Generally speaking, management and investors have a difference of opinion on what to do with the cash on the company's balance sheet.

Management wants to keep it to use for acquisitions, for growing the company, and as a buffer against bad times. Unless a company is in its early stages or in hypergrowth mode, investors usually want to get some of that cash back—particularly if the company is growing the amount of cash flow it brings in every year.

Going back to Marc Lichtenfeld's Authentic Italian Trattoria example, if you invested in my restaurant and after a few years, we're pulling in $200,000 per year in profit, you may start to get antsy and demand some kind of payout.

I, however, may have my sights set on a new location, want to knock down a wall to expand seating, or add more staff that will help turn the tables over more quickly.

At some point, I have to balance my investors' demands with my plans for growth. Of course, if you have more money than you know what to do with, it's an easier problem to solve.

Microsoft (Nasdaq: MSFT) had $86 billion in cash and short-term investments on its books against just $23 billion in debt as of June 30, 2014. So net, it has $63 billion in cash. As they used to say in the old New York Lottery commercials, “That's a lot of bread.”

Over the past three years, Microsoft has generated an average of $31 billion in cash flow from operations. Its dividend yield is 2.8%.

Despite years of huge profits and cash flow, it wasn't until 2003 that the company started paying a dividend. The $0.08 per share dividend wasn't acceptable to investors, who saw the huge stash of cash and wanted some of it returned. In 2004, with the stock price at about $24, Microsoft paid investors a dividend of $3.08 per share.

Immediately after, it went back to its $0.08 per share quarterly dividend, hiking it every year starting in 2006 to where it is now at $0.31 per share for a very respectable 14.5% compound annual growth rate.

Even still, with so much cash in the bank earning next to nothing, many shareholders believe they are entitled to some of their money back.

And thus starts one of the great arguments in investing: Who can earn a greater return on investors' money, management or shareholders?

Most management teams believe they can put the money to good use expanding their business, acquiring competitors, or buying back shares.

They contend that they can grow the money faster than an investor who receives capital back from the company.

Investors, however, argue that managements that are not making the money grow at a fast enough clip should return funds to shareholders, who can invest them in higher-growth businesses. They often feel that if management doesn't have a better use for the capital, it should give the money back to shareholders.

Buybacks versus Dividends

Rather than pay a dividend, one favorite management use of excess cash is a stock buyback—or at least the announcement of a stock buyback.

A typical buyback announcement will sound something like this:

Company X said Thursday it plans to repurchase up to $100 million or two million shares of its common stock as part of its stock repurchase authorization through December 31, 2015.

What this means is that management, at its discretion, can go into the market at any time and buy its own shares. Doing so reduces the share count and increases the earnings per share (EPS).

For example, see Table 4.1. A company that earns $20 million per year and has 20 million shares outstanding will earn $1 per share ($20 million divided by 20 million shares). If it buys back two million shares of stock, the $20 million in earnings is now divided by 18 million shares, which equals $1.11 per share.

Let's assume the stock trades at a price–earnings (P/E) ratio of 15. In the first scenario, it would trade at $15 (15 P/E × $1 EPS). In the second, if it maintained the 15 P/E after a buyback, it would trade at $16.65 (15 P/E × $1.11 EPS).

But here's why management teams love the share buyback program: Not only can it increase EPS, but the executives are also in complete control of the funds.

So if the economy turns south, there is a hiccup in the business, or executives simply want to hoard cash, they don't have to buy back any shares. All that they have announced is an authorization to repurchase stock. It doesn't mean the company has to, just that it is allowed to.

Very often, companies don't repurchase all of the stock in the plan. Then they extend the agreement when it expires. So if a company said it is authorized to buy up to $100 million worth of stock or two million shares by December 31, 2015, and it's bought only half that amount, in late 2015, it may extend the repurchase authorization to 2017 and even the amount of shares, upping it to another two million (probably knowing full well it will not purchase the entire amount). Nevertheless, the market will treat this as good news and likely give the stock a bump higher—decreasing the chance of the company actually buying back the stock, as management wants to buy its shares when they're cheap. However, will any investors complain that the stock is higher and management is not buying back shares? Probably not.

