Dividends are the easiest way to return money to shareholders. This draw a big enough following that there’s a label for it – dividend investing. For investors who proudly wear that label, I’d argue you should look for companies with a different type of yield appropriately called shareholder yield.
For me, a dividend is a nice addition to a great investment not a prerequisite. If you’re searching for great companies, there’s a good chance you’ll find one that pays a dividend now or down the road, because good companies deal with the same question eventually.
What To Do With All That Cash?
Just like people, some companies are better at managing money than others. Those that do it best use the five tools below to efficiently increase shareholder value:
- Do nothing
- Reinvest it to grow the business
- Pay a dividend
- Buyback shares
- Reduce debt
No surprise, companies that best manage their money do better in the long run. The last three make up shareholder yield which involve returning that cash to shareholder. Investors only looking toward dividends need to broaden their focus toward the last three.
You can’t knock the advantages of dividends. It adds to your gains when share prices rise and offsets losses when prices fall. When reinvested, dividends compound that growth.
This adds to the psychology of seeing instant results every time that dividend date hits. Money in the bank is a big seller, but it can leave investors with the idea that if you’ve seen one dividend stock you’ve seen them all. And that is simply not the case.
Below average companies regularly cut or cancel dividend payments. Then you get hit with a double whammy, no dividends and a price drop at the news.
A well run company that pays a dividend not only makes money, it makes more than enough to pay the day-to-day bills, continue growing, keep a little on the side, and share the rest with shareholders. These same companies look beyond dividends to most efficiently boost shareholder value.
You can argue the theory of buybacks versus dividends. When combined, stock buybacks should make dividend investors happy. Buybacks naturally increase your ownership in the company. You get a bigger piece of the dividend pie. You’re dividend payout rises as more and more shares are repurchased.
There’s only one problem. The effect of a buyback strategy is not instantaneous. Patience is required on your end while you wait for the stock price to revalue. Of course, a smart investor would take advantage of that lag time to reinvest dividends and boost gains.
While dividends and buybacks don’t necessarily make a company better, (it takes cash out of the company’s hand) it does improve your returns. You could stop there with shareholder yield. Or you could look for companies improving the balance sheet too.
When dividends and buybacks aren’t the best use of capital, debt is next on the hit list. When a company pays down debt, it lowers interest costs just like when you pay more money toward your mortgage. Do it often enough and you quickly increase the equity value in your home as you pay off the mortgage, not to mention freeing up interest payments once it’s gone. When companies do it, shareholder value increases over time.
A well run company will do a combination of these. But not all companies are well run, just like not all dividend stocks are good stocks. Investors should look for these companies. Here’s why.
The table below is from Shareholder Yield: A Better Approach to Dividend Investing (recommended afternoon read) which shows the performance of the 25% highest yielding stocks for each yield type versus the S&P 500:
|Annual Returns ’82-’11|
|Debt Pay Down Yield||13.25%|
The math for finding each yield is below:
- Dividend Yield = divide the dividend payout by price
- Buyback Yield = subtract the number of repurchased shares by issued shares then divide by the total outstanding shares at beginning of the year
- Debt Pay Down Yield = divide the total amount of debt paid by market cap
- Shareholder Yield = dividend yield + buyback yield + debt pay down yield
If you’re not inclined to do the heavy lifting, there are a few specialized ETFs – PKW, SYLD, and TTFS – that do the work for you. Be aware these come with higher cost and turnover than your typical index fund.
Most investors want to get paid, but dividends aren’t the only tool a company has to return cash to shareholders. Companies that combine dividends with stock buybacks while lowering debt do better in the long run.
Of course, watch out for overzealous companies fixated on short-term thinking. Misusing cash could force a company to cut a dividend, issue shares, or take on debt to refill the coffers. Instead, focusing on companies that efficiently manage cash will pay dividends down the road.