Why high dividend-paying companies outperform non and low-dividend payers

Theoretically, the argument goes that companies that retain a majority of their profits and reinvest it generate higher growth than those that pay out most of their profits as dividends.

That makes sense if those companies reinvest wisely. Berkshire Hathaway is the prime example of retaining all of its profits and reinvesting it back into producing assets. But Berkshire is an anomaly.

As the quote goes, “In theory there is no difference between theory and practice. In practice there is.” – Yogi Berra

Recent results also clearly show that in reality it doesn’t work.

The squandering of billions of shareholders’ capital by the Top 40 miners over the past five years is clearly an example of that. As we wrote yesterday, the miners combined wrote down or impaired their assets to the tune of US$197 billion, despite one of the world’s biggest commodity booms.

Instead of investing the billions of dollars of profits in sensible projects or paying out most of the proceeds to shareholders, miners spent up big on assets that were at high prices thanks to the same boom. Once the boom tapered off, the miners have been forced to write down the values of those investments, costing shareholders billions.

Had the companies had sensible dividend policies in place, shareholders would have reaped the benefits, and the miners would have been unable to splurge the cash on buying up expensive assets. It’s also one of the primary reasons why high-dividend paying companies tend to outperform other companies.

Instead, miners like Rio Tinto Limited (ASX: RIO) and BHP Billiton Limited (ASX: BHP) adopted ‘progressive dividend policies’ where they aimed to pay out ever-higher dividends over time and ignored the commodities cycles and even their own changing capital expenditure needs over time.

Those fairly low payout ratios also meant the miners had plenty of capital to reinvest.

Thankfully, both miners abandoned those policies recently and have vowed to pay more normal industrial-type company dividend ratios of a percentage of profits. That means shareholders will share in the boom times, but also share in the low periods. However, the biggest benefit will be that the massive misallocation of capital by the miners over the past few years shouldn’t occur again, along with the writeoffs, restructures and other one-off expenses.

Maybe all miners should adopt that tactic.

Having a sensible (reasonably high) dividend payout ratio also means that if companies need to raise a large sum of capital, they have to ask shareholders first – which is as it should be.

Foolish takeaway

There are exceptions to this rule of course, particularly for companies that can and do reinvest much of their profits at high rates of return – CSL Limited (ASX: CSL) comes to mind. But for the vast majority of companies, having a higher dividend payout ratio makes much more sense – both for the company and its shareholders.

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Motley Fool writer/analyst Mike King owns shares in CSL. You can follow Mike on Twitter @TMFKinga

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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