When life gives you debt, make dividends?

In every big decline, stock market investors learn a lesson. And although the lessons remain the same time and again, the pupils come to learn each lesson as a unique experience, one at a time.

The most current lesson for investors has been popularized as the danger of commodity investing. But I think it’s pretty safe to assume that even novice investors (especially Canadians) understood going into it that commodity companies are far more volatile than other types of assets. By equal measure, I don’t think this lesson has to do with the influence of environmental policy on energy either. Support or deny it, the legislation reform around emission reduction was not exactly a surprise, as lobbying efforts on both sides have been steadily increasing over the last decade. So if the lesson isn’t that commodities are inherently volatile, and it’s not that lawmakers rule the stock market, then what is it?

I think the real lesson for investors is about debt, and specifically the financial engineering that turns debt into dividends. Let’s take a lemonade stand as an example of how this works.

As the CEO of Forest Hill Lemonade Ltd, we put together some startup capital from investors to buy some lemons, some cups, a table, hang some signs around the neighbourhood, and hire someone to do the squeezing. At the end of the day our lemonade business generates $10 of sales. When we tally up our daily expenses however, we find it costs us $10 to produce the lemonade. Uh oh, we think. Just then a well-off kid from down the block comes over and lets us in on a little secret: investors generally don’t enjoy businesses with zero profit, but they are a patient bunch, and really do enjoy receiving dividends. So in order to keep our investors happy, we borrow 25cents from our well-off friend, and then pay out that 25cents to our investors.

As long as the price of lemonade remains stable, we could keep this charade going by continually borrowing money and paying it out as a dividend. The lender receives their interest, the investors receive their dividends, and our lemonade business covers its costs. If the price of lemonade increases, not only would the business actually make a profit, but the value of our unsqueezed lemons goes up too. But here’s the catch: if the price of lemonade starts to fall, our business loses money if it stays open. At that point we have to make a choice. We can use the debt to fund our business expenses, or use it to pay a dividend to our investors, but not both. And if things get really bad for lemonade prices, our well-off friend might stop lending altogether.

This is what finance calls a Minsky moment, named after economist Hyman Minsky. It is the tipping point when debt can no longer be serviced by operating cash flow. The business grinds to halt as lenders and investors lose faith, resulting in significant declines in asset value.

Leading up to the collapse in oil price about a year and a half ago, energy companies across North America had spent about a decade racking up huge amounts of debt. Much of the dollar value of that debt passed right through the companies, ending up in shareholder hands as dividends. In effect, many energy companies found their primary livelihoods in the financial engineering business, and just happened to produce some oil on the side.

Ironically, I’ve found that average and professional investors alike continue to favour high dividend companies across many industries without questioning how those dividends are being paid, and the source of growth behind increasing company share prices. The lessons from prior examples show that while debt-for-dividends bargains may work in the short run, they usually end up looking the same in the long run. 

Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.