Jason Zweig & Peter Bernstein Conversation: Why Companies Pay Dividends
Through owning shares in public stocks, investors in companies like Apple, Google, Microsoft, Walmart, etc, expect for their investments to be fruitful and multiply. There’s two ways this can happen:
Appreciation in the underlying business, which increases price per per-share
Periodic dividend (cash) payments sent to shareholders from the companies’ cashflow
But not all companies pay dividends. Some companies choose to retain and reinvest all cash, like Berkshire Hathaway (at the time of writing), while other companies make routine dividend payments to shareholder part of their DNA, like Walmart.
To Pay or Not to Pay?
Dividend policy could be represented by placing companies on idealized spectrum, with growth-oriented companies on one end and value-oriented companies on the other end.
The thinking goes that an ideal growth company, with so many lucrative investment opportunities, should plow all cash back into the the business, growing share price rapidly. Value-oriented companies, perhaps finding their cashflows outpacing favorable investment ideas, tend to return some cash to shareholders, in the form of dividends.
But why should a company pay a dividend at all, and not just plow back cash into the business?
Large businesses, no doubt lead by a world-class management, ought to be capable of generating tons of great projects for lucrative investment, growing shares in the process. Isn’t that management’s job?
Besides, if investors need cash, they could easily sell appreciated shares.
Luckily, we don’t have to figure out corporate dividend policy. We can listen to what other smart folks say about it.
In this 2004 interview between Jason Zweig and Peter Bernstein, both financial historians and educators, they talk about why corporations ought to pay dividends.
Peter Bernstein: On Companies Paying Dividends
Jason: Tell us why dividends are important.
Peter: In 1995 I said, “Dividends don’t matter.” I’ve been eating those words ever since. I assumed that reinvestments [the cash that companies put back into the business instead of paying out as dividends] would earn the same rate of return. I was wrong. Managements are more careful when they’re not floating in cash. (emphasis mine)
Dividends helps mold a culture of financial discipline for companies with more cash than high-return reinvestment opportunities, according to Peter Bernstein. Drawing on half a century on investment experience, he came to understand that businesses, on average, tend to leave shareholders worse off when cash exceeds sound business options. Mediocre projects can get funded.
And so, there comes a time, within each companies’ life-cycle, when it’s better to return cash to shareholders and let them—not management—decide what to do with the cash.
As someone who finds Peter Bernstein credible, it stands out that he publicly switched views on dividend policy, after multiple decades working in the industry. For me, this is strong indicator there’s wisdom in his updated beliefs.
Now, there’s a second point, indirectly mentioned and worth noting: finite business projects to invest in.
Regardless of how talented the management team is, there comes a time where meaningful high-return projects become tougher to constantly generate, unlike in the early days, when he company was much smaller. Most companies won’t frame the new paradigm (large size) in this way, but it’s roughly right.
While mature companies no longer possess endless streams of high rate-of-return projects, they possess large streams of cash. And capitalism demands something be done with cash—and timely.
Jason Zweig: Pn Companies Paying Dividends
Jason: Hugh Liedtke, the former CEO of Pennzoil, used to joke that he believed in the “bladder theory”: Companies pay dividends so that management can’t p–s all the money away.
Furthering Bernstein’s point, Jason recites a saying from former Pennzoil CEO, Hugh Liedtke. It seems Liedtke also understood there was a tendency for management and employees to fund weaker projects when cash was plentiful, calling it, “Bladder Theory”.
Conclusion
The interview between Zweig and Bernstein is a reminder that dividend-paying corporations, on average, tended to maintain more financial discipline than the alternative strategies (reinvesting all cash). From a 50,000’ view, it seems like dividends increase internal competition for project dollars, resulting in less funding for weaker internal investments.
Not every public company needs to pay a dividend nor should pay one, like fast growing businesses with countless great projects. Further, the decision to pay a dividend, and how much, is subject to misjudgment, which means imperfect policy decisions and execution.
Nevertheless, at some point in a productive business life-cycle, dividends demands consideration, and hopefully management gets the timing roughly right for shareholders.
Author’s Note
Keeping in mind the future is unknowable, new tax laws and a new business environment could change the way businesses look at dividends.
It seems to me that the feeling of cash abundance, creating fertile grounds for economic waste, doesn’t seem merely linked to the choice to pay dividends, but really exists as part of a broader pattern. Easy money, lacking tension, tends to lend itself to economic waste or low returns.