Everybody agrees on the taxation question, of course we prefer untaxed capital gains to taxed dividends. But high dividends can point as well to a poor capital allocation from management.
Let me explain:
At the end of the year, management has to decide what it will do with the earnings they made. They can:
- reinvest the money in the business
- distribute it as dividends
- acquire other businesses
- buy back shares
Let’s leave buybacks and M&A for the moment: the capital allocation will depend mainly on:
- the profitability of the business
- the opportunities of re-investment in the business
We can agree that the best business to own is the one that is highly profitable (ROIC >>20%) and can reinvest its earnings at the same rate in the business, year after year after year. You obtain then a compounding machine, and tax-free in Switzerland.
But obviously, not all businesses are like that! So let’s look at the possibilities:
High profitability, High reinvestment opportunities : this is the above case: the management has better opportunities than the shareholder to reinvest the money, so they should not distribute dividends, but reinvest earnings in the business
High profitability, Low reinvestment opportunities : the business is a cash printing machine but it cannot grow. That is the example of See’s Candies in Berkshire Hathaway. See’s redistributed the earnings to Berkshire Hathaway, tax-free, where Buffett could acquire afterward other outstanding businesses. It only works because Berkshire is a holding so the dividends are not taxed. For the retail shareholder, there is obviously more friction tax wise.
Low Profitability, High reinvestment opportunities: Well obviously the shareholder would not like that management reinvest the money at a low profitability in the business. So re-investing in the business is a no-no. Dividends may be an option, but other options exist as well (for instance, Buffett acquired outstanding businesses (See’s candies) with the earnings of his original very poor business (Berkshire’s textile operations).
Low Profitability, Low reinvestment opportunities : the shareholder still does not want to have the money reinvested in the business. So better pay it out as dividends. However those will be small (low profitability) and poorly growing (low reinvestment opportunities)
So now that we have made this distinction, what can we say about companies paying a big dividend?
- They might be in the second configuration, and in this case we should not expect them to grow that much. This is often the case of mature companies where growth opportunities are non-existent. So the shareholder will have dividends, but should not expect the stock to compound that much. Plus, if you are not in a holding structure, you get a lot of friction tax-wise.
- They might as well be in the last case, but in this case you have a mediocre business, which is not expected as well to grow.
Sometimes outstanding and growing businesses pay as well dividends. in my opinion this is a capital allocation error, and the company is thus handicapped by the management.
So, in a nutshell, I am not at all convinced by a retail investor chasing dividends…