I have recently been working my way through Howard Schilit’s book “Financial Shenanigans” which teaches intermediate investors the skills to identify companies possibly engaging in accounting behavior that would make Enron executives blush.

One of the things that Howard Schilit pointed out in his very informative work is the fact that companies cannot fake a dividend. Taking that logic one step further, they really cannot fake a growing dividend.

This makes sense at an intuitive. Imagine you are a slimeball executive trying to swindle thousands of hardworking, honest, decent shareholders out of their money by siphoning off funds from the company or overstating profits. By definition, these management teams that are engaging in fraud are overstating profits (either by artificially claiming the profits are higher so that the stock price will go up, or by stealing from the company to fund a lavish lifestyle). In either case, you want to keep the real profits you are generating in the company coffers for as long as you can. Paying out a dividend is the enemy of financial fraud because it involves letting go of cash that you do not have.

While there is no such thing as a 100% foolproof strategy to protect you against fraud (although divvying your portfolio up into 30-40 stocks worth 2.5% to 3.33% of your overall wealth seems like a damn good defense mechanism), putting most of your money into stocks with records of growing dividends seems like an intelligent way to guard against corporate fraud, particularly if you have limited familiarity with reading 10-Ks, annual reports, and other financial statements. A company with a long dividend growth history is an insurance policy of sorts because a company cannot really grow dividend payouts for two decades if there is sweeping fraud taking place (where would a fraudulent company come up with the money to make the dividend payments?).

Also, I try to keep in mind the general tendencies of human nature when thinking about corporate fraud. If you are company like Campbell Soup that is chugging along, growing earnings at 4-5% per year, there is not a whole lot of pressure to lie about your performance and try to start some kind of defrauding program. But if you are a high-flying growth company that is expected to grow earnings per share at 20% every year, and you know that your stock price will plummet the first moment you post disappointing results, the incentive to engage in fraudulent behavior seems a lot greater.

Companies like Procter & Gamble, 3M, Emerson Electric, and Colgate-Palmolive have been raising dividends for over fifty years. Half a century! You can’t make that. You need to be selling real products with timeless demand that generate real profits that work their way to the company coffers and eventually to your pocketbook in the form of a cash dividend.

If you are going to invest in the stock market, and your ability to read financial statements is not particularly strong, I would probably limit myself exclusively to dividend paying stocks. When you review the history of fraud in corporate America history, it is not the legendary companies with decades of dividend growth that fall victim to egomaniacs that engage in corrupt behavior. Usually, fraud occurs where a company is engaging in seemingly rapid growth, and the executives want to maintain the illusion.

The take home lesson is that a dividend payment is the enemy of fraudsters. That is not an exaggeration. Fraud is all about claiming to have something that you truly don’t. Dividends force you to part with cash, plain and simple. Why would anyone engaging in fraud give shareholders 10% dividend raises if they know that money isn’t actually in the corporate coffers? It would just make the sands of time until they get caught run faster. It’s pretty damn easy to maintain the illusion if everything is “on the books” and you do not have to do anything to tangible demonstrate your cash generating abilities. In that regard, dividends serve as an automatic gut check on corporate health, and a long history of growing dividends are the friend to the investor that has limited experience with reading accounting statements.

Originally posted 2013-07-01 06:28:03.

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