Don’t Dis Dividends

Who knew dividend-paying stocks were so controversial? Some view them as a great way to generate retirement income and lower a portfolio’s risk level, while others shun such stocks as tax-inefficient and dismiss their owners as irrational.

But wherever you stand on this issue, keep a key notion in mind: At some point in their life, we need publicly traded companies to start returning cash to shareholders—or there’s a risk they’ll disappear without creating any wealth for investors over their lifetime.

In their initial, fast-growing years, companies typically don’t pay dividends. Instead, they invest any spare cash back into the company. That makes sense: If the company is growing fast, shareholders get a big bang for every buck that’s reinvested in the business.

But as companies grow larger, not only does their need to spend heavily on research, marketing, equipment and other corporate investments typically dwindle, but also the return on those investments often shrinks. What to do with the company’s spare cash? The business could use that cash to pay down debt or acquire other companies. But often, it makes sense to begin returning some of the money to shareholders.

But how? A company might start paying dividends or it could buy back its own shares. Those who disdain dividends often embrace share buybacks. Why? A dividend means a bigger tax bill for any investor who owns the stock in a regular taxable account, while a buyback only triggers a tax bill for those who want to sell.

On the other hand, companies are often terrible market timers, aggressively buying back their own shares at market peaks, as they seek to offset the issuance of stock options to the company’s executives. By contrast, a regular dividend can provide a healthy dose of discipline for senior executives, who spend corporate cash more carefully because they know that failing to pay that dividend would crush the company’s share price.

But however it happens, it’s important that companies eventually start returning cash to investors—or there’s a risk they could disappear without creating any wealth for investors over their corporate lifetime.

Take General Motors, which filed for bankruptcy in 2009. Its shares, which had traded above $90 in 2000, became essentially worthless. If GM had never returned any cash to shareholders, it might have counted as one of America’s great wealth-destruction machines. But in fact, GM ranks as the past century’s eighth greatest creator of shareholder value, according to finance professor Hendrik Bessembinder.

“GM paid more than $64 billion in dividends to its shareholders in the decades prior to its bankruptcy and also repurchased shares on multiple occasions,” writes Bessembinder. “GM common stock was one of the most successful stocks in terms of lifetime wealth creation for shareholders in aggregate, despite its ignoble ending.”

The lesson: You may not want to own dividend-paying stocks—but we should all want companies to eventually return lots of cash to shareholders, whether it’s through dividends, stock buybacks or some other means.