Is the Stock Market a Ponzi Scheme?

You've heard of Madoff and how he bamboozled investors out of almost $50 billion dollars with his Ponzi Scheme. Well, I think there's an even bigger Ponzi Scheme going on. It's called non-dividend paying stocks.

I have only been investing for about 7 months, so I am still a little green behind the ears. I have learned a lot about stocks (and I know I still have a lot to learn). But one thing I just can't seem to understand is why someone would want to own a non-dividend paying stock.

Let's say two friends start a company (we'll call it Company X) and they each go in half for it. They do well and it grows and grows. They decide they could really use more money in order to expand, hire more employees, etc. So they come to me and ask me to invest in their company.

What if they told me that they have no intention of ever giving me any money, rather all the profit made is just re-invested back into the company. I would never receive a dime from Company X. Why would I ever want to do something like that? The only way I would ever make any money is by finding someone who will buy my part of the company for more than I paid for it. But why would someone else want to buy a share in the company knowing that they the company intends not to pay them a dime? The only way he would make money is by finding another person to pay for the investment, and so on – which would seem to me to be a sort of a ponzi scheme.

Say I went and invested in Company X, and I got 100 shares at $10 each ($1,000 total investment), and say the company does very well and expands, and after 25 years my shares are now worth $500 each ($50,000 total). That’s great. But what if 10 years later Company X starts to do very poorly, and the shares plummet, and now the shares are only worth $5 each? Or Company X goes out of business and my shares are now worth nothing? 35 years of investing down the drain. I’d have been better off putting my money in a mattress.

On the flip side, Company X had said that they obviously can’t afford anything right now, but once their business expands they plan on returning some of the profit to me. In that case, even if after 35 years the doors are closed, most likely I would received my original investment back many times, and at any rate I would received much more than if they had paid me nothing.

I do not understand why people would want to own stocks like GOOG, APL, or BRK.A. They have never paid a dividend. Slackerwealth has an excellent post on this. He used Google for an example. Google last year was at about $700 a share. Today it's under $300.

I've heard some people argue that you don't want dividends because you have to pay taxes on them. (This article here argues that dividend stocks are a mistake).That is just like saying you wouldn't want to win the lottery because you'd be taxed on that. I am also in a low tax bracket so those taxes don't affect me very much either.

I’ve heard (well actually, read) other people saying that instead of issuing dividends the company should buy back stocks. Personally, I am against stock buy backs in most situations. I’d rather have them pay me and then if I think they stock is undervalued then I can use that money to buy more. One stock I hold, GLW, has done buy backs when the share price was recently at around $20+. The stock is now at $8.68. Perhaps that money could have been better used being paid out to shareholders. (They do pay a dividend, but even with a share price of less than 1/3 of its 52-week high it’s only a 2% yield).

My personal view is that as a general rule most companies should return 25%-50% of its net income to the investor. Obviously there are exceptions to that - very small companies wouldn’t be able to do that and they should spend most of their profits on growing their business, or a company might have a couple real bad quarters and need to cut or postpone their dividend. B & G Foods (BGF, BGS) is an example of that. They were paying out a 21¢ dividend but just recently reduced that to 17¢ because they wanted to strengthen their balance sheet because of the way the economy was going. I fully supported that because they explained why they needed to do the cut, and at the same time the made it clear that they are committed to paying out dividends to the shareholder.

I did come across this article entitled “What is the incentive to buy a stock without dividends?” but it really doesn’t explain WHY you would want to buy a non-dividend paying stock. It does explain that you buy them for the capital gains, but again, that all goes back to finding someone who wants to hold a security that is never going to pay them anything, and if the share price falls you will loose money.

Feel free to leave some feedback. If you disagree with me, that’s great – convince me I’m wrong.