Oil giant Exxon Mobil has increased its dividend for the last 17 years without fail. They want to increase it again this year. They don’t have the money, so they are going to borrow it.
Stock dividend payments are a way that companies pay profits directly to their shareholders. When a company earns money, they need to decide between re-investing the money in their company, using it to buy back their own shares to repay part of what they borrowed from stockholders, or pay out some of their profits directly to shareholders.
There are competing interests at work as part of this decision-making process, and this has to do with the degree that a company wishes to grow its business longer-term versus how shareholders wish to be compensated in the shorter-term. To further complicate things, there’s a second conflict at work, as if we prefer the shorter-term, there is also a conflict of understanding among shareholders as to how they may best achieve the short-term payouts they desire.
Everyone understands the idea of a company re-investing its profits, and this involve real investment, not the kind that we refer to when we speak of investing in stocks. We might think that our buying Exxon Mobil stock involves us investing in Exxon Mobil, but this transaction does not involve the company at all and just involves the passing of a certain stake in the company from one person to another.
Economists define investment differently than the man on the street, and people who call themselves investors and do so by buying and selling stock aren’t doing any real investing at all. If you look up invest in the dictionary, you will see putting money into financial shares included, although it is only in there based upon common usage, which includes using a term incorrectly.
If we have a billion dollars to invest, sitting in a bank account, and we use it to buy Exxon Mobil stock, not a cent of this money makes it to Exxon Mobil or is invested in anything in the proper sense. Let’s say you buy the stock from another big investor who is happy to get out of the stock. You now own these shares instead of this other person. This does not change the amount of money invested in the company, the business, or the economy one bit, as it just involves these shares being owned by someone else, nothing more and nothing less.
Perhaps this big share purchase put the price of the company’s stock up quite a bit though, several dollars per share we’ll say, from the fact that this is the price you had to pay for the market to part with this much stock. This transaction has nothing to do with the company or the economy either, and a company’s stock price in general doesn’t have anything to do with the company’s business at all.
By extension, the stock market itself doesn’t have anything to do with the underlying businesses or the economy either, although there is a feedback loop the other way, where the performance of the economy and the underlying businesses do affect share prices by influencing the price people will be willing to buy and sell shares at.
Ownership in corporations are divided up fractionally by issuing shares, and this is the case whether these shares are privately held or publicly traded. When a company goes public, they place a certain percentage of their ownership in the market, where people trade these shares among themselves at various prices over time according to market forces.
Shareholders get to decide what happens to a company’s profits, which comes down to three different ways to distribute them, which are reinvesting them to grow the business further, reinvesting in the stock which places the money on hold while looking to grow the share price, or divesting them and paying them out to shareholders.
We normally think that the goal of a business is to grow itself through further investment, whether the money comes from reinvesting profits or to reduce expenses by paying down debt. Reinvesting profits does not just mean that they actually spend the money on capital investment, as paying off debt also uses the money to materially benefit the company by reducing the amount of interest they will pay, which translates to more profit in the future.
Companies decide whether to borrow for expansion based upon the expected rate of return that the spending is expected to deliver, and this is a big reason why lower interest rates will spur more capital spending. This is a lot like the price of oil influencing the capital expenditure of oil companies like Exxon Mobil, and as the price of oil goes up, their investments become more lucrative and they can invest in things that would be profitable at a higher oil price but may yield a net loss if the price of oil is lower.
The same thing applies to all companies when it comes to interest rates, as if they can borrow it more cheaply, they don’t need as big of a return on investment to profit from investing it in the company’s expansion. This is why you see companies borrowing so much when rates are very low like now because this lowers the threshold of the returns on investment that they need to justify additional borrowing.
Deciding what to do involves more than just looking at doing what we think companies are supposed to do, which is to maximize profit over time. This is where things get a little more complicated, but only if we don’t really understand the differences between a company and its stock and how the two are completely distinct.
A lot of people think that a company’s stock tells the story of how a company is doing, but this incorrect. They are two completely different things in fact. With privately held companies, the company’s results are all there is, but once a company goes public, this creates a separate measuring stick and even serves to displace concerns about the company’s actual welfare.
How healthy our businesses are does matter though, and this requires that we actually pay attention. We need to ignore stock prices if we want to understand how the business is faring because stock prices are not necessarily a good measurement of it. What we have done is replaced company performance with stock performance to a large degree, and these are not the same things at all.