Furthermore, a buyback can be used to manipulate earnings. For example, according to Barron's, in January 2012, Jarden (NYSE: JAH) suspended its dividend to buy back $500 million worth of stock.¹ Barron's estimated that the buyback would boost earnings from $3.78 per share to $4.50.

Sounds good for the investor, right?

It does, until you take into account that Jarden's top three executives would have received huge stock grants if the company had made $4.50 per share.

So in this case, the buyback was taking money directly out of shareholders' pockets by eliminating the dividend and transferring it to management in the form of stock grants.

Over the next two years, the number of shares outstanding declined from 133 million to 115 million, a 13.5% decrease. Turns out the company never made more than $3.12 per share since the buyback was put in place. So management did not get their stock grants. Too bad.

Most buybacks aren't that sinister. But this is an example of how buybacks can be used to manipulate earnings. And keep in mind that management often receives bonuses based on EPS or EPS growth. Notice that in both the Jarden example and the earlier made-up one, the company's actual profits didn't move at all. But because there were fewer shares, the EPS rose after the buyback. It's simply an accounting trick that doesn't reflect any change in the business.

When a company pays a dividend, that's real. It's not part of an authorization plan that may or may not be executed. If a company said it's going to pay $1 per share in dividends this year, then by all means, it had better pay $1 per share in dividends—or else the stock will get crushed.

A dividend declaration is like a vote of confidence by management not only affirming that there will be enough cash to pay the dividend and run the business but also stating that it has set an expectation for a certain level of earnings and cash flow.

If it is forced to cut the dividend in the future—or, in the case of a company that has been raising the dividend year after year, to keep the dividend at the same level—the stock will be hit hard. Management knows this and recognizes that establishing or raising a dividend is akin to setting the bar at a higher level and telling shareholders that the company will at least reach that level of success.

So, management commits the company to future payouts; if it does not meet that pledge, the share price will decline.

Murali Jagannathan and Clifford P. Stephens along with Michael S. Weisbach concluded that “dividends are paid by firms with higher ‘permanent’ operating cash flows, while repurchases are used by firms with higher ‘temporary,’ non-operating cash flows.”²

This theory was backed up in 2007 by economists Bong-Soo Lee and Oliver Meng Rui, who wrote: “We find that share repurchases are associated with temporary components of earnings, whereas dividends are not.”³

So, according to the statement by Jagannathan, Stephens, and Weisbach, long-term investors should have more confidence in a company that pays dividends as it has more permanent operating cash flow than a company buying back shares, which is manipulating the share count to boost the EPS and possibly the price of the stock.

The share buyback is symbolic of many of the ills of today's market. Although some repurchases are done intelligently at bargain prices, for the most part they're a quick fix to lower the share count and create some positive news, even if the news isn't based in reality—because the company does not have to buy back the shares, it's only announcing that it may do so.

Stock buybacks, particularly with large companies, reduce the share count but may not always benefit shareholders.

Azi Ben-Rephael, Jacob Oded, and Avi Wohl, in a 2011 paper published in Review of Finance, determined that small companies often buy back shares at lower-than-average market prices. However, large companies do not, because large companies are “more interested in the disbursement of free cash.”⁴ In other words, managers of small companies attempt and succeed in repurchasing their shares at attractive prices; executives of the larger companies are more concerned with unloading excess cash and showing that they're putting it to work, under the guise of benefiting shareholders. In reality, these executives are not living up to their fiduciary duties because they are repurchasing stock at whatever the market price happens to be rather than buying back shares when they are attractively valued.

The authors concluded that when it comes to large companies, stock repurchases do not lead to better returns over the long run.

Buybacks are also used to offset employee stock option plans. If a company has 100 million shares and awards two million shares to employees (many of which go to upper management), the company may buy back two million shares to keep the outstanding shares total at 100 million. It's a way of rewarding management without diluting shareholders. When you think about it, shareholders, the owners of the company, are the ones purchasing those two million shares for the employees, so, in reality, shareholders are being diluted.

A strong dividend policy, however, is a throwback to the way our grandparents invested and ran businesses. These managers are not taking the easy way out. Instead, they commit themselves and their companies to a level of performance that its shareholders can expect year after year.

Even when times are tough, by raising dividends, management is telling shareholders they can expect an increased return every year that they own the stock.

