Should I invest only in companies paying high dividends?

Is a high dividend a necessary feature of a high performing company? The answer is not necessarily!

Let’s start with some basics. A dividend is a periodic distribution made by a company to its shareholders. The distribution is usually made from current year profits, but may also be paid from reserves (ie accumulated profits from prior years). In some countries, dividends may also carry certain tax advantages.

So is a high dividend a necessary feature of a high performing company? The answer is not necessarily!

When deciding whether to pay a dividend, companies first assess their future cash needs — they may need to cash to replenish plant and equipment, or embark on new growth initiatives for example. So a low dividend may in fact mean that the company is reinvesting the cash in their business — not necessarily a bad thing!

The best way for investors to think about dividends is to consider the available alternatives — whether the dividend cash is best left with the company or reinvested elsewhere.

In the case of a high growth company (ie with a high return on equity, for example 20%), as an investor you are in a better position if the company “reinvests” your dividend cash because the return on the cash (ie 20%) is likely to be greater than most alternatives (like other lesser performing companies, or a bank deposit). So, for high performing companies a low dividend is not a bad thing.

For poorly performing companies the opposite is likely— a low dividend is a poor investment as the cash is probably better off elsewhere.

So although this may be counter-intuitive, low dividends are certainly not a negative for high performing companies — in fact it could be very positive as it may mean the company is investing in high return growth initiatives.

In summary, a value investor should consider all aspects of a company in making an investment decision — which are all covered by our snowflake - and not focus on one aspect in isolation. Dividends are an important part of the mix so keep an eye out especially for those companies performing well in all areas.

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