I’m amazed by the short-term thinking of people who see themselves as long-term investors.

I’m also constantly struck by the cult-like pursuit of companies who raise their dividends every year.

When you put those two things together you get weird incentives that result in truly bizarre behavior by public companies.

For example, oil majors are not only continuing to pay dividends, oil majors are actually raising dividends. This is despite the fact that the oil majors have been cash flow negative for 3+ years. That’s right – you have companies that are LOSING money but are paying increasing dividends to their shareholders. This completely defeats the whole purpose of dividends. A dividend is supposed to be a share of the company’s profits.

How dividends should be determined

Here’s the optimal way for a company to pay dividends. First, a company has a certain amount of revenue. They pay expenses and what’s left is profit. The company then decides to reinvest some of that profit back into the company (in hopes of growing future profits or maintaining current profits) and whatever is left is paid out to shareholders as dividends. If the company makes no profits in any given year then no dividends are paid. Large profits = large dividends. Small profits = small dividends.

This is how you would take profits if you owned the entire company.

When times are good your company makes lots of money. You’d reinvest some of that money back into your business and pay yourself the rest.

Here’s an example – my mom is part-owner of a self-storage facility (which is a fantastic business, by the way). From month to month the vacancy rate varies. Sometimes the manager of the self-storage facility runs specials (first month free, for example) to get new business. Vacancy decreases during the summertime (as college students put their stuff in storage and head home for summer break) and increases when school starts up again (when the college kids pull their stuff back out of storage). As a result, the profits vary from month-to-month. The self-storage business doesn’t commit to some sort of fixed payment to the owners. Each month the rents come in, expenses are paid, and the difference is paid out. The hope is that, over time, the profits sent to the owners rise as rents go up.

This is a rational dividend policy.

How dividends are determined

Unfortunately, demand from investors has made the dividend policy for US companies completely irrational. Dividends are no longer a share of company profits. Instead, dividend policy has become a way to signal financial strength, regardless of whether or not there actually IS any underlying financial strength.

Here’s how it works. First, when asked on calls with analysts, the CEO of a dividend paying company will almost always say that the dividend is the #1 priority for the company. Investors love to hear this. They believe that paying dividends somehow instills discipline in a company. After all, if the dividend is the #1 priority, then the thinking is that the CEO will be conservative, ensuring that profits are steady so the dividend can continue being paid.

This is bullshit.

There reality is that companies can (and do) pay dividends whether they are profitable or losing money hand over fist.

Let’s take Chevron as an example.

Look at Chevron’s cash flow for the last few years.

I’ve used my world class photo editing skills to highlight a few important sections.

First, the yellow section shows the annual cash flow from operating activities. This is the actual cash left over after selling oil and paying all expenses. You’ll note that this number has dropped from $31.5B in 2014 to $19.5B in 2015 to $12.8B in 2016. No surprise here – lower oil prices have hurt the profitability of oil companies. It costs the same amount of money to extract a barrel of oil from the ground regardless of whether you can sell the oil for $35/barrel or $110/barrel. Lower oil prices directly hurt profits.

The green section shows Capital Expenditures. These are the costs to keep the company running – maintain oil drilling equipment, buy new equipment when needed, find or buy new oil fields and drilling rights, etc. Chevron has been doing the intelligent thing and reducing capital expenditures as profits have fallen. Capital expenditures have gone from $35.4B in 2014 to $29.5B in 2015 to $18.1B in 2016. In just 2 years Chevron has cut capital expenditures by 49%. Unfortunately, operating cash flow (the yellow section) dropped by 59%.

But here’s the real story – the blue sections show the dividends paid and the net borrowings for each year. In 2014 Chevron borrowed $7.4B and paid $8B in dividends. In 2015 it borrowed $10.7B and paid $8.1B in dividends. And in 2016 it borrowed $7.5B and paid $8.1B. In total, from 2014-2016, Chevron borrowed $25.6B and paid $24.2B in dividends.

All of Chevron’s dividends were paid with borrowed money.

This is completely insane. Chevron is mortgaging the future to pay dividends today.

Why?

Because investors put so much emphasis on a consistent dividend streak that companies will cause themselves permanent harm to avoid cutting their dividends.

