Imagine a person that is not very well-off with money at the current time. Perhaps it’s a man that has been unemployed for quite a while, or maybe it’s a single mother with two children and two jobs, trying to make ends meet. Assume, also, that this person is quite responsible and making smart decisions on how to handle the situation.
Now think about how this person would use money. Any responsible person in a situation like this would use money very, very carefully. This means things like setting up a strict budget, using coupons at the supermarket, buying in bulk, saving all of their change, refusing to buy anything extraneous, and so forth.
Now imagine the same person in a situation of relative financial abundance. Would they still do all of these things as carefully and meticulously as they did when they had very little money? A person who’s good with money will use it fairly well regardless of how much they have, but they’ll still tend to relax their principles a bit when they have more than they need. So things like vacations, decorations, unnecessary but fun purchases, and so forth, become fair game.
This concept alone would make a good article on building wealth. But that’s not what this article is about. This article is about organizations.
The other day, a manager in my organization happily reported to his unit that they were given a new moderate-term budget to work with. “Use it or lose it!” he exclaimed, pointing out that the quicker they use the money, the quicker they’ll be given more money to work with. Units are “rewarded” by being conservative with their money by being given less money next time.
Obviously from an investor standpoint, this is not ideal. We don’t want our companies to think like that. It’s not just managers, though. It’s executives I’m worried about, from a high-level shareholder perspective. When executives have an abundance of cash to work with, they may be prone to spend it on things that aren’t as valuable as they should be.
Consider an example of a company that has enough cash flow to make ten investments this year. The company analyzes these investments, finds some to be better than others, and decides to invest in all of them for growth because they have the cash to do so. This is an example of loose financial principles.
Now consider a company that pays out half of its cash flow in dividends to shareholders, so it’s left with only half of the money. When looking through this list of ten potential investments, good management will select the best five investments, and discard the rest. Therefore, the company is investing in a higher quality of ideas. Even better, shareholders that receive the dividend can then reinvest it into the company to get even more exposure to those best investments.
It’s a misconception that companies that pay dividends must necessarily grow more slowly than peers that do not. Quite the contrary, a dividend is often evidence of strong free cash flow and sustainable profitability, rather than a hindrance to growth. But even if it were the case that dividends do reduce growth, to a shareholder’s perspective, quality is superior to quantity. What matters to a shareholder is total return on investment, the generally the best way to do it is by investing in only the very best ideas, and then giving the remainder back to shareholders in the form of dividends or share repurchases so that they can reinvest in these best ideas. This is better than the alternative of chasing growth simply for growth’s sake, and getting a mediocre return on investment.
This relates to the example of the person experiencing financial scarcity. The less money you have, the better you use it, and the more money you have, the more prone you are to wasting it. A company that forces itself into scarcity by paying out a significant percentage of its profits to shareholders as dividends helps force itself to maintain a frugal mindset.