Dividends: Who Pays? Who Doesn’t? Who Should?

There are two great risks an equity income investor takes. One is the obvious scenario, the one all should and usually fear; the prospect of a dividend cut or omission. We know how to manage this. The other is subtle, the risk of having one’s judgment clouded by nonsensical rhetoric. To manage this one, we need, every now and then, to refresh our basic understanding of what dividends are and why they are, or are not paid.

What are Dividends?

Contrary to what the New York Times suggested on 2/13/16, dividends are not a “status symbol,” and certainly not a “battered status symbol.” They are a portion of corporate profits, more specifically, the portion paid directly to shareholders as an alternative to retaining them for reinvestment in the company’s business.

Profits sometimes go up and sometimes go down so in theory, dividends should do likewise. But as a practical matter, companies try as best they can and as often as they can to keep them on a stable or rising trend. They can usually do this thanks to the flexibility they maintain by paying out less, much less in many cases, than the entire amount of profits they earn (thus saving some “retained earnings” for distribution on the proverbial rainy day). That this doesn’t always succeed (sometimes, companies wind up having to cut or omit payouts) does not in any way diminish the reality of this investment cash stream. So contrary to New York Times-style hand wringing, this ever-present risk instead calls for mature and rational analysis of factors that associated with increased probability of adverse outcomes, much the way lenders are supposed to analyze credit (cough, cough, wink, wink).

Others, following the lead of folks like Eugene Fama and Kenneth French, see dividends as a statistical series, a set of numbers. That is an unfortunate aspect of the “physics envy” problem that tends to beset not only the social sciences but finance too. This has lulled some into going so far as to suggest dividends actually damage corporate wealth (if you can figure out the logic, good luck) and that their validity should turn on the efficacy (alpha) of a naïve higher-is-better strategy. That’s false. Investors are not in the business of validating simplistic numerical factor sorts. For income seekers, higher yield is better only when we limit consideration to a pre-qualified universe consisting of stocks for which analysis leads one to believe the risk of cut or omission is modest.

The quant ideas are well and good – if you’re writing a grad-school paper. In the real world, however, they distract us from the less-than-gloriously-mathematical reality that dividends are a share of corporate wealth, again, the share withdrawn from (as opposed to reinvested back into) the business.

Good Dividends versus Bad Dividends