My idea of a perfect company is one that both a) regularly invests its capital at rates far above those I can find anywhere else, and b) has opportunities to invest even more capital at similarly-high rates. It follows then that the perfect company might pay no dividends.
Why? The first reason has to do with taxes. Most people who receive dividends will have to pay taxes on those dividends. This includes those who own dividend-paying stocks through mutual funds as well as those who reinvest their dividends. And by the way, taxes on dividends are due whether an investment grows or shrinks. It is a perfectly normal occurrence for people to owe taxes during times when the value of their stocks actually goes down.
The second reason is perhaps harder to grasp, but at least equally important. Historically, the ratio of stock prices to net assets has almost always been greater than one-to-one. The average ratio over the past seventy years is two-to-one, and over the past twenty-five years is almost three-to-one. That’s three dollars of market value for every one dollar of net assets, or book value.
Now, every accountant in the world knows that a dollar dividend paid out of the corporate treasury is marked as a one dollar reduction to net assets. Dividends are, in substance, withdrawals of capital. And it is an observable fact, one that is taught in college-level finance courses, that a stock’s price actually decreases on the ex-dividend date (the first date when the right to any declared but unpaid dividend does not pass to the buyer in a sale-purchase transaction). The evidence is particularly clear when studying large dividends such as Microsoft’s special dividend in November 2004, or more recently Costco Wholesale’s $7 per share dividend in December 2012.
It is a valid question to ask whether corporate dollars might not benefit shareholders more if they are retained – that is, not paid out as dividends. Available data would suggest that one dollar retained turns into two or even three dollars of shareholder value through increased stock prices. But to answer the question properly, it is necessary to understand how the money is to be used. If invested well, earnings will rise and the stock will likewise grow.
Historically, corporations have been able to earn around 12% on average for every dollar of shareholder capital retained. 12% is a very good rate and it is no wonder shareholders have benefited nicely. In fact, most if not all of the stock market’s growth is due to earnings retention. Had American companies paid out 100% of earnings as dividends, the stock market would have shown little or no growth at all.
Dividends do, of course, serve a valid purpose for most companies. They keep management honest, serve as a stable source of income for those who need it, and provide a good method for companies to give back money to shareholders when no better use is available. Even several of the companies in my own portfolio pay dividends, so they cannot be too terrible. But for perfect companies, the best use of corporate cash might just be to hang onto it.
(The above excerpt first appeared within Joseph’s 2012 Annual Letter to Premium Members).