We’ve been writing a lot about income, and recently I updated some analysis on the importance of investing in growth stocks rather than yield stocks because, over the long run, the pursuit of growth actually produces a better yield. Let me put forward some more reasons why you’re usually better off avoiding the siren call of high-dividend paying stocks.

To be fair, I like receiving my dividend cheques. Occasionally, I find one in the mail (rather than notification of an electronically transferred dividend) and it’s gratifying to separate the cheque from the letter along that perforated line. Of course, one takes particular delight in those that are especially large in comparison to the price paid originally for the shares.

So, it almost seems churlish of me to hold a view about dividends that would take the fun of opening those innocuous, white, windowed envelopes that used to arrive in the letter box and are now notifications of e-payments.

As much as I like receiving dividends, I struggle to accept them. Perhaps I dislike the tax structure that forces companies to behave irrationally, paying dividends when they ought to reinvest.

When a company’s revenues exceed the cost of generating them, a profit accrues. Owners of the business share in those profits through the payment of dividends. The board decides what proportion of the profit will be paid out, and this should be done with regard to the future maintenance and growth requirements of the business rather than their own personal financial requirements.

Of course, it’s not always that way. For example, when a single investor or founder owns a material stake in a listed company, especially if they are of a certain age, you can be pretty sure large dividends will be forthcoming. 

Additionally, after-tax profits produce a credit against the dividends, known as franking, and while these have no value to the company, they have enormous value to Australian shareholders.

The investment community focuses on these outflows, but in doing so, it often misses one important thing: the inflows, that is, the amount of money that was invested into the business to maintain it and its revenues.

And looking at these inflows changes everything.

By way of example, suppose you own a business that generates a 45 per cent return on the money you have invested (shareholder capital) and left (retained earnings) in the business. Given the returns available elsewhere, for example, 4.25 per cent in a two-year term deposit, where would you prefer to invest your money?

Suppose I send you a prospectus for an investment in a business with a reasonable certainty and track record of generating 45 per cent per year. Would you not take your funds out of the term deposit and invest it here? Sure, there are greater risks associated with owning a business, but doesn’t a ten-fold increase in the return compensate for that?

If, as Efficient Market academics suggest, investors are rational and profit-motivated, they should all be transferring funds out of the term deposit and into the business.

But, the reality is their funds go in the opposite direction! Investors demand the business pay them dividends so that they can put them in a term deposit! Crazy!

I am deeply sorry to all the Efficient Market academics out there because investors are not rational, nor it seems, purely profit motivated.

Why are dividends paid?

So why do investors demand dividends, and why do boards pay them if there is a reasonable certainty of very high returns from retaining the profits in the company?

Let me start by saying too much money is not a bad problem to have. No doubt airlines globally would love this problem, but fortunately, it’s one they’ll never have to worry about.

Dividends are paid or not paid for a host of reasons, but generally, they fall into one legitimate category and two illegitimate categories.

The legitimate category is that profits cannot continue to be retained and expected to generate high rates of return. In this situation, the company and its board are doing the right thing in handing the profits back to shareholders. This is certainly preferred to making an ill-advised acquisition – something BHP and RIO, for example, were fond of years ago, but have since seen the light of.

The first of the illegitimate categories is the payment of dividends to create the impression of being a “good” company. I cannot tell you how many times I have heard someone sing a company’s praises by saying, “but it pays a good dividend.”  I remember investors waxing lyrical about Telstra in 2005 when its dividend yield was an “attractive” 3.91 per cent and its dividend 32 cents per share. It was praised again in 2013 for its dividend yield of 6.25 per cent, despite its dividend of just 28 cents per share, lower than eight years earlier. And it’s probably being praised by some today for its yield of 4.11 per cent on a dividend per share of just 17 cents.

It would also not be hard to find a listed company in this country that had engaged in price promotion – paying dividends they could ill-afford only to replace the funds dispensed with either debt or equity via dilutionary capital raisings. When such a revolving door of capital is in operation, it’s time to head for the exits because when profits are inappropriately retained, so are the executives.

The other illegitimate reason is ignorance. When management fails to understand that retaining profits at low rates of return on equity destroys shareholder wealth, their intelligence does not run as deep as their mediocrity or, worse, their arrogance.

As shareholders, we may not always be rational, but we aren’t blind. The corporate track record in this country when it comes to salaries and ill-fated acquisitions has caused many investors to prefer the certain dollar in the hand rather than the uncertain two in the bush.

Profits have been retained to pay unjustified salaries, make nonsensical acquisitions, or maintain businesses that if not for their commercial aspirations, might otherwise be known as sheltered workshops. With a history like this fresh in the mind of investors, is it any wonder they want the dividend cheque thanks?

But importantly, it is true that if there is a good prospect for a high return on equity, more value is created for shareholders if capital is retained rather than paid out as dividends. If, however, low returns are expected, then the profits should not be retained and, arguably, neither should shares in the company.