This isn’t necessarily wrong, as the shareholders get to decide, and if they want to run their company straight into the ground by having it borrow money to put directly into the pockets of their owners, and this is what the owners really want, there isn’t any way to stop them, although we may want to consider using tighter regulation to rein in this temptation if we feel that this will end up limiting economic growth overall down the road.
We Need to Understand What We Are Doing to Be Able to Choose Well
There are competing interests here though, and if people pay attention to the stock over the company, the company will suffer. At the very least, we need enough transparency to at least allow those who do have a longer-term interest in the company by wanting to maintain their ownership stake over the long haul be making informed decisions.
These folks need to be worrying more about the health of the business than the shorter-term movement of their stock, by preferring that the goal of growing the business long-term be prioritized. There are a lot of shareholders in this situation that do not seem to realize the importance of this goal and are instead happy to see the company take action that limits their growth and the long-term interest of these investors in favor of cannibalizing their companies to various degrees.
We end up with three distinct strategies competing with each other, which is maintaining and growing the business, maintaining and growing the stock, and maintaining and growing the company’s dividend payout.
Growing the business ultimately grows the stock over the long-term, as these investments pay off down the road. This takes a while to play out, but the stock price should track this potential in both the short and long term, although that often does not happen in practice.
If we reinvest profits, this means less to pay out in dividends, and these two goals are completely competitive, where every dollar paid out in dividends is a dollar that could be reinvested. If we are interested in the long-term health of the company, we should always prefer that the money be spent on the company over being taken out of it and paid to shareholders as income, much like a small business owner will pay themselves a lower salary over a higher one so that they can make more money overall over time.
Once again, shareholders have the power to choose whatever they wish here, but they need to be clear about what the consequences of their decisions are. A lot of shareholders don’t really get this and will actually choose lower overall benefits from their ownership in favor of the benefits of skimming profits when doing so would negatively affect the company’s future potential and theirs in turn.
From the perspective of the company, it is going to be preferable to invest profits where this can be done at a positive rate of return, where doing so benefits the company. Capital expenditures to promote growth is one way to do this, but there may be some cases where the company can’t find a good place to put the money due to limited opportunities. If this is the case, and the company owes money, and using profits to pay down debt will provide a better return than using it for something else, paying down debt would be the sensible move.
If a company neither has suitable investment opportunities nor any debt, as rare as that is, they can either hold the funds in cash, use it to buy back their shares, or pay the money out in dividends.
Both reinvestment and debt repayment provide positive returns for the company, and from the perspective of the company, benefiting the company itself is preferable. Buying back shares when no real opportunity to benefit the company exists is a neutral move that just parks this money where it may be used later if the opportunity arises, where they can re-issue the stock and recapture the money spent to buy it back, and at a profit if the stock price has risen appreciably in the interim, which it often does.
Reinvestment is therefore positive for the business and positive for the stock long-term. Stock buybacks are neutral for the business short-term and positive for the stock short-term, and this can also be positive for the stock long-term if further growth opportunities emerge later where they can not only put this money back to work in the economy but put even more back due to raising more money from issuing the new stock than was paid for it earlier.
Dividend payments, on the other hand, both limit the company’s results and its stock price, and ultimately harm everyone. If shareholders don’t get this though, they will be prone to making this mistake.
Shareholders have a variety of interests in a company, from the short term to the very long term, and dividends hurt them all. They hurt the growth of the company by paying out this money instead of re-investing it, and they hurt the growth of the stock because this reinvestment helps stock prices in the long run as well.
Everyone Loses When a Company Chooses to Borrow to Pay Dividends
If shareholders are only in it for the short-term, the money could have instead have been used to grow the stock and this is a benefit that you don’t have to wait to receive. Even if you are planning on selling your stock after the dividend gets paid out, you’ll clearly do better with a buyback, especially since dividend payments result in these amounts being priced out of the stock. For instance, you get a certain dividend payment, this payout reduces the value of your shares, and you sell them with no net benefit from this action.
A buyback, on the other hand, involves a multiplier effect, where the money spent on the buyback will increase the value of the stock disproportionately, and provide more value to those who are looking to get out soon. Dividends are just a bad idea for everyone, period, every time, but there are so many people out there who misunderstand this that they just miss this.
When a company has debt out there and pays out profits to shareholders instead of paying off the debt, this results in a form of direct cannibalization of the company’s value, where the company is undisputedly left in an inferior position as a result of the payout. We’re getting paid now but this reduces the company’s ability to make profits later, because their interest costs are higher than what they would have been otherwise.
When you take this a step further and borrow money directly to pay out dividends, like Exxon Mobil is doing these days, this takes this craziness to a whole new level and serves to cannibalize the company even more dramatically.
