For years, I have been investing for dividends.
I pick stocks that are profitable and invest in them for recurring dividends.
Over time, as their profits increase, so does my dividend income.
Receiving dividends is always a nice feeling.
So much so that I see only the positive (and no negative) on dividends.
Recently, my perception on dividends had evolved marginally.
That arises as I reflect upon Buffett’s writings on dividends in his annual letter 2012.
It was a masterpiece that discusses when dividends are appropriate and when they are not.
So here, I’ll summarise my reflections on his writings and list down investing lessons from it.
The Basis to Determine the Sensibility of Dividends
Imagine there is a stock (business) known as A Co.
A Co has a solid track record of earning profits – in cash – consistently.
In its latest year, A Co generated $50 million in cash profits.
So, how much dividends should A Co pay out from its cash profits?
From Buffett, the answer lies in A Co’s ability to reinvest its cash profits to grow future profits.
Can A Co turn $50 million into an amount greater than $50 million?
If yes, A Co should retain the $50 million for reinvestment.
Otherwise, A Co should return the $50 million to investors in the form of dividends.
So, the question is – “What options A Co can choose to reinvest profits for greater profits?”
In general, there are three main options as follow:
Option 1: Capital Expenditures (CAPEX)
Can A Co reinvest its $50 million into expanding its current businesses?
Can it strengthen its economic moat by becoming more efficient, expand geographically, lift its market share, increase its product and service lines and so on and so forth?
Can it widening the gap between itself (if it is a market leader) versus its closest peers?
These are CAPEX.
According to Buffett, A Co should first prioritise its allocation of the $50 million into CAPEX.
Option 2: Business Acquisitions
Let’s say A Co only requires $10 million for CAPEX.
That leaves A Co with $40 million to utilise.
The next option that A Co could consider is to acquire businesses.
These businesses can be either strategic to its current businesses or unrelated at all.
Strategic acquisitions could result in the following outcomes.
For instance, A Co can acquire its competitor to enhance market leadership in its industry. Also, A Co can acquire its suppliers so that it can dictate the cost, time, and quality of its supplies. As a result, it would lead to greater efficiencies for A Co. Plus, A Co can acquire its distributors and retailers to dictate its sales channel. Such acquisitions would lead to better margins for A Co.
Unrelated acquisitions are common among diversified conglomerates.
Typically, conglomerates act like a fund or portfolio manager.
If A Co is a conglomerate with a wide business interest, its managers can invest its cash profits, either channeling them from one business to another business that requires CAPEX or to invest in a new business to further diversify its portfolio of businesses.
For Buffett, business acquisitions rank in second place in priority of capital allocation.
Option 3: Share Buybacks
Let’s say, A Co chooses to invest another $10 million into business acquisitions.
Now, that leaves A Co with $30 million to utilise.
The next option to consider is to buy back its own shares in the stock market.
This requires A Co’s managers to first know the intrinsic value of its own shares.
Assuming that A Co has an intrinsic value of $10 a share.
The stock price of A Co is trading at $8 a share.
In this case, A Co can buy back its shares at $8 a share (20% discount from its intrinsic value).
As Buffett quoted, it’s hard to go wrong when you’re buying dollar bills for 80¢ or less.
But, what about a time when A Co’s stock price is $12 a share?
Then it makes no sense for A Co to buy back its own shares at a premium.
Finally, the Dividends
From Buffett, A Co should first consider the three options above before paying out dividends.
If A Co has excess cash and has no idea how to maximise its value, it should pay out dividends.
So, the answer to determine if dividends make sense or not lies in the following equations:
If A Co can turn $50 million into an amount >$50 million, dividends don’t make sense.
If A Co can’t turn $50 million into an amount >$50 million, dividends make sense.
In a way, this is a reflection of a stock’s ability to allocate capital.
The more places a stock can choose to reinvest profits, the less dividends it should pay out. For investors, it is ultimately a stock’s capacity to reinvest that determines its ability to further grow and compound wealth for the long-term.
