Dividends are paid by public businesses for two reasons only one of which is a

Dividends are paid by public businesses for two

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Dividends are paid by public businesses for two reasons, only one of which is a good reason. The good reason is the business has more cash than it knows what to do with. A good CEO knows that this excess cash belongs to you. The only justification he has for keeping it is if he can use it to grow the business at a rate high enough to justify keeping the money. We call this rate the ROE (Return on Equity), and you already know it’s a very important number. A good CEO will judge the performance of his team, in part, by how well the team invests owner capital. In fact, overseeing the allocation of owner capital is arguably the most important job of a CEO. One of the legitimate choices for allocating that owner capital is to give it back to the owners when the CEO can’t think of something better to do with it. (Some CEOs think “better” means they can buy a new Gulfstream jet, but when they do that without a business justification, it might be time to look for a new business to own.) The second reason is a bad reason: Some businesses set a percentage of their earnings aside as a dividend to provide the illusion of being a solid business. This common practice is driven by Mr. Market, who prefers the illusion of stability to the real thing. If the earnings fluctuate, so does the amount that can be paid as a dividend, and that makes Mr. Market nervous. Mr. Market does not want a fluctuating dividend. He wants a steady dividend that produces cash flow like a bond. If he gets that he will put a high price on it. Some CEOs, being human, respond to Mr. Market’s desire by delivering a rock-solid dividend quarter after quarter. This steadiness attracts investors, particularly retired investors who think, wrongly, that a steady dividend indicates a steady business and therefore low risk. GM has had a steady dividend for many years. They were paying a steady dividend of $0.25 per share in 2008. This is quite the magic act, considering they were completely out of cash and in the process of going bankrupt. They got the money by borrowing it, because they didn’t have
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any profits or cash flow to get it from. But in the illusion business the show must go on, so they continued to pay it. And ignorant investors continued to hold the stock because of the dividend. An eighty-four-year- old friend of mine in Jackson Hole got hit by this. Before her husband died, he told her to hold on to GM stock because of the dividend. He didn’t see the last ten years coming, and she didn’t know any better than to do what he said. She held it from the time it was in the $80s per share down to today, when it’s at $0. That loss of $80 took eight years and was offset by $13 of dividends. That’s not really that good a trade-off. Why did she hold it? Because GM had always been such a steady producer of dividends that she couldn’t believe the business was in trouble. In 2002 I took her to a friend’s birthday party and we got to talking about her investments. I told her I thought GM was in trouble and she should sell it. She didn’t believe me. She said, “But it keeps paying the dividend, so it must be doing okay.” She believed the illusion,
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  • Spring '20
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