For many investors, dividends are an integral part of investing. Some investors will only buy companies with dividends, and some will only buy companies with high dividend yields compared to the rest of the market.
Other investors avoid dividends entirely. Instead of looking for dividend stocks, these investors might concentrate on growth companies, which can reinvest their capital at high rates of return and, therefore, would be making a bad decision returning this cash to investors.
I believe both of these approaches are inadequate. Dividends do not tell us anything about the stock we are looking at. A dividend yield only tells us how much the company is paying out in relation to a share price. The figure is just one number, which can mean many things.
Rather than focusing on whether a company is paying a dividend and what level of dividend the company is paying in relation to the market, I believe investors should focus on a company's capital allocation strategy as a whole.
The capital allocation framework
When looking at the capital allocation framework, there are three integral parts and stages of capital allocation that managers need to follow.
If a company has additional capital to deploy, the first decision for managers is whether or not this capital is reinvested back into the business.
If there is an opportunity to deploy the capital at a high rate of return, similar to the rate of return the rest of the company is earning, this will undoubtedly be the best choice. If a company can make a return on invested capital of 20%, reinvesting $1 will achieve a higher return than reducing debt or paying the cash out to shareholders.
Management has to balance the opportunities. If the company's cost of debt is more than 20%, then reducing borrowings may be the best course of action compared to reinvesting back in the business if the company can only earn a 20% return on invested capital.
If a company cannot find any attractive opportunities for reinvestment, the next best course of action for capital allocation is debt reduction.
And finally, when a company has no other options, the last option is to return cash to investors.
Either dividends or share repurchases are great ways to return capital, though the preferred route will depend on the company's share price and intrinsic value at the time.
The track record
Rather than judging a company on its dividend yield and track record, investors should instead look to a management's track record of capital allocation.
If a company does not pay a dividend but continually undertakes initiatives that destroy value, it may be sensible to avoid this business at all costs.
Similarly, if a company spends all of its money on a dividend, leaving nothing for reinvestment or debt repayment, it may also be sensible to avoid this business.
If a company borrows money to fund its dividend or capital spending while cash flows out to investors, this can be a red flag once again.
The best way to analyze the quality of a dividend is to start with the quality of the company in general.
If a corporation has a sensible capital allocation policy, prioritizing growth and then debt reduction, there is no reason why it should not pay out a dividend to investors at an appropriate level.
Abbott Laboratories (ABT, Financial) is one of my favorite examples of this principle in action.
Over the past few decades, the company has prioritized business reinvestment. As the company has grown, it has increased its dividend to shareholders with cash that is left over. The conservative approach has yielded fantastic results, with the stock producing a total return of nearly 28% per annum over the past five years.
Some of the world's largest mining companies also provide an example of this capital allocation framework in action.
Over the past couple of years, Rio Tinto PLC (RIO, Financial) has reduced capital spending as it has not been able to find enough projects to justify additional capital expenditures.
With capital spending falling, the company used free cash to reduce debt. It moved into a net cash position a few years ago and now returns enormous chunks of cash to investors—the stock yields around 9.4%.
