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Do Not Buy Stock Because of its Dividend

Dividend-Return

Kevin OLearyKevin O’Leary thinks the best stocks are those that pay dividends. He loves bragging about the “juicy dividends”. Here’s why he’s wrong.

Let’s say a company has $1,000 of capital deployed and it makes $200 profit (20% return).  What can this company do with the $200?  One of the following:

  1. Invest the $200 into the business, to generate more revenue and to make another $40 of profit (20% return). This will continue to increase the value of the company.
  2. Company cannot figure out how or where to invest the $200, so it gives it to shareholders, as dividend.
  3. Sit on it.

Ideally, the company should do #1.  This is what shareholders should want.  They invested in the company to get 20% return. #1 is what you see most high-growth companies doing. They re-invest all of their profits back into the company. They put the money into R&D to create new products or services. They buy more stores or factories. They put it into Marketing and Sales to get more customers. With many early phase, fast growing companies, they show little or no Net Income. This is because they plow everything back into growth, in order to make the company more valuable.

#2 is not ideal because shareholders now need to find somewhere else to invest the $200 and try to make 20% return, which is unlikely.

#3 is the worse option.  Cash loses 2% of value every year, due to inflation.

Warren Buffett has explained these three options in the past.

Carl Icahn has berated Tim Cook (Apple’s CEO) for sitting on so much cash.

carl-icahnTim-Cook

Here is another example of a shareholder who is not happy with the company doing #3:

“Longtime Berkshire Hathaway shareholder sells stake, accusing Warren Buffett of ‘thumb-sucking’”

Berkshire Hathaway is sitting on $120 billion of cash and not doing anything with it. Unfortunately, Buffett is not practising what he preaches.

Warren BuffettIn Buffett’s defence, it is hard to deploy $120 billion of cash.  There are only so many good companies to buy.  The majority of companies are mediocre.  A small percentage are bad.  A small percentage are excellent.  He cannot buy small companies anymore.  Even if he buys $1 billion companies, he would have to find 120 of them.

Buffett said himself that the bigger a fund or company is, the harder it will be to maintain the same percentage return.

You should find companies that can execute #1 from above. Failing this, then invest in companies that pay dividends.