How to protect your shares from bad company management

There is one thing that small shareholders can use to protect their shares from bad management decisions: dividends. John Stepek explains how.

When you buy a stock, you have a say in the running of the company. You are a part-owner, after all.

You can attend annual general meetings. You get to vote on things like director pay and appointments. In theory, you can tell managers where you think they're going wrong and what they should be doing instead.

But let's not kid ourselves here. Unless it's a tiny company, and you own a very large chunk of it, you have very little influence over what the company does.

Don't expect big shareholders - fund managers, insurance companies, pension funds etc - to take your side. Their interests are different to yours. The big institutions don't want to kick up a fuss about ridiculous pay packets, because that might draw attention to their own ridiculous pay packets.

And they're often more interested in pushing short-term policies that might hype the share price over the next 12 months, rather than the next 12 years.

But there is one thing that you, as a small shareholder, can use to protect your shares from bad management decisions. And, surprising as it may seem, that one thing is dividends.

What do dividends have to do with all this? I'll come to that. But let's start by explaining exactly what a dividend is.

What is a dividend?

When you invest in a company, you're paying for a share of its current and future profits. You get your share of those profits in two ways.

1. Capital gain: if profits go up, all else being equal, you'd expect the share price to rise too. (It doesn't always happen, but we'll discuss that another day). So you get a capital gain although you have to sell the share to realise it.

2. Income: companies can also choose to pay out part of their profits in the form of an annual dividend. So you get a little bit of your share of those profits here and now, in the form of an income stream.

Dividends can be paid in pence or pounds or dollars or whatever. But the key to measuring how big a dividend is, is to look at the yield. You just divide the annual dividend by the share price and multiply by 100, to get a percentage. So if a share costs £1, and the annual dividend is 5p, you've got a dividend yield of 5%.

But what I want to focus on now is why dividends are important.

Why do companies pay out dividends at all?

Some people argue that dividends are a waste of time. Here's the rationale.

When companies make money, there's a range of things they can do with it: they can pump it back into the company, to make it even more profitable; they can buy other companies, to expand and dominate their sector; or they can pay it out to shareholders.

Now, the argument goes, if they can't think of anything better to do with their money than hand it back to shareholders, then that's not a very exciting company. It's gone ex-growth'. And you're not going to make your fortune by investing in ex-growth' companies.

Like many financial arguments, this one makes a lot of sense, if you ignore the human element. But if you only learn one thing from MoneyWeek Basics, it should be this: when you're investing, the human element be it your own psychology, or the irrational' actions of other players in the market is the single most important thing to take into account.

If companies always made the most sensible decision about how to spend their money when they get it, then yes, dividends would be a waste of time. But companies don't always make sensible, profit-maximising decisions.

For example, chief executives like empire building which is often about ego, not good business. And investment banks love them to empire build. As soon as a company gets a big chunk of cash together, the temptation to splurge the lot on a big headline-grabbing deal that will generate lots of fees for the banks and lots of kudos for the board, is huge.

Don't get me wrong. Sometimes acquisitions make sense. But usually at the bottom of the market, when the market is dead. Not when a boom is in full swing - which of course is when most deals get done.

Some of the stupidest deals in history have been done in a sector that's famously stingy when it comes to dividends the technology sector. I don't think that's a coincidence.

In cash-rich technology companies, the managers sit on huge amounts of money, and then feel the need to spend it by jumping on every new bandwagon that rolls through the sector. Just look at the frenzied buying of social media companies at enormous prices. Managers forget who the money really belongs to. Instead of returning it to shareholders the owners of the company they spend it recklessly.

How dividend payments keep company management in check

Dividend pay-outs don't prevent bad deals from happening. But they do ensure that you get paid first. If there's one thing that companies hate, it's having to cut the dividend. It does happen, but it really upsets shareholders, and normally results in heads rolling in high places.

So the need to make sure there's enough cash around, every year, to pay the shareholders, provides a valuable check on management. It won't stop them from making stupid decisions, but it will make them think twice. It reminds them however briefly of whose money they're actually playing with.

And as a small shareholder, that's about the best you can hope for.

We're not saying you should avoid companies that don't pay dividends altogether. Small or new companies that are still growing rapidly generally have good reasons not to pay dividends their core business is still expanding and it makes sense to reinvest spare cash in trying to dominate their market.

But once a company starts paying a dividend, it's usually a good sign that it expects to be able to keep paying one. So if an established company cuts its dividend, or has a poor record of dividend growth, it's worth investigating exactly why that is before you consider buying in. We'll look in more detail at how to do that in a future article.

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