The reality of consistent dividends

In public companies the owners don’t directly control the company. In theory the shareholders elect the board, which in turn hires and manages the CEO, who then runs the company on behalf of the shareholders. In reality, individual investors have no say over how a company is run. The small number of shares that any individual shareholder owns means the shareholder’s votes are inconsequential, and the CEO will often insist on stocking the board with friends and supporters. Additionally, shareholders do not have complete information about a company’s financial position. Shareholders are forced to rely on quarterly earnings reports and an annual report.

In this context I can see how a constant dividend policy makes sense. Many dividend growth investors believe that everything you need to know about a company’s financial health can be boiled down to a single number – the dividend.

The idea is that companies only raise their dividend if the company is pretty confident in their ability to continue paying the new, higher dividend. Shareholders know this, so a raised dividend is seen as a sign of strength (and a dividend cut as a sign of weakness). There’s even a saying among dividend investors – “The safest dividend is the one that’s just been raised.”

This thinking makes dividend raises even more important and the whole thing becomes a self-perpetuating cycle. A company increases the dividend to attract investors, and these investors then demand further dividend raises.

But here’s the thing – in order to pay a consistent, steadily increasing dividend a company must be paying lower dividends today that they could otherwise pay. Companies are forced to be very conservative about raising dividends because they know that any future dividend freeze or reduction will be seen as a sign of calamity rather than a byproduct of a normal business/economic cycle. Rather than pay out all excess profit, companies horde it to ensure they have layers and layers of protection against needing to reduce the dividends at any point in the future.

You can get a good idea of how rational a dividend policy is by looking at the payout ratio over time. A rational policy would have the payout ratio remaining relatively consistent from year to year. This means that dividends paid roughly track the profits of the company. An irrational policy would result in the payout ratio varying widely from year to year, as this would imply that a fixed dividend was being paid, regardless of underlying profits.

The perfect example of an irrational dividend policy – Chevron. In the last 10 years the payout ratio has varied from 22% to 175%. In good years they paid out far less than they could afford to pay (as evidenced by a 22% payout ratio) and in bad years they paid out far more than they could afford to (as evidence by a 175% payout ratio).

I understand investors’ desire for constant, reliable income. Steady income is a lot easier to live on than mercurial capital gains. However, what investors SHOULD care about is that their overall portfolio provide a constant and reliable income stream, and this does not require that each individual investment in a portfolio provide a constant and reliable income stream.

For example, if you own oil stocks you should expect higher dividends when oil prices (and profits) are high and lower (or no) dividends when oil prices (and profits) are low. If you own oil stocks and want a portfolio with a constant, steady income then you’d add companies to your portfolio that benefit from low oil prices. For example, you could add airline stocks and maybe downstream oil processors – both of these types of businesses benefit from low oil prices. The overall effect would be steady, consistent portfolio income. You can have wildly varying income streams inside a portfolio and still have the overall portfolio provide a steady income stream.

It doesn’t make sense to insist that individual investments provide steady income when the real goal is to have a portfolio that, in aggregate, provides a steady income. And, by freeing individual investment from the requirement of never lowering their dividends, in any given year the dividends received will be higher.

Conclusion

It’s actually pretty cynical for companies to put so much emphasis dividends. Companies do this because they know that many investors will heavily weight dividend consistency when making investments. Companies know that investor won’t look at profits or the underlying health of the business – investors will see a recently increased dividend and assume everything is fine (despite the MANY instances of a dividend being raised and then subsequently cut or eliminated).

There’s nothing inherently wrong with paying a consistent dividend, as long as the dividend is matching the performance of the business. There are some businesses that are inherently stable (tobacco and health care are two great examples). However, it’s crazy to think there’s something wrong with a company (or its business) if profits fluctuate from year to year. And the idea of paying steadily rising dividends regardless of profits is just stupid.

And even more stupid is borrowing money and/or selling assets so you can continue paying dividends that are unsupported by profits.

If you are looking at making an investment, look at whether a company has been loading up on debt. There are times when it might be reasonable for a company to take on debt (if it’s investing in new production facilities, or to make a bolt-on acquisition that accretive to profits), but in general, debt is bad.

Debt is either repaid or a company goes bankrupt. If the debt is repaid that means future profits are used to pay off the debt and interest incurred today.  Future shareholders will be enjoying lower dividends so that current shareholders can enjoy higher dividends.

Do you want to be that future shareholder?