Stagnant Earnings Create A Risky Environment For Dividend Investors

As a dividend growth investor, my goal to purchase shares in a company at an attractive valuation, and then receive a rising stream of dividend payments for decades. 

The companies that tend to shower shareholders with more dividends every year tend to be the ones who manage to grow earnings per share over time and have manageable payout ratios. These companies manage to distribute excess cash to shareholders in the form of dividends. As earnings are rising, this translates into higher annual dividends for these shareholders. Any remaining earnings are retained to maintain and grow the business, which results in more growth down the road. 

At some point, corporations start facing challenges due to changes in the competitive environment. As a result, companies are unable to grow revenues and earnings per share. This in itself is not a problem, because shareholders could still, in theory, generate high returns, even if revenues and earnings are flat. For example, if a company stops growing and as a result sells at 10 times earnings, it can generate great returns to shareholders if it distributed most of its earnings in the form of dividends or share buybacks. If the company manages to cut costs a little bit, it can generate good long-term returns to shareholders. This is management’s job – to work for the shareholders.

Unfortunately, at some point, management teams become unhappy with the status quo. It is not exciting to be sitting still, generating a lot of excess cashflows, but not growing the business. All of this creates the urge for management teams to do something. Rather than focus on shareholder returns, they focus on growing the enterprise at all costs, in order to perpetuate the entity and get higher status in the corporate world ( and bigger paychecks too). This is an example of the tug of war between top management and shareholders. In theory, top management works for shareholders who have capital at risk. In reality, top management is only looking after themselves. Most CEO’s are not very good at what they do. It is usually the business model or the business environment that creates shareholder wealth – management usually just take the credit for being in the right place at the right time.

In some cases, they end up buying growth at inflated valuations, so that revenues grow and net income grows. That doesn’t fool investors however. In the process, these management teams discard the prudent strategy of dividend growth and share buybacks used to share profits with investors. By taking on more debt, or using stock at cheap prices to fund acquisitions at inflated values, these companies waste shareholder resources and endanger the financial viability of the enterprise. 

A few companies I had in mind when writing this article include General Mills and IBM. I am tempted to include Altria as well, despite the fact that the company has managed to grow earnings and revenues.

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Disclaimer: I am not a licensed investment adviser, and I am not providing you with individual investment advice on this site. Please consult with an investment professional before you invest ...

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