Investors tend to view companies that pay dividends as boring, but reliable, stewards of shareholder capital, but there are a variety of reasons why these payouts aren't necessarily the best sign of a strong company.
Dividends and stock buybacks have been the staple demands of activist investors in the past few years as they push company managers to unlock more value for shareholders. These are often vulnerable managers who have been struggling to unlock growth. Take General Electric Co. for example, a U.S. stalwart that many fear is about to slash its dividend after falling short of third-quarter profit expectations. With a yield of 4.8 per cent, GE's dividend seems attractive, but the company has been struggling with restructuring, weakness in operations and management upheaval.
Obviously investors like dividends, especially when interest rates low. The regular payments are a way to reap reliable income from a stock portfolio without being forced to sell shares.
High corporate profits are encouraging analysts to push for the return of capital, yet the dividend yield on the S&P 500 is around 1.8 per cent, the lowest it's been since 2012.
"Dividends are as popular now as they've ever been," said private-equity investor William Thorndike in a recent podcast interview. "It's not rational behaviour."
Mr. Thorndike, the author of The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, did several years of research looking into the management habits of top chief executives and found that contrary to conventional wisdom, those who avoided dividends ultimately delivered stronger performance.
That is because dividends are not terribly tax efficient. Like short-term gains, they are taxed at the higher ordinary-income rate in the United States – and for extremely affluent taxpayers, there's an additional charge on top of that – while long-term investments are taxed at a lower rate. In Canada, dividend income does not carry the same level of taxation as in the United States, but even when dividends are grossed up and incorporate the dividend tax credit, investors still are subject to a tax in non-registered accounts.
Even if an investor holds the stock longer than one year, the quarterly dividend payment is adding to their year-end tax bill.
What Mr. Thorndike found in the eight CEOs he profiled was that they were focused on tax efficiency. He also found that these companies tended to buyback shares opportunistically, when they were trading near recent lows. Seven of the eight executives bought back 30 per cent of their company's stock during their tenures.
But apart from tax efficiency, paying out big dividends can be a sign the manager believes there isn't much to invest within the business and fewer opportunities to grow by acquiring other companies or using that cash any other way.
Many people think dividend-paying stocks are safer bets than growth stocks, which tend to be newer companies with less of a track record to evaluate. A glance at the list of 86 stocks in the S&P 500 that have a zero yield would confirm a lot of non-dividend payers are companies in the technology sector, including Facebook Inc., Advanced Micro Devices Inc. and Netflix Inc.
On the flip side, big dividend payers now include CenturyLink (12.1 per cent), Seagate Technology (6.8 per cent) and Macy's Inc. (7.8 per cent). It could be argued in all three cases that the dividend yield looks so rich because the shares have not performed as well as the broader market and their core businesses are potentially impaired.
Shunning dividends completely may not be realistic for many investors, but finding stocks that offer value and pay dividends could be a winning long-term formula. At Validea, we have developed portfolios that help investors find opportunities by screening for a variety of different fundamental criteria. Screening for low-dividend-yield stocks comes up with the following three:
Argan Inc. – This power company scores highly on several of our models, including the strategies tracking the styles of investors Peter Lynch, Joel Greenblatt and Kenneth Fisher. Its dividend yield is 1.5 per cent – lower than the average of S&P 500 companies – but the stock looks good based on many other measures.
Thor Industries Inc. – This maker of recreational vehicles scores highly on the models tracking Mr. Lynch and Mr. Fisher, as well as James O'Shaughnessy, an investor who uses quantitative analysis to find mispriced stocks. It fits Mr. O'Shaughnessy's cornerstone growth strategy, as a relatively cheap growth stock with persistently growing earnings.
Signet Jewelers Ltd. – We recently added this stock to one of our portfolios. The beaten-down retailer of diamond jewellery has been brought out to the woodshed by investors, but most of the bad news could be priced in. The model based on Ben Graham's deep-value approach scores the stock at 100 per cent. The shares have a price-to-earnings ratio of 10.6 and the yield is just shy of 2 per cent.
It's probably worth noting that one of the best investors over the past 50 years, Warren Buffett, the CEO of Berkshire Hathaway Inc., has not paid a dividend because he believes he can deploy capital better and more tax efficiently than most shareholders, even though he certainly likes to pick stocks that pay dividends.
Mr. Buffett has always said he prefers to use Berkshire's cash to buy companies or, if the stock is trading cheaply, Berkshire shares. That said, Berkshire's cash hoard is $100-billion (U.S.) and counting. At May's annual meeting of shareholders, Mr. Buffett had a huge change of heart when he suggested his mind could be changed about paying a dividend "when the time comes. And it could come reasonably soon."
John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock-screen service.