We’re not sure why Exxon Mobil is being so stubborn about their dividends and insisting on adding to their debt load to preserve and even keep increasing them, but the only possibility is that they are pandering to confusion among their shareholders who are assumed to prefer the company and themselves be harmed in such a way as a result of their misunderstanding.
Exxon Mobil stood fast in 2019 by trying to choose both to spend on growth and keep their dividend. They are planning on continuing this practice in 2020, where they are spending almost all of their profits on expansion and then both selling off assets and borrowing the rest to pay these dividends.
The dividend strategy is separate from the growth strategy, and given that they have chosen to expand, we then need to look at what they should be doing with their dividend, cutting it dramatically or doing whatever it takes to preserve it.
Taking a look at their chart, and knowing how a lot of investors think, if they did limit their dividend to even just their profits, perhaps a lot of these shareholders would exit their positions. This would very likely cause their stock price to drop in the short-term. This stock has performed absolutely terribly with no real end in sight, and the last thing this stock needs is a lot more selling pressure from confused investors.
There are actually a lot of investors in these types of stocks that only are in it for the dividend and even seeing the stock dropping like it has doesn’t bother them. When you see a stock decline like this, you can count on a lot of this, as anyone who has been paying attention to the overall returns of this stock would have fled some time ago, as the stock has lost over a third of its value since 2016.
It’s not that things are turning around either, as Exxon Mobil has lost 12% in 2020 already, with perhaps even more to come. We grinned in a previous article a couple of months ago at reports of analysts seeing this as one of the hottest stocks of 2020, and as we expected, the joke has been on them so far with no real reason to think this may change. When you take a company that is being managed so poorly and combine that with being in such a horrible sector, this does not add up to anything good.
From the company’s perspective, it would have sure been nice to have not paid out these huge sums each year, currently at $16 billion, and at least kept these amounts reasonable enough that they would not have $46.9 billion in debt, up from $37.8 billion just a year ago.
They also would have more money to invest in the growth of their business, but just allowing this debt to grow instead of shrink is what makes their moves so terrible. They had to borrow to pay the dividend last year, and will need to do the same next year, and all this does is leave them with much higher liabilities and no benefit at all from a business standpoint.
When you borrow to invest, you get the revenue stream that the investment will provide in the future, where the idea is to make more than this costs you and leave you in a better position overall. When you borrow and just toss the money right out of the business, all this can possibly do is reduce future profits and harm the business with no benefit to the business whatsoever to offset or even dilute this harm.
For every shareholder who thinks that gaining a 5% return by way of dividends a year while losing even more than this on the price of their stock is a good deal, there are others who would see Exxon Mobil acting more responsibly and paying off their debt instead of ballooning it as a much more healthy thing to do, and this would at least offset the short-term impact on its stock of suspending this dividend until the company is at least debt-free.
You don’t have to crunch any numbers to figure out why maintaining their dividends is harmful to the company. Even though some people believe that Exxon Mobil can pay back the money that they are borrowing for these dividend payments in a few years once the benefits of their new investments kick in, the company would surely be a lot better off if they just didn’t borrow this extra money overall and see future profits sucked out of the company by all this.
This strategy has also caused their corporate bonds to be downgraded, meaning that their interest costs have risen overall as a result of this mismanagement. No one seems to care about this or whatever else this preoccupation with dividends will cause.
Are dividends such a priority that we will do whatever it takes to keep paying them at current levels or better even if this requires us to blind ourselves to other considerations to the point of significant harm? Are we so eager to get paid a little now that we’re willing to hurt ourselves down the road and end up assuring ourselves of being in a worse position?
This cannot be a matter of Exxon Mobil being able to make enough money later to pay for their current dividends, as we need to first ask why anyone in their right minds would ever want such a thing. It turns out that people don’t really even ask the question of whether a certain level of dividends is a good idea or not, they just want them and don’t even pay attention to how this affects the company or even the ultimate value of their ownership in it.
The company has chosen not to cut their dividend in 2020 and will probably increase it again, although probably not by much this time. They plan on selling off more assets and borrowing a lot more again to meet what they appear to be confusing with payroll, where a company does not consider making payroll to ever be on the table due to it being essential to the business.
Dividend payments are far from essential though, and many companies don’t pay them at all. The least we should expect is that they don’t borrow to pay them, and both lose the potential return of this paid out money and add the cost of borrowing on top of this. This is true corporate cannibalism, and if this is the goal, we should not be surprised to see Exxon Mobil’s carcass continue to rot.