Understanding Dividends: How Companies Allocate Money

When Meta recently announced that it will be paying a quarterly dividend (albeit a modest one, at $0.50 per share on a $458 stock), its stock advanced by over 20% that same day, adding ~$200 billion in market value. (While strong earnings contributed much to the gain, the dividend was also likely a significant contributing factor.) With results like these, the way corporate America allocates capital just might start to change. 

Companies have three basic options for allocating their capital: they can reinvest in the business (or acquire new businesses) to improve its prospects, buy back their own shares to make the remaining shares more valuable (in theory), or distribute the cash to shareholders as dividends, letting investors decide what to do with the money. Which option is the best depends on a variety of factors, such as the business’s future prospects and whether it is under- or overvalued in the stock market (companies repurchasing shares when their business is overvalued in the stock market is value destructive). 

Berkshire Hathaway, run by master capital allocator Warren Buffett, offers a good window on the capital allocation options available to corporate America. Buffett loves dividend-paying stocks (Berkshire’s equity portfolio will generate a projected $6 billion in dividends in the next 12 months), but at the Berkshire Hathaway 2004 annual meeting, he said (referring to buybacks) that “when a stock can be bought below a business’s value, it is probably the best use of cash.” Through the years Buffett has used Berkshire’s growing cash pile to reinvest in its own businesses and has also made enormous acquisitions of entire companies such as Burlington Northern in 2009 for $34 billion. In 2011 he also started buying back shares of Berkshire Hathaway stock for the first time in four decades. Notably, however, as much as Buffett likes receiving dividends from the companies he invests in, Berkshire itself has never paid a dividend, believing that shareholders have, and will continue to be, better off with him retaining and reinvesting Berkshire’s profits. 

Dividend-paying stocks have fallen out of vogue recently, as illustrated by just a 4% total return of the SPDR S&P 500 high Dividend ETF in 2023 versus 26% for the S&P 500 proper. Just the other day Jon Sindreu, writing for the Wall Street Journal, published an interesting article titled “Can Dividend Investing Rise from the Dead?, in which he notes that since the financial crisis, U.S. stocks with dividend yields above 5% have returned 450%, as opposed to 1,200% for companies that do not pay a dividend. (We note, however, that yields of 5% or more can signal trouble within a company; so, although a high dividend wouldn’t automatically disqualify an investment in our view, it would make us question what has gone wrong with the business to push the share price so low.) Similarly, economist Robert Schiller has noted that from the 1870s through the 1950s, dividends’ contribution to total returns averaged 80%, but for this past decade the figure was just 30%. He also notes that yields on dividend payers have decreased from 4.3% historically (time period not specified) to less than 2% for the past decade. 

Boyar’s Take:

Dividend investing deserves a place in most investors’ portfolios, but with a few caveats. Ideally, because dividends are taxed so severely for many investors, they should be bought in a tax-deferred account when possible, such as a 401(k) or an IRA.  Nor should investors purchase a stock simply for a high yield, which may portend a future dividend cut or other troubles at the business. A dividend is better viewed as a bonus for buying stock in an undervalued business that pays investors to be patient (a 3% yield, for example, is no reason to buy a stock that is 20% overvalued). In addition, investors who are considering a dividend-paying stock should also be asking whether it can increase its dividends over time—an important reflection of the business’s underlying health. 

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