A share buyback keeps management in control of the money. A dividend program relieves some of that control, which investors should view as a sign of capable and confident management.

Don't overlook the fact that today's management teams often own millions of shares of their companies. And while they would love for the stock price to go infinitely higher so that they can sell their shares for millions of dollars more, investors in it for the long haul also benefit from the dividend.

A CEO with one million shares of a $10 stock that pays a 4% yield receives $400,000 per year in income, which, right now, is taxed at the lower rate than his or her ordinary income rate, which is taxed significantly higher. Note that tax rates on dividends may increase at a later date. We discuss taxes in Chapter 12.

For management teams that aren't thinking about cashing out their stock anytime soon, a healthy dividend is in their best interest as well.

Critics of dividends often say companies pay a dividend because they can't come up with a better use of the money.

I disagree. There is nothing wrong with investors receiving returns on their investment every year as a reward for putting funds into a business and riding it out for the long term. Additionally, a rising dividend also instills confidence that management expects cash flows to continue to grow and puts pressure on executives to ensure that they do. You won't see many executives just punching the clock when business is tough, if they know they have to increase the amount of money they are paying out to shareholders every year.

Management Speaks

I posed this question to several executives: Why does a company adopt a policy that commits it to an ever-increasing outlay of cash in the form of dividends?

I received some interesting replies.

Scott Kingsley, the CFO of Community Bank System, Inc. (NYSE: CBU), an upstate New York bank that, as of October 2014, paid a dividend yield of 3.4% and had raised its dividend every year since 1992, said he believes the dividend keeps existing shareholders happy but also attracts new shareholders.

Regarding the idea that a company can retain capital for other uses rather than paying a dividend, he stated:

We are very “capital efficiency” conscious. We believe “hoarding” capital to potentially reinvest via an acquisition or some other use can lead to less than desirable habits. We prefer to raise incremental capital in the market when needed—and we have a track record of doing that. Having excess capital on the balance sheet when assessing a potential use can lead to bad decisions—because at that point almost everything results in improvement to ROE [return on equity]. The case in point in our industry are the overcapitalized, converted thrifts. Their ROEs are usually so low, any transaction looks like it improves that metric, but it may not add franchise value longer term.

So, according to Kingsley, not having a stash of cash forces management to be more responsible stewards of the company's assets. When a company has lots of cash on hand and makes an acquisition, it usually increases ROE since cash, particularly these days with such low interest rates, returns practically nothing.

He is saying that you can make an acquisition that looks good as far as ROE is concerned because it returns more than cash, but in reality it doesn't do much for the business.

Kingsley is absolutely right. How many boneheaded acquisitions have we seen that ultimately led a company to difficult times or even its demise?

Perhaps the most famous cash acquisition flop was the 1994 purchase of Snapple for $1.7 billion by Quaker Oats. At the time, Quaker Oats was a publicly traded company. Most on Wall Street believed that Quaker was overpaying by $1 billion.

Turns out those estimates were too conservative. In 1997, Quaker sold Snapple for just $300 million, losing $1.4 billion in three years.

The price paid equaled $25 per share of shareholders' money that was handed over to Snapple's investors.

In 2007, Clorox (NYSE: CLX) shelled out $925 million to acquire Burt's Bees so that it would gain market share in the natural products space. Apparently Clorox overpaid, as it took a $250 million impairment charge in January 2011.

Now, $250 million is small potatoes to a huge company like Clorox, but it does represent nearly $2 per share in cash, funds that I'm sure shareholders would like to have back.

When CEOs throw around millions of dollars to acquire companies, we tend not to think much of it. After all, that's why we're paying them the big bucks—to be the dealmakers, the captains of industry.

In many instances, the deals are well thought out and completed at an appropriate price. Those are situations where everyone wins in the long run.

But unfortunately, in many other cases, the Quaker Oats–Snapple or Clorox–Burt's Bees deals of the world are not unusual. And when all that money is thrown around, we tend to forget that that money belongs to shareholders. They are the owners of the company.

In 999 times out of 1,000, a company with extra cash that it might otherwise have spent on an acquisition is not going to give it back to shareholders. If Clorox hadn't bought Burt's Bees, there is no way that it would have declared a special $2 per share dividend.

