10/25/08

Random Thoughts on Dividend Payers vs Non Dividend Payers

These are just some random thoughts I've had recently. There are probably a few errors in my thinking below, but I still consider it worth thinking about and posting. A previous post on the subject can be found here.


Companies can be categorized in all sorts of ways, like small caps, consumer discretionary, industrials, etc. Two general categories are dividend paying companies and non-dividend paying companies. During the course of this bear market, I've been thinking about their advantages and disadvantages, and about stocks in general.

Although it is a rather plain fact, I don't think most of us usually regard shares of stock as basically pieces of paper that provide documentation of our rights as owners of a business (it's slightly more complicated, of course, but this simplification should do).

When individual investors buy shares of stock of businesses that we cannot afford to buy controlling interests in (I mean companies listed on the major exchanges, and I don't mean small businesses like the corner store), we buy pieces of paper that we hope we can sell to someone else at a later time for a higher price. This is true of both categories of companies, but less so with dividend payers. With dividend payers, you get a cash deposit into your brokerage account or a check in the mail one, two, four, or more times a year. To a certain extent, owning shares of a major stock exchange listed dividend paying company is close to owning a large or full stake in a small business. You get paid regularly for your ownership stake. While having all the same rights that come with owning a non-dividend paying company, owning shares of a dividend paying company gives us cash on a regular basis that we can use to buy other stuff.

With non-dividend paying major stock exchange listed companies, we buy only with the plan to sell our stake to someone else for a higher price at a later date. It struck me recently that with these types of stocks, we're not really getting anything "real" for our trouble. That is, we have to sell them to derive any benefits from them. Yes, we can go to shareholder meetings, contact management, etc, but most of us, by ourselves, can't really affect the course the business takes. And even if we manage to affect the course of the company's business, short of making it pay dividends or hiring us, we don't really get anything in return until we sell. Owning shares of a non-dividend paying company is like owning a painting, except we can derive aesthetic enjoyment from the painting before we sell it. If you want financial benefits, you cannot own a non-dividend paying stock forever.

Suppose I bought shares of Berkshire Hathaway (BRK-A) when Warren Buffett did, and, like him, I never sell a single one. Assuming I have no descendants and don't care about the government or charity, I'd be better off had I never bought them. Unlike a deed to a house, a non-dividend paying stock certificate doesn't amount to anything until you sell it. You can live in a house, on the other hand.

There are market booms and busts. Share prices for both dividend and non-dividend paying companies fall during market busts. Suppose company A is a solid dividend payer that will last and grow for another thousand years. Suppose company B is a solid non-dividend paying company that will last and grow for another thousand years. What advantage would you have in owning company B your entire life? Your paper net worth would be high, but without selling you wouldn't be able to do anything with that potential money (yes, you can sell calls on your shares or use them as collateral, but I consider this a part of selling because that's what these transactions can lead to).

Suppose there's a major crisis and the stock markets are closed for an extended period. You will find it exceedingly difficult to sell your shares (and likely for a much lower price) if you suddenly need the money (you'd have to find a buyer, and then either transfer your stock certificates to him or enter into a contract to do so at a later date). Company A, on the other hand, will continue sending you checks. At such a time, I'd bet potential buyers would be more interested in company A than B.

Though seemingly likelier now, an extended market closure isn't that probable. But a market bust would still hurt company B owners more than A owners. Investors typically look to the future to decide how much to pay for a company's stock. They're usually willing to pay more than the company's book value. Two common measures are share price multiples on earnings and discounted future cash flow. During good times, investors are willing to pay more for earnings and cash flows. In bad times they're often very stingy. A company can double its earnings while its stock price and share counts stay the same. The P/E ratios (forward and trailing) just contract (in this example by 50%). A company can keep increasing its earnings while potential buyers, pessimistic about the future, can be willing to pay less and less. With company B this probably means that you have to wait for investors to get more optimistic before you want to sell. With company A, it means the dividend payments you receive will probably be higher.

The stock market is to a large extent a Ponzi scheme. Future buyers have to pay more than past buyers for participation to be worthwhile. In a certain sense, it can't be sustainable. As we saw with the housing bubble, it took more and more money for homeowners to get the same percentage return (and down payments as a percentage of purchasing price kept going lower and lower). For example, buying an asset for $2,000 and selling it for $4,000 requires finding a buyer willing to pay $2,000 extra for one to get a 100% return. That buyer has to find someone, call him C, willing to pay $4,000 extra for him to get a 100% return. C has to find someone willing to pay him $8,000 extra for him to get a 100% return. It doesn't take long before some future buyer, call him Z, can't find anyone willing to pay him double what he paid. Z and, more likely than not, prior owners, have to settle for lower percentage returns. For example, let's say some buyer, F, paid $400,000 for the asset. Whereas C doubled his money when he found a buyer willing to pay $8,000 extra than C paid, if F finds a buyer willing to pay $8,000 extra, he'll only make a 2% return. F has to find someone willing to pay $40,000 extra just to get a 10% return.

Eventually, the potential returns are so low and potential losses are so high that there are no willing buyers. No asset can forever increase in value.
This makes dividend paying stocks worthier investments. While like any other asset these stocks can't go up forever, they pay you regularly. Their earnings don't have to increase indefinitely, they only have to remain stable.

What I'm taking away from all this is that non-dividend paying large cap stocks are worse investments than large cap dividend payers and small cap non-dividend payers. Small cap dividend payers are probably the best lifetime stock investments. When buying non-dividend paying companies, we take a gamble on future buyers' willingness to pay more than we do. When we buy dividend payers, we make the same gamble, but we also take into account how much we will be paid in the meantime. If a stock will pay me $x a quarter for the rest of my life, what do I care if future buyers are willing to pay less for the stock than I did (as long as $x does not decrease substantially due to inflation)?

Depending on how we distinguish investing from gambling, I think the latter approach is more worthy of being called investing than the former.

Disclosure: I don't have any positions in any securities mentioned above. It would be nice, though, to own a good number of BRK-A shares. Although if this were the case, I'd have already exchanged them for cash.