GE GE Aerospace

By James Mackintosh 

If you invested in General Electric for the dividend, you discovered your mistake on Tuesday when the payout was slashed from 12 cents to 1 cent a share each quarter. You were in good company in your error: Investors focus far too much on dividends, distorting corporate behavior and making it easy to forget that what matters isn't the payout, but whether the business can sustain it.

GE cut the dividend because it needs to hoard cash as it restructures and shrinks. Yet, even the token penny payout is a sign of the distortions the demand for dividends creates. The decision to maintain it is clearly down to the excessive value shareholders place on dividends.

There were plenty of warning signs that the dividend was unaffordable. Dividends are a way to return profits to shareholders, but GE's net income has been higher than the dividend cost in only four of the past 15 quarters -- compared with all but two quarters in the entire period from 1989 to Lehman's failure in 2008.

Even excluding this week's monster $22.8 billion loss, GE has paid out almost twice as much in dividends since 2012 as it made in net income. Every shareholder should have realized that the dividend was getting riskier, even if they weren't looking at the falling amount of cash the business was producing.

In parallel, GE slashed its capital spending from $15 billion in 2012 to about $8 billion over the past 12 months, taking it back to where it stood in 1998 -- before inflation. The business has been eating its seed corn recently, partly to maintain the dividend.

Dividends do, of course, matter. The prospect of eventual future dividends is the main reason shares have any value at all. Their reinvestment has accounted for the bulk of long-term returns on stocks. Better still, dividends can instill discipline on executives, preventing them from indulging their wildest flights of fancy by reminding them that they have to generate the cash to pay stockholders. Chief executives given a free rein and plenty of money have an unfortunate tendency to engage in value-destroying takeovers, build fancy new headquarters and diversify into trendy new businesses about which they know little. Better to pay dividends or buy back shares than fritter the money away.

However, dividends should be the result of a successful business throwing off cash, not something that executives strive to maintain even when the cash could better be used elsewhere. GE is a classic case of the dividend being prioritized in the hope that something comes up.

For the major oil companies, something did come up, making it look as though steady dividends could be justified. Consider Royal Dutch Shell, the Anglo-Dutch oil company that is among the world's most reliable dividend payers. It resorted to borrowing to pay its dividend in 2015 and 2016 as it was hammered by the oil-price slump, with earnings below the cost of the dividend for six quarters in a row.

To save cash Shell offered investors the option to take their dividend in the form of new shares, and like GE it and other oil companies took an ax to capital spending. Unlike GE, Shell was rescued by the oil-price recovery, and is now generating enough cash both to pay the dividend and to buy back the shares it issued.

Shareholders like the regular Shell dividend, and can argue that Shell was right to keep paying it, since it all worked out OK. But even here it would have been less risky for the company and its long-term value had it scrapped the dividend when trouble hit, and borrowed less. Investors who need cash should sell some of their shares (for some of the smallest investors trading costs might be a bar, but at $10 a trade this is irrelevant for most). Instead, their irrational attachment to steady payments pushes companies to borrow and to cut back the business in bad times to maintain the payment.

Those eagerly anticipating their next dividend check might be spluttering into their latte in horror at these views. But whether the dividend is paid out or not should make no difference to them. Shareholders own the company. When it pays out money to shareholders, it is worth less -- by precisely the amount of the dividend. The shareholder's pocketbook is unchanged. Somehow investors still fail to notice this.

In an ideal world, companies would pay out cash when they have no good uses for it, and invest it in new projects only when justified by expected future profits. In an ideal world, shareholders would trust the board's judgment, and executives wouldn't be swayed by the latest fashions. In reality shareholders swing from encouraging massive overinvestment to demanding all cash be returned (now!) while managers frequently ignore solid projects to game some ratio currently in vogue with Wall Street, or set out on empire-building projects to boost their egos.

Demanding a solid dividend has merit as a way to limit empire-building, but investors should beware companies that make it a target to be met at all costs. Shareholders need to keep an eye on much more than the quarterly payout to avoid their investments going the way of GE.

Write to James Mackintosh at James.Mackintosh@wsj.com

(END) Dow Jones Newswires

November 01, 2018 14:24 ET (18:24 GMT)

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