But as Community Bank's Kingsley pointed out, having such a large hoard of cash can lead to decisions that do not benefit shareholders. So maybe returning some of that cash isn't such a bad idea after all.

Attracting the Right Shareholders

Thomas Faust, CEO of money manager Eaton Vance (NYSE: EV), told me he recognizes that keeping the owners of his company happy is his job and pays off in the long run. He explained:

Investors value dividends as an important factor in owning our stock and we have been told this firsthand by large institutional holders of Eaton Vance. You could say we benefit indirectly to the extent our stock has a higher valuation because of our long record of dividend increases.

Eaton Vance has grown its dividend every year since 1980, including a 50% increase in 2003, when the dividend tax rate dropped to 15%. That had to have made shareholders very happy. (See Figure 4.1.)

Clearly it did. Over the past 25 years, when dividends are reinvested, Eaton Vance's stock outperformed the S&P 500 by over 9,780%!

As Freyman and Faust appreciate, a dividend that is consistently climbing keeps existing shareholders happy and attracts new ones.

Stocks that have a lot of momentum and whose price is rising rapidly also attract new shareholders, but are they the right shareholders?

Ultimately, management wants long-term investors as owners of the company. These investors will typically be those who understand the big picture and won't get bent out of shape if the company's earnings fail to meet expectations one quarter. They will likely be more patient shareholders than those who are in it for a quick buck.

Investors usually understand the company's business. As long as there has been no fundamental change to the business, shareholders will stay invested, particularly if they are receiving a growing dividend.

Other investors with a shorter time horizon often bail out of a stock that fails to meet earnings expectations during a quarter. Stocks that miss analysts' estimates frequently fall in price immediately after the earnings report is released, triggering a stampede out of the stock.

But shareholders who do not panic have the opportunity to buy more shares or reinvest their dividends at a lower price as a result.

Investors who have owned shares for years are likely satisfied with their returns (and yield); otherwise they would no longer be shareholders. Managements and boards of directors have a vested interest in keeping long-term shareholders satisfied. If those investors are happy, management and the board members probably get to keep their jobs.

When shareholders are not content, people get fired. Occasionally, you will see a group of investors so unhappy that they attempt to vote out the board of directors or force the CEO and other executives to resign.

That was the case in 2014 when Darden's (NYSE: DRI) CEO was forced to resign and shareholders voted to replace the entire board of directors after years of slow growth and a sale of assets that was not in shareholders' best interests.

This group of investors who force change at a company are called activist investors. They are usually hedge funds that own a big stake in the company and recruit others to vote along with them to make substantial modifications.

Management wants to avoid getting into a battle with activist investors for several reasons.

It can be expensive to counter the activist's arguments. An activist may issue press releases, hire attorneys, and demand a vote to make changes within the company.

Countering those activist moves can cost millions of dollars.

Additionally, activists occasionally resort to public humiliation of a CEO or board to achieve their goals.

In 2011, for example, Dan Loeb, a noted activist investor, wrote a letter to the board of directors of Yahoo! (Nasdaq: YHOO) demanding the resignation of cofounder Jerry Yang after Yang had engaged in negotiations to sell the company.

In the letter, Loeb stated:

More troubling are reports that Mr. Yang is engaging in one-off discussions with private equity firms, presumably because it is in his best personal interests to do so. The Board and the Strategic Committee should not have permitted Mr. Yang to engage in these discussions, particularly given his ineptitude in dealing with the Microsoft negotiations to purchase the Company in 2008; it is now clear that he is simply not aligned with shareholders.⁶

As you can imagine, these kinds of letters don't do much for the reputation of Yang or the rest of the board. So a company generally does not want to get into an altercation with an activist.

By the way, Loeb succeeded. Yang resigned from the board of directors in January 2012. Today, other than being a shareholder, Yang no longer has a relationship with the company he started.

What does all of this have to do with investing in dividend stocks?

Normally, a company that is paying a healthy dividend and lifting that dividend year after year doesn't incur the wrath of angry shareholders. Investors who buy stocks with 4%+ yields that grow every year by 10% are typically doing so because of the income opportunities. As long as the dividend program remains intact at the levels the investors expect, they probably will stay quiet, let management do its job, and collect dividend checks every quarter.

