
Shareholders prefer dividends for tax reasons because they are treated as tax-free income for shareholders in many countries. Conversely, capital gains realized through the sale of a share whose price has increased are considered taxable income. Traders who look for short-term gains may also prefer getting dividend payments that offer instant tax-free gains.
Increasing share buybacks as the alternative to return cash to shareholders
Many companies opt to do share buybacks as the other way to return profits to shareholders:
- Uncertainty: Fewer companies are confident in the ability to maintain stable and predictable earnings over the long term. There is more uncertainty with globalisation (i.e. more competition) and disruptions so they do not want to promise a high dividend payout. They prefer having a lower dividend and varying share buybacks based on the share price and their financial performance.
- Tax efficiency: Buybacks can be more tax-efficient than dividends for investors. Dividend payments can attract a Dividend Distribution Tax (DDT) when companies pay to shareholders. The latter may also be taxed based on their ordinary income tax bracket.
- Undervalued share price: The company felt that the share price was undervalued. Share buybacks are more effective than dividends.
Buybacks reduce the share count and improve the earnings and dividends per share. There are situations where share prices fall after share buybacks.
Income shareholders are not interested in buybacks as they do not result in having cash distributed to shareholders; they want cash.
A significant percentage of cash return to shareholders has been through share buybacks. Globally, they represent 42% showing the evolving shift from dividends to share buybacks.
Companies like Apple are spending much more on buying back their shares than dividends while companies like AutoZone have been buying back shares that reduced their shares outstanding by 75% in 17 years.
Similar to dividends, some companies may use share buybacks as a “market signal” to show the company is undervalued and confident about the future potential. However, the share prices can go (way) below the share buybacks’ levels. We have to do our due diligence and not be misled by these market signals.
A mix of regular dividends, special dividends and share buybacks
More companies use a mix of regular dividends, special dividends and share buybacks. Regular dividends are what they think they can afford. Special dividends occur when the company has a good year and wants to reward shareholders more. This allows the company to set the expectations to the shareholders that these are special and do not come often. Share buybacks are deployed when they think their shares are undervalued.
Conclusion: Defining returns
Income investors tend to emphasise income more on dividends. It is a narrow definition of income which should include capital gains. A dollar from capital gain is just as good as a dollar from dividends.
Given the less predictability and more volatility of the business environment, it will affect how companies think of regular dividends.
| Dividends | Uncertainty makes companies cautious to pay less on their regular dividends (relative to their trading price) and may increase correlating to earnings growth. Companies prefer to pay special dividends occasionally (when times are good) and do share buybacks (when they believe the shares are undervalued) instead. |
| Capital gains | Capital gains are also less predictable. While share prices of high-quality companies will go up over time, there will be short-term volatility and we can be unsure of their long-term potential upside. |
We also have to tighten our criteria in choosing high-quality companies and we cannot buy and forget as the business environment becomes more unpredictable and business cycles get shorter. We need to ensure the high-quality companies we invest in continue to stay relevant and competitive. This is the evolving investing landscape that we may have to adapt to. However, the general principle of investing remains: Buy well, buy cheap and keep validating to hold long.
Case study: Berkshire Hathaway — Love to receive but do not give dividends
Berkshire Hathaway’s “Annual Shareholder Letter 2012” explains why it relishes the dividends we receive from most of the stocks that Berkshire owns but has not and will not pay dividends.
- A company’s management should first examine reinvestment possibilities offered by its current business – projects to become more efficient, expand territorially, extend and improve product lines or otherwise widen the economic moat separating the company from its competitors.
- Next, it is to search for acquisitions unrelated to their current businesses with a simple test: Can Berkshire effect a transaction that is likely to leave the shareholders wealthier on a per-share basis than they were before the acquisition?
- Share repurchases are sensible when its shares sell at a meaningful discount to conservatively calculated intrinsic value (undervalued). In repurchase decisions, price is all-important. Value is destroyed when purchases are made above intrinsic value. Berkshire currently defines its buyback threshold as 120% of book value.
Above are the three ways that Berkshire’s capital will be deployed instead of giving dividends. If none of the three options looks appealing now, it intends to continue to add its stockpile of cash and wait until one of the options becomes attractive.
Buffett loves dividend-paying stocks for the same reason he loves most of Berkshire’s businesses. They generate a consistent source of cash flow that Berkshire can deploy in whatever way it sees fit.
Berkshire’s desire for dividends and not giving dividends stems from its strong belief that it can generate much higher returns with cash over the long term.
Lectures by Professor Aswath Damodaran in 2023 on dividends:
Session 22: Dividends, Taxes and Trade-offs
Session 23: Dividends and Potential Dividends
Session 24: Dividend Closure and First Steps on Valuation
