With Dividends Look For Quality, Don’t Chase Yield by Royce Funds
When analyzing companies that pay a dividend, it is more important to see how the income stream fits with the firm’s overall culture and operations rather than looking for companies with the highest dividend yields.
Our experience suggests that dividends are best seen as part of the menu of items in a company’s capital allocation toolkit.
There are several things a company can do with its free cash flow. It can:
- reinvest in the company
- make acquisitions
- pay down debt
- buy back stock
- pay dividends
A company must decide which options offer the best use of capital. If the business lacks an effective way to use its excess cash, it may be best to give it to shareholders.
Dividends can thus function as a form of corporate governance, a mechanism to further align the interests of management with those of shareholders.
When companies decide to pay a dividend they are typically making a commitment, and companies almost never want to cut or eliminate dividends. And we have found that most of our dividend-paying holdings tend to be even more conservatively managed than many of our other stocks because the companies tend to be more mature.
The practice of paying dividends becomes even more relevant in a market where corporate balance sheets are generally in excellent condition and in many cases flush with cash because dividends are by nature the byproduct of healthy free cash flow generation.