Additionally, if a management team has a dividend policy, such as the one just described, chances are, it's running a shareholder-friendly company. Executives who are committed to increasing the dividend every year are more likely to take seriously their fiduciary responsibilities to shareholders than executives who are simply focused on jacking up the quarterly earnings numbers.

Once in a while you get an activist situation that demands a special dividend, particularly when a company is sitting on a lot of cash and there aren't any attractive acquisition opportunities.

But those are usually companies that are paying very small dividends or none at all.

Even a company with a war chest of cash usually will not come under pressure from shareholders if it pays a solid dividend that grows every year.

Although the yield is very important, serious dividend investors consider the safety of the dividend (the likelihood it will get paid) to be just as important. So they won't force a company to blow a large chunk of its cash in order to push the dividend yield through the roof. They'll be happy as long as the dividend is growing at a respectable pace year after year.

Dividend investors tend to be rational; they understand the logic in how much of a dividend is paid as well as the reasons to invest in these stable, “boring” companies rather than chase the next big thing.

Signals to the Market

When companies report their quarterly earnings results, the language they use is couched in legal speak and cautionary statements. Companies never want to set expectations too high because when they fail to meet those prospects, the stocks get punished.

Additionally, when things are not going great, management will try to use more optimistic language to dilute the bad news.

But a raised dividend says more than a CEO can ever state. Generally speaking, it says: We have enough cash to pay shareholders a higher dividend, and we expect to generate more cash to continue to sustain a growing dividend.

As economists Merton H. Miller and Franco Modigliani point out, when “a firm has adopted a policy of dividend stabilization with a long-established and generally appreciated ‘target payout ratio,’ investors are likely to (and have good reason to) interpret a change in the dividend rate as a change in management's views of future profit prospects for the firm.”⁷ They were the first economists to suggest that dividend policy is an indication of executives' beliefs on the prospects of their companies.

The University of Chicago's Douglas J. Skinner and Harvard University's Eugene F. Soltes agree, writing: “We find that the reported earnings of dividend-paying firms are more persistent than those of other firms and that this relation is remarkably stable over time. We also find that dividend payers are less likely to report losses and those losses that they do report tend to be transitory losses driven by special items.”⁸

In the same paper, the two professors concur with the earlier statements that stock buybacks do not convey the same confidence as dividends because they represent “less of a commitment than dividends.”

Especially for companies with track records of five years or more of raising dividends, the higher dividend not only delivers a higher income stream to shareholders, it also sends a clear message that the policy of raising dividends is intact and should be for the foreseeable future.

A higher dividend is certainly not a guarantee that the dividend will get a boost next year. But it is a good indication that management is serious about the policy and will likely work to ensure it can be maintained.

The growth in the dividend is especially noteworthy during a disappointing earnings period. As I mentioned, when a company misses earnings expectations, investors sometimes panic, which can lead to management getting unnerved and making drastic decisions, such as layoffs and restructurings.

But when earnings are not so hot and the company still raises the dividend, the message is that things are not so bad. It's as if management is telling you, “There is still plenty of cash on the books, and it's likely that we'll generate enough cash next year to raise the dividend again.”

For an investor looking at the big picture, that's a powerful message. The chatter may be about the near-term disappointment; the shareholder who's in it for the long haul and understands that businesses go through cycles of ups and downs sees that the company's strategy is intact and should be able to weather the storm.

The market gets this message loud and clear. Companies that raise dividends year after year tend to outperform the market. As I showed you in Chapter 3, the Perpetual Dividend Raisers historically outperform the market.

And keep in mind that most of the Perpetual Dividend Raisers are what you might describe as stodgy, old companies. They aren't high-growth tech companies that will benefit from some hot new technology or trend.

The market clearly appreciates the fact that these companies are strong enough to raise their dividend payment every year.

Summary

• Dividends represent a stronger commitment to shareholders than stock buybacks.
• Companies that pay dividends have higher-quality cash flow.
• Management teams that take their fiduciary duty seriously act responsibly with the company's cash.
• A raised dividend signals management's confidence in the company's prospects.
• Jarden's executives like money more than their shareholders.