A Dividend Polaris

Why do dividends matter?

Photo: Ashley Dace. Source: Wikipedia

Dividends have become quite popular in recent years. With interest rates so low, many income-oriented investors have used dividend-paying stocks as substitutes for bonds in their portfolios. And dividends have a lot to recommend them. They usually pay cash quarterly, they can grow with inflation, and taxable investors may owe less to the government if the dividends are qualified.

But one of the most significant advantages dividends bring is the accountability they impose on management. Dividends enjoy a special place in corporate finance. They are the one item that can’t be fudged. Earnings can be tweaked with special charges or credits; there may be legitimate issues about when to recognize sales; balance sheets don’t always balance. But dividends can be objectively verified by investors. Either the check comes, or it doesn’t.

In addition, dividends can restrain the empire-building instincts of many managers. If a company is successful, excess earnings accumulate in its bank accounts. This cash can burn a hole in corporate pockets, tempting CEOs to do something stupid—like building unproductive plants, or getting involved in expensive mergers and acquisitions, or paying for lavish office renovations. Share buybacks and dividends both return this cash to shareholders, but with one difference: buybacks reward investors who sell, while dividends reward investors who continue to hold onto their shares.

Dividends tend be sticky. A high dividend payout ratio may indicate management’s confidence in the stability and growth of the company. And growing dividends are associated with growing companies. Over the years, dividends are far less volatile than earnings. So dividends tend to be a guide-star—something stable amid shifting economic and financial variables.

Dividend Payout versus Earnings Growth. Source: Financial Analysts Journal

Just remember: dividends aren’t contractual, the way bond payments are. Equity holders have the most junior claim on earnings. Shakespeare’s Julius Caesar once declared that he was “constant as the northern star.” He said this, of course, just before he was cut down in the Capital. Investors need to be careful their capital doesn’t suffer the same fate.

Douglas R. Tengdin, CFA
Chief Investment Officer
Phone: 603-224-1350
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