No dividends may just be a good thing for investors

There are many investors who take dividends very seriously. They invest only in companies that have a good dividend history and avoid others that are not generous enough. But a high dividend payout ratio may not always be in the best interest of investors. This is an insight that is reinforced by Warren Buffett time and again.

Busting the myth
A healthy dividend payout is often lapped up by the markets. The stock gets a thumbs-up and all parties - the company and its shareholders - are happy about the outcome. But dividend largesse may not always be in favour of investors. Companies could deploy that cash into existing growth opportunities to remain competitive and in the game.

According to Buffett, a company can utilise its cash in four ways. First, it could re-invest the proceeds back into the business. Second, it could go in for an acquisition. Third, it may re-purchase shares and finally, it might pay out dividends.

Paying dividends may not always be the best option. In fact paying no dividend could even have a positive impact on the fortunes of companies like Coke. Buffett says, "If Coke had paid no dividends, and simply repurchased shares and developed the bottling system, the shareholders probably would have been even better off...And that's true for Gillette and Disney" (Berkshire Annual Meeting, 1997).

The idea of dishing out dividends no matter what is something that Munger, Buffett's partner also laments. "That (utilising cash for purposes other than dividend) is not the standard thing that's taught in the corporate finance departments of our major universities. Why do we have this simple idea and they have another one? I've tried to understand why they think the way they do, and I have great difficulties with it. I've just concluded that they're wrong," he says.

Buffett's view on dividends does not mean that he disapproves of dividends altogether. His four largest investments - Coca-Cola, Wells Fargo, IBM and American Express together bring in $1.1 billion by way of dividends! The point he makes is that dividends should not be paid out to investors when there are other very good uses the money could be put to that could help the business grow.

The test
Should a company go in for dividend distribution? Buffett says, "The test on dividends is, 'can you create more than one dollar of value with the one you retain?'...If we do that, taxable or not, they are better off if we retain money. But when the time comes that we don't think we can use money effectively, we will pay it out." (Berkshire Annual Meeting 2008).

Berkshire Hathaway is famous for not paying any dividends. Many years ago, Buffett would explain this decision at a lecture at the University of Florida Business School, "It (Berkshire) won't pay any dividends either. That is a promise I can keep. All you get with Berkshire, you stick it in your safe deposit box and then every year you go down and fondle it. You take it out and then you put it back. There is enormous psychic reward in that. Don't underestimate it."

The rationale underlying this decision is that if he can create more value with the dollar retained compared to if he distributed it as dividend, then he should retain that money.

'Berkshire won't pay any dividends either. That is a promise I can keep. All you get with Berkshire, you stick it in your safe deposit box and then every year you go down and fondle it.'

If hugely successful companies can for very good reason not pay their investors dividends, then investors too can benefit from looking for companies that are doing well and growing even if they don't pay dividends. Not being narrowly focussed on what you will get out of an investment in terms of dividend will open up far more deserving avenues for you to consider.