Mathieu Martin |
Dividends: friends or foes for microcap investors?
A member on our message board recently asked me some questions about dividends, or rather about companies that don’t pay regular dividends and how to value them. Isn’t the goal of every company to pay regular dividends to their shareholders at some point? Returning capital to shareholders by issuing dividends and buying back shares is certainly a reasonable goal for most large and established companies. For microcaps, however, there are a few important reasons that explain why most of them don’t want to pay dividends, or simply can’t. But first, let’s define a dividend:
‘’A dividend is a distribution of a portion of a company’s earnings, decided by the board of directors, paid to a class of its shareholders. A company’s net profits are an important factor in determining a dividend. Net profits can be allocated to shareholders via a dividend, or kept within the company as retained earnings. A company may also choose to use net profits to repurchase their own shares in the open market in a share buyback.’’[1]
Factors that influence a company’s dividend policy
For the board of directors, determining a company’s dividend policy can be a complex process, as a lot of factors need to be considered and evaluated. Here are some of the most common reasons why most microcap companies don’t pay dividends:
- Attractive internal investment opportunities: When a company has some internal projects in which it can invest, such as buying a new piece of machinery to increase production, it may prefer to make these investments with internally generated cash flows (reinvesting its profits) instead of returning the money to shareholders.
- Volatility in earnings: Most microcaps are early-stage companies with a limited history of profitability. Initiating a regular dividend when you can’t predict fairly accurately what you will earn next year is a dangerous endeavor.
- Financial flexibility: Keeping cash on the balance sheets provides management with more flexibility to act quickly on good opportunities, such as developing and launching a new product or acquiring a struggling competitor, for example.
- Flotation costs: Raising capital by issuing new shares has a cost, which for microcaps can range from 5% to 10% in cash plus another 5% to 10% in warrants. Companies may prefer to retain their profits and use them to reinvest in the business, rather than pay a dividend and then issue new shares with all the associated costs.
- Debt covenants: When lending money to microcap companies, most lenders will include covenants that, among other things, prevent the company from issuing dividends unless some level of financial stability is achieved.
Why would an investor not want to receive a dividend?
Even though most factors mentioned above represent sound financial management principles, the only true reason why I, as an investor, don’t want to receive dividends is if the company has attractive internal investment opportunities (the first point above).
Let’s illustrate this with an example:
Company A is a stable and mature company that earns $1.00 per share in profits every year, with a shareholder’s equity (book value) of $10.00 per share. This means that Company A generates $1.00 in profits for every $10.00 invested by its shareholders. At the end of every year, the company pays all its profits as dividends, which resets the shareholder’s equity to $10.00 per share. The total return for shareholders is always 10% per year ($1.00 in dividends for $10.00 invested).
Company B also earns $1.00 per share in profits, with a shareholder’s equity of $10.00 per share. However, instead of paying out the profits as dividends, company B’s board of directors thinks the company should buy a new piece of equipment that is expected to generate a 50% return on investment per year over the next several years. The $1.00 per share that the company intends to keep and reinvest internally will generate an additional $0.50 per share in profits per year for subsequent years. The next year, as expected, the company earns $1.50 per share in profits and is now able to pay $1.50 per share in dividends (assuming it no longer has attractive internal projects). Your $1.00 in foregone dividends in year 1 effectively yielded $0.50 more in dividends in subsequent years, which is a return of 50% (exactly like the company’s internal project). The total return for shareholders has now increased from 10% (like company A) to 13.6% per year ($1.50 in profits for $11.00 in shareholder’s equity), thanks to the reinvestment in year 1.
This example is oversimplified, but the point is that when a company keeps its profits to invest in projects that generate high returns, it’s as if you were doing these same investments with your own money because you will benefit later by receiving higher dividends. For microcaps, paying dividends can take many years and even decades, but the concept is the same no matter how far into the future you extrapolate.
As an investor, if you can achieve 10% returns per year on average, that means you will generally be able to reinvest the dividends you receive at that 10% rate on subsequent years. If a company has an investment project that will return 30% a year, you should very much prefer that your share of the profits stays in the company and is reinvested internally, rather than receiving the money as a dividend.
Personally, my goal is to find companies with exceptional management teams that have the ability to reinvest the company’s profits at a high rate of return (measured by ‘’Return On Equity’’, or ‘’ROE’’) for many years. I don’t mind if I don’t receive dividends, because I should still earn positive returns through capital gains (stock price appreciation). Indeed, the more a company is able to reinvest its profits at a high rate of return, the faster its shareholder’s equity and ability to pay higher dividends will grow over time, thus forcing the stock price to appreciate.
I should also mention that there are some conflicting theories regarding dividend policy and its effect on share values. There is empirical support for the theory that dividend-paying stocks are perceived as less risky by investors and achieve better valuations than non-dividend stocks. If you’re curious about that, I encourage you to read more on the bird-in-hand theory.[2] This is somewhat outside the scope of this article, so this debate will be for another day..!
The bottom line is this: when I see a dividend-paying stock in the microcap space, I can’t help but think that the company has run out of attractive internal reinvestment opportunities. If that’s really the case and the company can’t generate a high Return On Equity, it usually means the upside is limited for me as an investor. The microcap space is where I want to find high growth companies early, and it usually means I won’t get any dividends for a long time.
Obviously, there are many different investment strategies that can work and it is totally possible for a dividend-paying stock to perform excessively well. There are always exceptions! Did that happen to a stock you’ve owned? If so, tell us your story in the comments section below!