Dividends in Quality Investing: A Tool, Not the Goal
Are dividends a sign of strength or a limitation on growth? Let’s break it down.
The Role of Dividends in My Investment Strategy
Dividends are one of the most debated topics in investing. Some investors won’t touch a stock without a solid yield, while others see dividends as a sign that a company has run out of growth opportunities. The reality, like most things in investing, is more nuanced.
First, let’s name the popular dividend strategies companies use:
Dividend growth—Companies committed to returning an annually growing dividend to shareholders, often with low initial yields.
High-yield—Companies with high dividend payout ratios, often paying a yield above 5% and without much dividend growth.
Fixed payout ratios—Companies that return a fixed payout range of their earnings back to shareholders without caring for a dividend growth streak. More likely to pay a special dividend, cut or suspend dividends if needed.
Non-dividend payers—Companies that either prefer to spend their cash on buybacks, reinvestment or debt repayment—or ones that aren’t profitable yet.
Dividends Are a Tool, Not a Strategy
A dividend is simply a way for a company to return capital to shareholders. It is neither inherently good nor bad—what matters is why a company is paying it and whether that decision makes sense given its opportunities. We must keep in mind that dividends are tax-inefficient unlike buybacks and reinvestment, we must not stop compounding to pay the tax bill.
Here are a few key points I keep in mind:
If a company can reinvest at high returns, it should. A business generating 20% + returns on reinvested capital should not be paying out a high dividend; instead, it should compound those earnings. For example, Eckert & Ziegler cut its dividend by 90%, because it wants to accelerate reinvestment into the business. A great decision.
If attractive growth opportunities are limited, dividends make sense. A mature company with stable cash flows and limited reinvestment options should return excess cash to shareholders rather than hoard it, or worse, destroy it by reinvesting in speculative or low ROIC investments.
Dividends should be sustainable. A high yield means nothing if it’s not backed by strong free cash flow. Many companies overpay dividends, leading to cuts that hurt investors once the business gets into a downturn.
Dividends should be part of the equation, not the whole story. A strong business with durable competitive advantages is more important than its yield. I’d rather own a great company with a low yield than a mediocre one paying a high dividend.
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When Do Dividends Raise Red Flags?
Not all dividends are created equal. Some can signal weak capital allocation rather than strength. Here are some signs that a dividend might be a red flag:
❌ The company is borrowing to pay dividends. If a business isn’t generating enough cash to fund its dividend, it’s a ticking time bomb. This can be maintained over a short period. For example, Texas Instruments is currently in an accelerated reinvestment cycle and did not cover its dividend in 2024, but the situation is temporary.
❌ Focusing on earnings instead of cashflows. Dividends should always be paid out of Free Cash Flow. We should always look at cash, especially in businesses with weak cash conversions. Earnings can be manipulated, but cash on the balance sheet is hard to trick over the long term.
❌ The payout ratio is too high. A company paying out 80%+ of earnings as dividends has little room for error if cash flows decline and is limiting its capital allocation toolbox.
❌ The company has better uses for capital. If management is returning cash while also taking on debt or issuing shares to fund growth, that’s often a sign of poor discipline. Companies that refuse to discuss buybacks alongside dividend payments to return capital also limit their options.
Dividends in My Portfolio
I don’t actively seek out high-dividend stocks, but I also don’t ignore them. If a high-quality company naturally pays a dividend while maintaining strong reinvestment opportunities, I see that as a bonus.
For example, some boring, capital-light and cash-generating businesses like financials, consulting or distribution companies balance dividends with disciplined capital allocation. These companies can make fantastic long-term holdings.
My best example is Stemmer Imaging, which got acquired last year at a 52% premium. The company is a capital-light machine vision distribution business with strong cash generation and limited required capital to grow. This means Free Cash Flows can be paid out entirely. The company was very cheap and paid an 8% dividend while I owned it. A high yield is not enough to interest me, but it can be part of an investment case.
How Do Dividends Impact Valuation?
Dividends don’t just provide income—they also influence how we value a business. Understanding how they affect valuation models, expected returns and growth can make the difference between a good investment and a value trap.
In the premium section, I’ll break down:
How I integrate dividends into my valuation models.
The trade-off between dividends and buybacks. Which is better for investors and when does each make sense?
One dividend-paying stocks that meet my quality criteria. A high-quality company that balances growth, profitability and shareholder returns by paying out >3% annually. Why do I like their dividend strategy?
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