Dividend Policy and How to Structure Your Investment Portfolio Correctly?

As an investor you have noticed that some companies pay dividends, while others do not. Even among the companies that do pay dividends, the dividend yield vary greatly. What accounts for these differences? Is any one style of dividend payment better than others?

To answer these questions, let’s take a look at why different dividend policies exist.

Dividend Policy is a Strategic Decision – As an Investor, You Need to Understand this Intimately

Many investors prefer high dividend stocks. Some like to see a history of consistent dividends going back many years, while others want a history of consistent dividend increases. On the other hand, there are investors who do not like dividends at all, preferring the management to reinvest the profits back into the business.

Neither of these preferences are good or bad – rather how the company wishes to treat its dividend payment depends on the strategic imperative of the company at that time. As an investor, if you prefer a certain type of dividend policy, you will end up investing in a certain specific kind of company. You need to know what you are investing in, therefore it is important to understand how and why are different dividend policies set.

To begin, let’s define the term dividend policy. Dividend policy refers to the choices a company makes to

1. Pay a dividend or not to pay a dividend,
2. How much of a dividend to pay,
3. How often to pay this dividend (once a quarter is common in US, semi-annual or annual dividends are more common in other countries),
4. Should the dividend be consistent over the period or whether it will be a variable figure based on the business performance?

Dividends are Not the Only Way to Reward a Shareholder

Stock buybacks are an alternate way to return money to the shareholder. Arguably, a stock repurchase reduces the number of outstanding stock, and therefore, each share now represents a larger stake in the company. This should in theory increase the stock price and therefore the remaining shareholders will be richer.

Stock repurchases are more attractive in countries where capital gains are taxed less than a dividend income. When a stock buyback is done, a shareholder can continue to hold the stock. Therefore even if the stock price may have increased, no taxes are due. If an investor does sell the elevated stock, the profits are taxable at a lower capital gains rate.

In practice, this does not work out as intended for a simple reason that the company may choose the wrong time to complete the stock repurchase. If the company overpays for its own stock, it essentially destroys value. This capital could be better used by sending it to shareholders as cash directly in form of a dividend payment.

Finally, a company may choose to not return any capital to the shareholders. This is very likely if the company has attractive projects that it can reinvest the capital in, that is likely to generate a higher rate of return then the company’s hurdle rate. The calculation is that the reinvested capital will grow faster in the company projects, and the shareholders are better off delaying the capital return to the future.

A Growing Company May Choose to Not Pay Dividends

As long as the company is well managed and has attractive prospects, shareholders (and the management) are better off by foregoing the dividend and reinvesting it in growing the business.

If you are a dividend investor, insisting on dividends will essentially eliminate most, if not all, of the up and coming and fast growing companies from your consideration.

These companies can be very rewarding, if the business grows as expected, but do come with tremendous amount of risk as well. It is hard to be accurate in future predictions. Many things happen – new competition arrives, technology grows obsolete, regulations change, management stumbles, or perhaps the market is just not as big as the company originally thought.

By insisting on dividends, you will also give up the risk and rewards that come with buying a high growth company. However, you will in exchange gain the predictability and security of income from a steady business.

Dividends are a Sign of a Mature Business

Once a business reaches maturity in its company life-cycle, growth is hard to come by. The objective is now to defend its market share in its existing business and perhaps enter new markets to explore and incrementally add growth. A well run company at this phase of its life-cycle generates more cash than it can potentially use. This is an appropriate time for the company to pay dividends and reward the shareholders.

Most well established dividend paying companies fall into this category. They may still be growing, but no longer as rapidly as they did when they were younger. The 15% annual growth may have come down to 7% or 5%. However, because of the scale and market share, it is also difficult to displace these companies. The stock of these companies make for great long term investments with steady or growing dividend income that compensates for lower business growth. An investor can reinvest the dividends in more stock and start a compounding cycle in their portfolio.

The drawback could be the higher tax rates on dividend income. However, this can be handled by investing in dividend stocks in tax deferred accounts, or when the personal income tax rate declines (during retirement, for example).

Dividends Define the Value of the Company? Or Do They?

Dividend discount model proposes that the value of a stock is equal to the sum of its future dividends, discounted by the investor’s risk free rate.

Is this really true?

What if a stock doesn’t pay any dividend? You might say that in this case, the company will reinvest capital in future growth and eventually sometime in the future a large value will be returned back to the shareholder, in form of dividend of some sort. Therefore, the dividend discount model will work, we just need to properly estimate the future dividend, and the growth rate of the company earnings.

It makes for a great armchair argument. However, we ignore a few things when we do this.

Mature companies that pay dividends do not necessarily diminish their ability to invest in new projects. These companies generally have greater access to outside capital. For an attractive project, let’s say, acquisition of a large competitor, they can issue new stock or put together a credit syndicate to fund these projects, without impacting their dividend policy.

Young growing companies may not be able to access the market so easily or cheaply.

Other thing to remember is that value of the equity is not necessarily the full value of the business. Many companies try to maximize their earnings per share. This is done by keeping the equity low and financing most of their capital requirements with debt. This is also why we are likely to see companies that pay attractive dividends but are heavily indebted. This is not a knock on the use of debt, on the contrary, debt is often a cheaper way of financing a business and makes more sense. However, investors need to be aware of the capital structure, when they review a dividend paying company. Capital structure management is an integral part of the dividend policy, at least in the eyes of a smart investor.

Coming back to the valuation – companies are better valued using the enterprise value – not the market value. Market value just considers the stock price and number of shares outstanding. Enterprise value adds in the value of the debt funding the business, less the cash on the books. This is more representative of the value this business will fetch in the market if it were to be sold to a sophisticated investor.

Okay, So Should I Invest in Dividend Paying Companies, or Not?

This is the money question.

It depends on whether you want the security of a regular dividend or the possibility of a greater growth in the future. The security comes at a cost of increased taxes and less growth. You will have to create the compounding in your portfolio by reinvesting the dividend yourself.

I recommend that you take a portfolio approach to your investments.

Just as a mature company has many cash cow businesses and it undertakes incremental projects to keep growing funded by some of the cash generated by the cash cow businesses, you should have a good balance of dividend paying stocks and high potential reward stocks.

The high potential reward stocks tend to be growth stocks for most. These also come with high potential risk.

There is also an alternative you should consider. If you focus on undervalued dividend stocks, you could potential get all these qualities in one stock. Dividends give you the cash flow, undervaluation reduces your risk, and you are likely to be rewarded well as the stock price adjusts to reflect the value in the stock.

While undervaluation may denote a certain amount of skepticism about the company business, a good and steady dividend is a solid signal that the company generates real cash, and is therefore a good additional consideration when looking at value stocks.

This is what value investors mean when they talk about getting paid to wait. As you wait for the stock price to adjust to the value, the stock pays you a regular dividend. So the opportunity cost of the waiting is reduced.

This is as close to free lunch in investing as you can get.

References:

• Dividend Policy (Wikipedia)
• Dividend Policy decisions in private companies