The way I define dividend-based companies are one that consistently pay dividends and/or consistently grow dividends. There are multiple schools of thoughts on how companies should use income generated with primary business activity (i.e. selling a product and/or services). Should the company pay back certain amount profits to shareholders or invest back into the business for further growth? To me, it depends upon the company, its business plans and objectives. Whether I prefer it or not depends upon what are my investment objectives.

In general, in developing industry sectors, companies earn their profits by innovation, product uniqueness, time of market, etc. For examples, companies in technology, alternative energy, biotechnology, traditional pharmaceuticals, etc., sectors need heavy capital investments to continue their growth and maintain competitiveness. The argument that all profit needs to be ploughed back into the business holds ground. Therefore, it is rare (if not impossible) that a growth-oriented company will provide dividends. New startups, early years of Infosys, early years of Wipro, early years of HCL, early years of Tata Motors, et. al., fall under such groups. Although it can be argued that some companies in technology sectors, such as Infosys, Wipro, and HCL are becoming more of a value (and perhaps dividend) play. There is nothing wrong in this argument and intentions of management of such companies. From my viewpoint, when such companies are at nascent stage, it is very difficult to understand them and their proposed business model for generating earnings. By the time they start demonstrating their potential with revenue and growth in market share, Mr. Market already prices them at higher multiples.

On the other hand, in mature industry sectors, companies earn their profits by efficient execution and economies of scale. For example, companies in consumer staples, retail, real estate, banking, and technology services are the ones that depend heavily on these two factors. These sectors do not need large capital investments for “continued innovation”. So if I am investing in these sectors, I expect management to share their profits with shareholders in the form of dividends. They do not have any strong argument that all profits need to be invested back into business for growth. When such companies are consistently paying and growing dividends, they are (1) ensuring that shareholders are an important part of their business; (2) shows management’s ability to be financially responsible; and (3) confidence that their business strategies will continue to generate earnings. Since most of the companies pay dividends from free cash flow, the likelihood of engineering the balance sheet is very low.

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This post was originally published on The Income Portfolio Blog on February 23, 2009.

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