The attraction of dividends 2 comments

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High-yielding stocks, in particular REITs but also including quite a number of shipping stocks such as NOL and Singapore Shipping as well as other blue chips such as SingPost and SMRT, have been in focus for almost one year now, seeing handsome capital gains in their stock price. The attraction of their high dividend payouts to investors is clear.

Some growth investors, including even GARP (Growth At a Reasonable Price) investors such as Warren Buffett, do not see dividends as being an essential part of their investment choices. Indeed, Buffett himself has said that the company should re-invest the earnings instead of paying it out as dividends (additional problem is dividend taxes) if it is able to obtain a high return on capital on the reinvested income.

That being said, I generally agree with most investors on the attraction of dividends and usually look for those companies which pay at least average dividends for their industry sector (will come to that later), and try to increase dividend payouts every year. The attraction comes not just from the dividends, but also from the mentality shown by such dividend-paying companies.

The first point, of course, is that dividends provide a tangible income on capital which investors can "see" regularly, say yearly, half-yearly or even quarterly for some companies. In fact, stock pricing models typically take the theoretical price of a stock to be the discounted sum of all future cash flows to the investor from the stock, which is of course dividends. Hence, dividends can be said to support the price of the stock.

To me, more importantly, above-average dividend payouts signal strong shareholder orientation of the company, as well as good cash flow management. The fact that minority investors get actual access (through dividends) to the earnings of the company means the majority shareholders (usually board directors) do not treat the earnings as their own honeypot which they are reluctant to share with "outsiders". Good dividends signal strong net cash flows which the company does not have to keep reinvesting to maintain earnings (the equivalent of having to run on a conveyor track to remain on the same spot). Increasing dividend payouts every year signals that cash flow continues to keep pace with earnings.

Of course, for different industry sectors the usual dividend payout is different, so one should not compare apples to oranges. For banks and telcos, payouts are usually attractive at 5% or above, their cash flow generation being strong and they being generally considered as blue-chip yield stocks. For growth stocks typically found in the technology industry, one would be lucky to find those paying higher than 3% dividend yield.

There are two things to beware. The first is when the dividend yield becomes attractive not because dividend payout rises, but because price falls. That is the wrong way for a yield stock to behave and indeed suggests the next dividend payout might well drop. Anwell comes to mind in this respect. The second is when the dividend payout is in excess of the operating cash flow; if the company has to borrow or draw from its reserves to pay dividends it suggests an unsustainable dividend policy. Yellow Pages is a good example (see my writeup on Yellow Pages).