“Why pay dividends when you can reinvest?”
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That’s what my non-dividend investing friends tell me over the years. It sounds reasonable - growth compounds, so you pour more money back into the business. Whereas dividends don't. In reality this is not always true. The thing is, not every company can reinvest every dollar it makes. At some point, some businesses only need a fixed amount of capital to grow. Past that point, that extra cash doesn’t go into deepening its economic moat or win more customers. Let’s look at Vicom. This is Singapore’s biggest vehicle inspection business. We know it's a monopoly that’s well regulated in Singapore. Vehicles need inspection each year and there’s only a fixed number of vehicle quotas on the road set by the Singapore government. Now, there’s really no point building another ten new inspection centres to keep growing. Vicom’s capex needs are fixed and predictable year after year. So what happens to the excess cash Vicom produces ? Well it doesn’t make sense to keep building new inspection centres. In my view, the next best use of its cash is either buy back its shares or distribute cash back to its shareholders. My investing principle here doesn’t change: a business exists to maximize shareholders’ value - one way or another. And dividends are still a great way to signal that. In other words, it’s only worth reinvesting more cash if there’s somewhere for that capital to go. Otherwise it’s just a drag on a company’s return on investment. Next, over the years I’ve learnt cash on the balance sheet may not be 100% valued by the stock market. I’ll explain. This is because the market knows undistributed cash has uncertainty - for example when this cash would be distributed, or whether this cash could be allocated and whether it could be wasted. Holding too much cash is never a good sign too. Again, dividends remove that uncertainty. For a company paying dividends, it forces discipline on management, making sure the company doesn’t hoard too much cash or get into unprofitable projects. My favourite lens for this is Warren Buffett's favourite indicator: the Return on Equity (ROE). Every business has a ceiling on the ROE it can generate. Pouring more money back into the business doesn’t mean it can be more capital efficient. Past a certain point, it just dilutes returns. Some businesses don't need more capital to keep growing. Vicom is one of them. Growth for growth’s sake isn’t a strategy. Sometimes, it makes sense to distribute the excess cash back to its shareholders either buying back shares or distributing as dividends. And dividends are still proof a business is a reflection of business excellence. P.S. I had the most incredible Saturday afternoon yesterday with my Diligence Wealth Club members! Sometimes, investing can be simple. Willie Keng, CFA Founder, dividendtitan.com P.P.S. Like this issue? Click HERE to join other dividend investors reading my DT Compound Letter. I send my regular letters to your inbox. |
Dividend Titan
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