Why You Should Own Dividend-Paying Stocks

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As an investor, I generally want to find long-term opportunities in companies that have a lot of potential to grow their businesses, even in the face of economic weakness. This often means investing in companies that either don’t pay dividends or that pay small dividends.

A company pays a dividend only after it has paid its creditors, its employees, and after it has made investments into improving its business. Thus in some way, in paying a dividend, a company seems to be saying, “We don’t know what to do with the money, so you take it.”

Consider, for instance, the tobacco companies. These companies have very few choices when it comes to allocating their profits. There aren’t many investments that they can make with them unless they want to buy and sell existing brands from one another. They are also generally fairly limited in their marketing due to regulations forbidding it.

Tobacco companies therefore have a lot of profits that they cannot reinvest into their businesses that end up going to shareholders in the form of dividends. This in itself suggests to me that tobacco companies have very little opportunity to expand their businesses through capital investment, and it makes them less appealing than a company such as Amazon (NASDAQ:AMZN), which is finding so many opportunities to expand and improve its business that it uses all of its profits to do so.

This sort of thinking has led me to limit the dividend-paying stocks in my portfolio to just a handful. But at the same time, I do reserve a place in my portfolio for companies that pay dividends, and in particular, companies that are raising their dividends consistently. Here’s why.

First, paying dividends keeps a company honest. Companies can interpret their financials in all sorts of ways when determining their earnings, even if we wouldn’t necessarily think of certain things as profits.  For example, when financial companies were recovering after the financial crisis, they started reducing the size of the reserves they put aside for bad loans.

When they did that, they counted this change as “profits.” Other companies have been known to assign their pension funds a lower presumed return, which enabled them to count the difference as “profits.” While we can kind of see where these companies are coming from, we can also see that these “profits” resulted from bookkeeping games and not from successful business activities.

Dividends are less easily manipulated than profit statements. None of the aforementioned bookkeeping games gave the companies in question an enhanced ability to pay dividends. But a company that pays a dividend — or better yet, a company that raises a dividend — is more likely to have the “real” profits to back up the dividend.

Second,  by paying a dividend, a company’s management is expressing real confidence in its business. If you read company news releases or annual reports and investor presentations, you will undoubtedly find that management has a positive view of its business.

Even if things are slow, management will put a positive spin on the current operational environment. But this positive spin has more meaning if it is accompanied by a dividend announcement, especially if it is a dividend raise. It also loses meaning if it is accompanied by a dividend cut.

For instance, we can take a look at gold mining companies, which had a very rough 2012-2013. If you read through company statements, the managements for all of these companies say that they are confident in their businesses going forward — but several of them cut their dividends. Meanwhile, others such as Royal Gold (NASDAQ:RGLD) actually raised dividends by 5 percent in early 2014, after a 33 percent raise in 2013.

This observation gives me added confidence in Royal Gold’s business that I don’t have in, for instance, Agnico Eagle’s (NYSE:AEM) business. That company cut its dividend substantially, which suggests to me that there is reason to be concerned even if the company is providing positive projections.

Finally, while I don’t need dividends as a younger investor, plenty of investors do need them, and this is going to generate demand for stocks of companies that are paying dividends. An investor might not be enamored of the tobacco industry, but if s/he needs dividend income and sees that Atrial Group (NYSE:MO) is yielding 5 percent, s/he might buy the stock, especially given the relative scarcity of low-risk, high-dividend opportunities.

Given these points, I think it is prudent to own at least a couple of dividend-paying stocks in your portfolio, even if you don’t need the income. But that doesn’t mean that you should buy a stock for the sake of its dividend alone — this can be extremely dangerous.

Make sure the business is sound and that it is able to generate consistent cash flow, even in a weak economic environment. A dividend is supposed to be reflective of this ability, but you need to do your own due diligence to make sure the dividend is sustainable.

Disclosure: Ben Kramer-Miller is long Royal Gold.

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