Why rising dividends aren’t always good for investors

There are few issues that most people in the financial markets agree on. Is gold the only safe long-term store of value, or a relic of a defunct monetary system? Is China the future of the world economy, or a corrupt communist dictatorship about to explode? Will the euro split up, or become the world's reserve currency in a decade's time? These questions are guaranteed to start a fight wherever two or more financial experts are put in the same room together.

However, one principle unites just about everyone: strong and rising dividends are a good thing. On that basis, the past year had been a good one. Capita Registrars reported this week that British companies paid out record amounts of money during 2011. Total dividends came to £67.8bn, up almost 20% over 2010. It forecasts that there will be another strong rise in the coming 12 months, taking the total to £75bn in 2012. That's the entire market value of GlaxoSmithKline.

A few big companies led the way. BP resumed its dividends after the Gulf oil spill. Vodafone has hiked its payouts to shareholders following the increase in dividends it gets from its US partner, Verizon Wireless. But it wasn't just the big firms there was growth across the board, with banks and miners both strong.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Overall, the British market now has a dividend yield of 4.4% a lot better than gilts or most bank accounts. For the level of income you can expect, there has never been a better time to buy shares.

It's obvious why rising dividends are seen as a sign of a healthy, functioning stockmarket. Owning a share of the profits from a firm is ultimately the only reason to buy equities and the bigger the slice of the pie that goes to the actual owners of the business, the better.

Just about every academic study shows that dividends are a crucial component of total returns reinvesting dividends is a far better way to build up a solid portfolio over the medium term than relying on the market going up. Even in a broadly flat market (such as Britain over the last 12 years), you will still make money, so long as the dividends are strong.

Dividends are a great way to discipline management. Just about every number in the annual report can be manipulated with the help of clever accounting. But the cheque you send to the shareholders either goes up or down there isn't really any way of spinning that.

Even so, as with so much else in life, you can have too much of a good thing. Rising dividends aren't always entirely great news. In fact, the level of payouts we're now seeing suggests the market is not as healthy as it might seem at first glance. There are three big issues.

First, companies may be reluctant to invest. A reasonable dividend is one of the best ways to reward shareholders. But businesses also need to be investing in the future. They need to be creating new products and tackling new markets.

There is explosive growth in many emerging markets, and if your firm doesn't get there, someone else will. It is hard to think of many FTSE companies that are really setting the world alight right now. The high level of dividends might be a sign that firms have run out of ideas that can hardly be good in the long term.

Secondly, many firms may be scared of failure. Bold chief executives make big, daring bets on new markets. They take risks and try new things. Sometimes these risks will pay off, and sometimes CEOs will end up with egg on their faces. That's life. But no one ever got fired, or got into trouble with their shareholders, for raising the dividend. In many cases, rising dividends are a sign that CEOs have become too nervous of taking risks and that is hardly good either.

Thirdly, dividends may be as much about rewarding the board as creating a long-term future for the business. Most pay schemes for directors are now linked, in one way or another, to the share price. The emphasis that investors now put on dividends means there is no faster way of getting the share price up than by hiking the payout to shareholders. So if you need to hit a share-price target to make your options pay out, that is the way to do it.

In fact, some of the best companies don't pay dividends for many years. Computer giant Apple last paid a dividend in 1995 but it has hardly had a bad decade. Internet behemoth Google has never paid a dividend. BSkyB stopped paying dividends for five years as it spent a fortune giving away free set-top boxes to all its subscribers.

Would shareholders really have been better off getting a cheque every year from Apple or Sky? Or were they better off leaving the cash to be re-invested in growing the business? It's not a difficult question to answer.

What the markets really need is a better balance healthy dividends, for sure, but also healthy levels of investment to build the platform for future growth.

There is scant evidence of British companies investing boldly right now. Even companies such as Vodafone, in the middle of what is still a fast-growing technology sector, seem more concerned with turning themselves into utilities dull, low-growth, but safe and paying out big dividends. That is hardly encouraging for the long term.