This Guy Hates Dividends

"I avoid companies that pay dividends like the plague," wrote Andy Kessler.

Kessler used to be hedge fund manager in Silicon Valley... trading technology stocks during the boom. When the bust came, Kessler wrote a book about his experiences.

The book became a bestseller. Since then, Kessler has written three more books and dozens of stories for big newspapers. The other day, I came across a Kessler essay in The Wall Street Journal. I'd never seen it before. It was called "I Hate Dividends," and he published it in 2002.

"When [companies] pay dividends, they are admitting they have nothing better to do with their money," Kessler wrote. "If they won't invest in themselves, why should I?

"Dividends entice investors into debt-laden, slow- or no-growth companies, more likely to cut their dividend, burning investors worse than conflicted research analysts. Run away. They are wearing a scarlet dollar sign. You want yield? Buy a bond.

"Dividends don't create economic growth. Failing companies just bribe investors with dividends. Encourage companies with a future to invest in their operations, seeking high returns. If all that mattered were dividends, we would still be investing in railroad stocks."

I respect Andy Kessler, but I have to tell you, his views are totally wrong.

First, it's ironic Kessler mentions the railroads. Investors have ignored railroad stocks since the 1960s. Commercial airlines took all their passengers, and truckers stole their freight market. Kessler's right about that.

But what's this? According to Jeremy Siegel in his excellent book The Future For Investors, railroad stocks outperformed the S&P over the last 45 years... by a long way.

Siegel calls this mirage the "growth trap." After studying the last 50 years of stock market data, Siegel shows that old companies always outperform new companies over the long run. In other words, the original companies in the S&P 500 index in 1957, as a group, have performed much better than the new companies added by the S&P over the years.

Expectation is the reason. Hot new stocks – like Kessler's technology darlings – have such high expectations built into their share prices, they offer hardly any upside to investors. Their volatility often causes gut-wrenching losses. Exxon Mobil, BNSF, and Altria (Philip Morris) – on the other hand – are among the best-performing stocks in history. Yet investors have always considered them old economy fuddy-duddies with no growth prospects.

Kessler is wrong about dividends, too. History is unambiguous. Returns in the stock market come from dividends, not capital gains.

Siegel found that from 1871 to 2003, only 3% of the market's return came from capital gains, while the remaining 97% came from reinvesting dividends. "Dividends have been the overwhelming source of stockholder returns throughout time," writes Siegel. "And firms that have higher dividend yields have given better returns to investors."

An independent study from Chicago-based research firm Ibbotson Associates, Inc. shows that $1 invested in U.S. large company stocks in 1925 grew to nearly $98 by 2005. That sounds pretty good, until you see what happened when you reinvested the dividends. That same $1 grew to $2,658.

Ibbotson also calculated U.S. stock market returns for 180 years. Beginning with $1 in 1824, the capital gain in 2005 was $374. With dividends reinvested, it became $3,177,865.

Compounding. It's the power behind these amazing results. Reinvesting dividends increases the number of shares you hold. And the more shares you hold, the bigger your dividend payout, which gets reinvested again. This way, investments in high-yielding stocks compound exponentially into fortunes over time.

Kessler hates dividends. He prefers companies that reinvest their cash in growth. It's a great idea in principal, but the problem is, when corporate managers have too much cash, they tend to waste it on bad ideas. Cash is a curse to most CEOs. But when there's a dividend to be paid every quarter, it makes managers thrifty. And that's good for stockholder returns.

So there you have it. Sorry, Andy, dividends are the secret to successful long-term investing.

Good dividend investing,