Businesses should consider the objectives of their shareholders like you and me. After all, we are the owners of the business. This article explores the dividend and suggests to businesses why the dividend may no longer be the best way to reward loyal shareholders like us. An upcoming newsletter will take a deeper look at an alternative, the stock buyback.
How Investors Have Historically Used Dividend
Dividend-producing businesses have long provided a steady stream of income to their investors. Historically, investors have depended on dividend income to fund their retirement and pay their monthly bills.
Dividend production has also been a key metric for value investors. Benjamin Graham, the father of value investing, explained that when picking value stocks “each company selected should have a long record of continuous dividends.”
It’s clear that, at least historically, dividends have had a place in a business’s playbook. What’s not so clear is whether they continue to have a place there today and here’s why!
Are Dividends Still Important?
Dividends are a way that a business generates income for shareholders. In the 20th century, shareholders who benefited from dividends also dealt with high trading costs, lower taxes, slow and opaque business news, and a time-intensive trading process.
But now we have a robust internet, advanced technology (computers/smartphones), and the luxury of using discount brokers. The issues faced by the 20th-century shareholder are not the same as the issues we face in the 21st-century. And this is a key reason for the lessening importance of the dividend.
Shareholders’ lives and finances no longer have a need to be built around dividend income. Why? Because the advances in technology have provided us access to “on demand dividends.” We can buy and sell custom amounts of shares, for little to no cost, from a smartphone in the palm of our hand in a matter of seconds.
In this way, we can decide when we want our distribution and how much based on our individualized needs. We no longer need to rely upon the dividend producing stock or mutual fund to tell us how much we are getting and tell us when we are getting it.
This “on demand” dividend concept is not only a matter of increased convenience; it also helps us avoid the negative consequences associated with dividend distributions.
How Dividends Hurt Investors
Dividends, more often than not, harm shareholders’ ability to compound their investment. As an example, when dividend producing businesses are held through an ETF, the ETF is unable to immediately reinvest the business’s dividends, even if we prefer it too.
The ETF holds onto the dividend distributions in cash until the ETF’s dividend payment date. Any time our money is forced to be in cash, we are out of the market and therefore losing the potential to have our investment compound.
If the potential loss of compounding from being in cash is not harmful enough, add on the government’s take through taxes. If we are holding our shares in a taxable account, a portion of our dividend will be lost to capital gains or income tax.
We not only lose the ability to have that investment compound by paying a premature tax, but the business who distributed the dividend also lost demand for their stock. This loss of wealth to the shareholder and loss of demand to the business equally hurts both parties.
While the reality is that many businesses distribute excess cash as a dividend, this is just one option. A business sitting on extra cash can choose to buy back shares, re-invest in the business, or acquire new businesses. There is no law demanding that a business distribute a dividend; it is a choice that can be changed.
We at HIT Investments would prefer to see businesses that have a longstanding history of dividends begin to swap them out for an equivalent share buyback program. This allows the business to give back to the shareholder while eliminating all of the detrimental aspects of the dividend.
While each business’s circumstances are unique, it doesn’t hurt for a business to evaluate the reason for doing what they do. If you have a business that is just piling cash into a dividend because it’s what the business has always done, it may be beneficial for you to take a second look.
If the reasons for staying the course are still valid, keep on keeping on. If not, consider having your business make a change by using the extra cash for a share buyback program or for business expansion opportunities. Over the long run, your shareholders will reward you.