"Never buy a share for its dividend," the big shot fund manager hissed...
I'd just proposed a stock and pointed out its great dividend yield. But he was not impressed. And as a rookie, I decided to keep my thoughts to myself.
In the years that followed however, I became a lot more vocal about dividends. It was an unpopular opinion to have in the City. The received wisdom amongst City folk is that companies should keep their profits. That way they can reinvest them to grow the business and boost their share price.
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But that ignores a chronic problem with investing - bad management. You can't simply place blind faith in a company's management to grow the business. Because, as I'll explain today, there is a good chance they'll betray you.
What you need is a way to keep management in line. And that's where dividends come in.
In today's Right Side, I'd like to talk about how I came to recognise the critical importance of dividends.
It's starts with a simple question....
Do company managers really have your best interests at heart?
You can tell a lot about company managers by how they treat shareholders. To me, fair treatment means paying shareholders a decent slug of the profits and let them reinvest it as they see fit. It's like recognition of who is the real owner of the company.
I've seen too many companies blow up where management, left to their own devices behave like nothing more than a kid in a sweetshop...
Bad management, if you give them half a chance, are bound to get involved in costly acquisitions. And they don't do it just to be bloody-minded... it's worse than that.
Remember, a CEO tends to be remunerated in relation to the size of the business. If he's in charge of thousands of people and hundreds of millions in turnover - he should be paid handsomely - right?
So rather than pay cash to shareholders he'd rather use it to grow his empire.
Just look at what happened to Vodafone and Marconi during the tech boom of the late nineties... these businesses lost billions by leveraging up to buy other businesses. And sure, for a while the share prices flew as the boom roared on. But ultimately it ended in disaster and wholesale changes in the boardroom. The argument was that these giants were growth' businesses - dividends could go hang. The important thing was to expand the empire.
And that introduces a whole string of other problems into the bargain.
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Why bad management needs your dividends
As well as keeping you from your payouts, empire building can get the company deeply into debt. For every pound they keep back from shareholders, they can borrow some more. Then he'll meet up with his friendly City adviser and go off on the acquisition trail.
Most accounting scandals are also based on the fraud of making it look like the business has more money on the balance sheet than it has. The last thing they want to do is hand out cold-hard cash to shareholders.
They need the cash to move it around the books and make the business look like it's viable. I'm not saying that every firm that pays out pitiful dividends are crooks, but by not paying out, it's certainly easier for the crooks to fudge the figures.
The point is, that if you don't get paid your dividend, there's a risk you'll never see the money again.
Good management recognises how the relationship works. Bad management arrogantly assumes they know best how to spend their money. And crooked management take it one step further...
As far as I'm concerned, a dividend is as important as honesty in a relationship. They are a sign of recognition of the partnership... in this case between investors and company management.
Having said that, not all dividends are the same...
What to look for in a dividend stock
First of all, you should beware of the ultra-high dividends. Sometimes a company will ratchet up its dividends to curry favour with investors. But ultra-high dividends are very rarely sustainable.
Constantly increasing dividends are important too. You want a company with a long and steady record of lifting dividend payouts. That way you know they are committed to long-term thinking - and your relationship with them.
You also have to make sure that the company can afford to pay the dividend. I have found that a good rule is to ensure that it's twice covered - so if they're earning £100m, and payout £50m, then you can say the dividend is twice covered. You can get all the details in FT - look for the yield p/e and cover.
Better yet, get your guidance from someone who makes it their business to invest for dividends. I've spoken about Stephen Bland before. Stephen has a simple but very powerful strategy. You invest for the income. And just hold the stocks forever.
I have to say that I am utterly convinced by this hands off approach to investing. For one you're not constantly handing over money in fees and commissions. And for another it takes a hell of a lot of the stress out of investing.
Ultimately, it's a strategy that has been paying off for Stephen. If you're interested in finding out why, I think you should take a look at a smashing video that Stephen has put together.
The Dividend Letter is a regulated product issued by MoneyWeek Ltd. Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Please seek independent financial advice if necessary. 0207 633 3780.
This article was first published in the free investment email The Right side. Sign up to The Right Side here.
Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.
Managing Editor: Theo Casey. The Right Side is issued by MoneyWeek Ltd.
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