Sunday, March 4, 2012

High dividends not always a good thing

Mar 4, 2012

By Andy Mukherjee

Companies pay dividends for the same reason that peacocks unfurl their feathers: to get ahead in the mating game.

By handing out cash to investors at regular intervals, a company woos shareholders who may have reasons to be sceptical of its financial strength.

Like all serenades, paying out of dividends, too, has its special rules. First, a dividend should be an easy-to-remember, round number. Second, it should either rise or remain the same from year to year, but it must never be reduced. Investors dump shares of a company that cuts its dividends more quickly than they are attracted to a company that raises it.

If the chief executive officer (CEO) of a dividend-paying company ever had an honest chat with a shareholder, it might go something like this:

CEO: 'We're pleased to announce a 12-cent dividend for the full year.'

Shareholder: 'Last year, you paid 10 cents. You know what it tells me, right?'

CEO: 'Yeah, it tells you that I'm committing myself to paying you at least 12 cents next year, if not 14.'

Shareholder: 'And that means...'

CEO: 'No investing in fancy projects that could go wrong; no growing a beard, or wearing turtlenecks. I'm not here to change the world.'

Shareholder: 'Precisely. We want you to work on your golf handicap instead.'

Your eyebrows are rising in disbelief. Surely there is a more fundamental motive behind paying of dividends? There isn't. If anything, in jurisdictions where dividends are taxed but capital gains are not, there is even less of a reason for shareholders to want to receive them.

Yet, the cult of dividends exists. It has been spawned by the likes of Mr Warren Buffett and other value-investing followers of Mr Benjamin Graham because it gives them the certainty that their money is not at the disposal of a maverick.

Value investors do not like excitement. They like their companies to be like bonds with stable, predictable cash flows, a part of which is ritually distributed. Their dream chief executive is someone whose presence is irrelevant. It's in fact better if the CEO is largely absent. At least he will do no harm to the franchise, especially if the company has been successfully selling sugared soda water for 100 years or more.

Still don't believe me? Mr Gueorgui Kolev, a behavioural finance scholar, studied publicly available data on golf handicaps of CEOs in the United States. His research shows that golfing ability has no relationship with corporate performance, but it is linked to CEO pay.

'Golfers earn more than non-golfers and pay increases with golfing ability,' he writes. In other words, CEOs are paid to be out on the green - as long as they can show up once a quarter to announce a dividend.

Apple, the most valuable company on the planet, does not hand out one. That's fairly well known.

But few people remember that the maker of Macintosh computers actually did distribute regular payouts - four times a year - between 1987 and 1995. That was the period in which Apple was floundering. The board had fired Mr Steve Jobs, the founder of the company, in 1985; by the time Mr Jobs came back to run the company in 1997, it was already teetering on the verge of bankruptcy.

In his second innings, Mr Jobs did many things. He launched the iMac, iTunes, iPod, iPhone and iPad. But he did not reinstate the dividend. Did investors mind? People who bought Apple shares at the start of 1998 have earned 41 per cent a year annually since then. Show me a hedge fund that has done better.

With Mr Jobs dead, there is pressure on Mr Tim Cook, the new CEO, to unlock Apple's US$98 billion (S$123 billion) cash hoard and pay dividends. If Mr Cook caves in, he will basically be admitting that Apple is now old and boring and needs to show plumage to remain attractive to shareholders.

That's just what happened to Microsoft when it began paying dividends in 2003 - a year before rival Google's initial public offering (IPO). But to what end?

Between 1986 and 2002, Microsoft shares returned 39 per cent a year without paying out any cash to investors. Between 2003 and last month, share price appreciation gave Microsoft investors a paltry 2 per cent annually. Include the dividends that an investor took and ploughed right back into Microsoft shares, and the returns rise to a still sub-par 5 per cent a year.

Meanwhile, Google has yet to pay a cash dividend. It's trying to change the world, for instance by trying to pioneer driverless cars. Mr Buffett, who has professed his admiration for the company, does not own its shares.

When Asian companies pay too high a dividend, they are signalling their inability to participate in the economy of the world's fastest-growing region. Why do you want to own such companies?

In the final analysis, plumage is not a substitute for performance. Peahens may not know this (bird-brained as they are), but investors should.

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