Investors Should Be More Suspicious of Dividends

As a general rule, I avoid companies that pay large dividends. I do this because in the best case, it is a sign from management that investing its cash back in the business will not yield a solid rate of return. That is, management would rather give the cash to shareholders than invest it to grow the business. In the worst case, management will raise dividends even when that cash could yield a good return on reinvestment, or is needed to pay down debt.

There are always exceptions to this rule, but it is a good starting point when getting a first look at a dividend paying company. For those that do not regard dividends with suspicion, there is the problem of understanding risks. To many investors, dividends are seen as a sign of stability and strength in the business. While that may have been true historically, that is not so true today.

The world’s largest insurance company, AIG, nearly went out of business in 2008. Thanks to the derivative mess, in nine months, AIG lost more money than it made in the previous 20 years combined. Oddly, during this meltdown, AIG raised its dividend payout three times. In a year that wiped away two decades of profits, AIG paid its shareholders $2.1 billion in dividends. It wasn’t until the company was taken over by the U.S. Treasury that dividends finally stopped, by congressional order. “We are being asked why we raised the dividend,” former CEO Martin Sullivan said during a conference call in May 2008, after reporting a record loss. “The answer is that the dividend increase is a reflection of … management’s long-term view of the strength of the company’s business.”

AIG is a particularly egregious example, but this kind of thinking is fairly common among today’s CEOs. Many companies will cut vital spending, or borrow, before cutting dividends. Since 2003, S&P 500 companies have raised their quarterly dividends 2,854 times, cut them 168 times, and stopped paying them just 46 times, according to Standard & Poor’s. Forty-one S&P 500 companies raised their quarterly dividends this past January and one company cut its dividend.

This behavior is unique to present day America. Deutsche Bank published a recent report asking global CEOs their thoughts on dividends. Most managers from Europe, Asia, and South America took a pragmatic approach to dividends: they were willing to adjust payouts to reflect earnings. American managers, however, responded that cutting a dividend should be avoided. The researchers wrote: “After cutting deferrable investment, North American firms would borrow money to pay the dividend, as long as they do not lose their credit rating. Next, they would sell assets at fair value and cut strategic investment. Only if all these actions are insufficient, would they resort to a dividend cut.” That is a dire assessment of management behavior.

This dividend at all costs phenomenon is relatively new. Historically, dividends were volatile, and would rise and fall with the company’s cash generation. Yale economist Robert Shiller’s database of historical stock returns shows that from 18070 through 1920, aggregate dividends fell in more than one-third of all months. From 1920 to 1950, dividends were cut in 23% of all months. Since 1980, they’ve declined in less than 10% of all months.

Historically, with these large dividend paying companies, the priority was investing back in the company, then paying down debt, and then dividends. Today, these companies prioritize dividends (and stock buybacks), then reinvestment, and then paying down debt.

This reprioritization causes two problems. First, it likely makes overall dividend payouts lower than they would otherwise be over time. Most companies that borrow and don’t reinvest will generate less cash over time. Had AIG not spent $2.1 billion on dividends as its finances eroded, it would have been in a better position to weather the economic storm. The second problem is that it gives investors a false sense of stability, which skews the perception of risk. There was a significant amount of AIG investors who thought company finances were stable enough in 2008, because they kept receiving their dividend payments. Had AIG cut dividends as its finances deteriorated, investors may have been more attuned to the risk they had accepted. There are several theories in economics revolving around the idea that stability is actually destabilizing. That is, stability gives people a false perception of safety, which causes them to take on too much risk. A stable dividend, regardless of the underlying health of the company, fits neatly into those theories.

Stock investing is supposed to be volatile. By pretending that isn’t so, many companies create unnecessary problems for themselves and their investors.

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