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Are dividends making fools of investors? One former hedge fund
manager thinks so

John Heinzl on dividends
Globe Investor Magazine, May 22, 2008
Illustration by Amedeo De Palma

In volatile markets, dividends are an investor’s best friend. They put cash in your pocket. They get taxed favourably. And because many companies raise their payouts regularly, dividend income can soar over time. Who could say anything bad about dividends?

Meet Andy Kessler, a former hedge fund manager and probably the world’s most outspoken critic of dividends. He doesn’t just dislike dividends; he hates them.

Here’s why: “Dividends are just a bribe to get you interested in slow-growing companies that can’t be bothered to reinvest their earnings in something useful,” he wrote recently on his blog.

Kessler isn’t just some crank with a web page. He worked as a Wall Street tech-stock analyst before co-founding Velocity Capital Management, a Silicon Valley investment firm. Nowadays, he devotes his time to writing articles for The New York Times as well as books, including the 2004 bestseller Running Money: Hedge Fund Honchos, Monster Markets and My Hunt for the Big Score.

So what’s he got against dividends? Plenty. His main beef is that, when a company pays a dividend, it’s a tacit admission that it has no better use for the money. He’d much prefer to see a company build shareholder wealth by reinvesting the profits to expand the business or, at the very least, to buy back its own stock.

Another problem with dividends, he says, is that they lure investors into debt-heavy, mature companies whose best days are long gone. The high dividend yield looks attractive, until the company runs short of cash and chops its payout, sending the stock into the doghouse.

There’s no doubt that dividends that aren’t supported by a company’s cash flow can seduce unwary investors. Just look at all the Canadian income trusts that slashed their payouts because the companies, in their eagerness to win over investors with high yields, didn’t leave themselves any wiggle room.

But are dividends really as evil as Kessler makes out? Are they really just a “bribe” to lure investors into has-been companies? With all due respect to Kessler, we think he’s got it wrong. Far from being a sign of weakness, dividends are actually a sign of strength. When a company pays a dividend or, even better, raises its dividend, it’s a signal that management is confident about the future.

What’s more, just because a company pays a dividend doesn’t mean it can’t reinvest in itself. A lot of successful companies do both: They look after the shareholders with a cheque every quarter and, with the money left over, they look after their own internal capital needs.

We were curious to see if other investors shared Kessler’s disdain for dividends. So we got a copy of Stephen Jarislowsky’s book, The Investment Zoo, and looked for references to dividends. We found this on page 94: “I…do not believe in buying companies that do not pay attractive dividends—preferably rising dividends with rising company fortunes!”

If Stephen Jarislowsky doesn’t convince you, maybe Warren Buffett will. True, Buffett’s phenomenally successful Berkshire Hathaway doesn’t pay dividends, which would make Kessler proud. But a funny thing happens when you scan the list of publicly traded companies Berkshire invests in: Virtually all of them pay dividends. There’s Johnson & Johnson, Anheuser-Busch, American Express, Coca-Cola, Kraft, Wal-Mart.

As for the notion that companies should reinvest all their earnings instead of paying them to shareholders, Buffett doesn’t buy it. “There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return,” he wrote.

If that doesn’t convince Kessler that dividends are more than a “bribe” to investors, nothing will.

John Heinzl is an investing reporter and columnist with The Globe and Mail’s Report on Business.