Dividends do not make a good company – Part 1

Roger Montgomery

Montgomery Investment Management

I once relished receiving my dividend when they were sent as cheques in the mail. I liked tearing along that perforated line and took delight in those that were especially large in comparison to the price I had paid for the shares. I remember my shares in Fleetwood, whose dividend cheques were equal to 20 to 27 per cent of the investment I made. How silly of me then to ever hold a view about dividends that would cut out the fun of opening those innocuous, white, windowed envelopes that arrived the letter box twice a year.

Dividends should be the bane of your investment life. We like them and yet I struggle to accept them. But perhaps it’s the tax structure that forces companies to behave irrationally that I dislike.

When a company’s revenues exceed the cost of generating them, a profit accrues. Owners of the business share in those profits through the payment of dividends viz a vie the discretion of the board, who should have regard to the future maintenance and growth requirements of the business rather than their own personal financial requirements. Additionally, after-tax profits produce a credit against the dividends known as franking and while these have no value to the company, they have enormous value to Australian shareholders.

The investment community focuses on these outflows but in doing so it often misses one important thing – the inflows – the amount of money that was invested back into the business in order to commence and maintain it and its revenues. And, looking at these inflows changes everything.

By way of example suppose you own a business that generates a 45 per cent return on the money you have put in and left in the business. Given the returns available elsewhere, for example, 5.10 per cent in a five-year term deposit, where would you prefer to invest your money? Suppose I send you a prospectus for an investment in this business with a reasonable certainty of generating 45 per cent. Would you not take your funds out of the term deposit and invest it here?

If, as the efficient market academics suggest, investors are rational and profit motivated, they should all be transferring funds out of the term deposit and into the business. But the funds go in the opposite direction! Investors demand the business pay them dividends so they can deposit them in the term deposit! Crazy! I am sorry efficient market theory (EMT) academics, people are not rational, nor it seems, profit motivated.

So why do the investors demand dividends, and why do boards pay them if there is a reasonable certainty of very high returns? Let me start by saying too much money is not a bad problem to have. No doubt airlines globally would love this problem, but unfortunately, its one they’ll never have to worry about.

Dividends are paid for a host of reasons but generally, they fall into one legitimate category and two illegitimate categories.

The legitimate category is that profits cannot continue to be retained and expected to generate high rates of return. In this situation, the company and its board are doing the right thing in handing the profits back to shareholders. This is certainly preferred to the purchase of an ill-advised acquisition.

The first of the illegitimate categories is the payment of dividends to create the impression of being a ‘good’ company. I cannot tell you how many times I have heard someone reply to my criticism of a company with; “but it pays a good dividend”. It would not be hard to find a listed company in this country engaging in price promotion – those that pay dividends they cannot afford, only to replace the funds dispensed with either debt, or equity via dilutionary capital raisings. When such a revolving door of capital is in operation, it is time to head for the exits because when profits are inappropriately retained, so are the executives running the show.

The other illegitimate reason is ignorance. When management don’t understand that retaining profits at low rates of return on equity, destroys shareholders’ wealth, their intelligence does not run as deep as their mediocrity or, worse, their arrogance.

As shareholders, we may not always be rational, but we aren’t blind. The corporate track record in this country when it comes to board salaries and ill-fated acquisitions has caused many investors to prefer the certain dollar in the hand rather than the uncertain two in the bush. Profits have been retained to pay unjustified salaries, make nonsensical acquisitions, or maintain businesses that, if not for their commercial aspirations, might otherwise be known as sheltered workshops. With a track record like this fresh in the minds of investors, is it any wonder that they wanted the dividend cheque in the mail?

But importantly, it is true that if there is a good prospect for a high return on equity, more value is created for shareholders if capital is retained rather than paid out as a dividend. If, however, low returns are expected, then the profits should not be retained – and, arguably, neither should shares in the company.

Have a read of, Dividends do not make a good company - Part 2

Roger Montgomery
Founder and Chairman
Montgomery Investment Management

Roger Montgomery founded Montgomery Investment Management in 2010. Roger has more than three decades of experience in investing, financial markets and analysis. Roger also authored the best-selling investment book, Value.able.

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