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Two Key Misconceptions about Dividends

It’s not uncommon to see investors valuing dividends dearly. After all, studies (see here and here) have shown how investing in shares with strong dividends has been a winning strategy. There are also others who think that companies that pay dividends are disciplined in terms of capital allocation and have shareholders’ interests at heart.

But, such thinking might have led some to generalize all dividend-paying companies as ‘good’ while categorizing all companies with no dividends as ‘bad’. Although the simplification of an idea into a rule-of-thumb can help investors remember it easily, I am afraid that the concept of dividends might have been made too simple for investors’ own good. As Einstein once said, “Everything should be made as simple as possible, but not simpler.” Let us look at some misconceptions about dividends and what investors should look out for.

Misconception 1: Companies that pay a dividend are more stable

This is one of the more common mistaken-beliefs that investors have.

For example, after the share prices of a few of the S-Chips (Singapore-listed companies with operations mainly in China) collapsed over the past few years due to issues related to management’s integrity, many investors lost faith in other S-Chips. This led investors to focus on S-Chips with a consistent history of paying dividends as a proxy for management’s integrity.

However, a history of consistent dividend payouts did not prevent Eratat Lifestyle (SGX: FO8) from defaulting on interest payments on its bonds back in January this year even when its financial statements showed it to have ample cash on hand that even exceeded its market capitalisation at times. The company’s now suspended from trading and has been unable to verify the validity of its cash balance in its corporate bank accounts till date.

It is true that there are many other companies, such as SingTel (SGX: Z74), that have a very reliable dividend pay-out history because of their ability to generate strong free cash flow. However, investors shouldn’t be lax to situations where some companies might be paying dividends in order to create an illusion that they are a “reliable company”. As investors, we should always scrutinise the dividends of a company to see if it is indeed sustainable.

Misconception 2: Dividends provide more downside protection

Some investors also assume that investing in a company that pays a dividend can provide more downside protection for them. It is because having returns from dividends might offset the occasional capital loss their portfolio might suffer. However, unlike a bond coupon, a dividend is not a fixed return for investors. Dividends can be cut or reduced and when that happens to a company,  its share price might even suffer more than a company that has never paid a dividend.

Foolish Summary

Although dividends provide investors with cash flow from their investments, basing our investment decision purely on the dividend pay-outs of a company is hardly prudent. The basic tenet of investing was best articulated by the legendary investor, Benjamin Graham: “Investment is most intelligent when it is most businesslike.” When looking at a share for investment, it is best to focus on the fundamentals of its business, as the most sustainable dividends will be dividends coming from a fundamentally strong business.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.