In general, stocks that pay out as dividends either nothing or a low portion of profits have, in recent years, been outperforming those that pay out a higher proportion of income.
"This was because he took the view that growth was overrated"
What should matter most to an investor is the long-term total return of his portfolio. Total return will be a combination of dividends and capital growth. If a company is generating high capital growth – by reinvesting profits in its business, say – should an investor care whether he receives a dividend? Theoretically, he should not. Capital growth of 20% but no dividend is preferable to 10% growth with a 5% dividend yield, right?
Yes. And no.
While there are indeed great performing companies that pay no dividend – Facebook, Amazon, Netflix, and Alphabet are good examples – there is strong evidence that over time, companies with higher pay-out ratios perform better.
A 2003 study by Robert Arnott and Cliff Asness titled Surprise! Higher Dividends = Higher Earnings Growth analysed data going back 130 years and found that the higher the pay-out ratio, the higher the earnings growth in the subsequent 10 years. Their explanation? On the one hand, high pay-out ratios reflected confidence in future earnings; on the other, they prevented management teams spending cash foolishly.
A company can do one or a combination of four things with the cash generated by its operations: keep it to reduce gearing; spend it on fixed assets; pass it to shareholders as dividends; or reduce capital through share buy-backs. Picking the precise mix is what is known as capital management and, done well, it is a powerful tool.
How much should companies pay out in dividends? In his final edition of The Intelligent Investor in the early 1970s, legendary investor Benjamin Graham wrote: “Shareholders should demand of their managements either a normal pay-out of earnings – on the order, say, of two thirds – or else a clear-cut demonstration that the reinvested profits have produced a satisfactory increase in per-share earnings.”
This was because he took the view that growth was overrated. Investors, he argued, overestimated the extent to which companies were able to extract excess returns on capital from existing assets, let alone new ones. Graham’s view is supported by empirical studies that showed value significantly outperforming growth over time, notwithstanding the last couple of decades in which the reverse has been true.
Has the world changed since Graham’s day? In some key respects, yes. It is possible that the structural changes the world has been experiencing in recent years are greater than those in the last two centuries. Companies like Amazon have thrived in the current crisis as transportation all but ground to a halt.
Indeed, the coronavirus crisis is only going to accelerate what was already a particularly rapid process of corporate creative destruction. Companies that went into the crisis with weak balance sheets will come out of it even weaker.
Which are the best businesses? Time will tell, but a key ingredient will no doubt be a large cash pile that can be deployed to kill off injured competitors. This suggests that the ‘big six’ US internet-oriented companies – Alphabet (formerly Google), Apple, Amazon, Facebook, Netflix, and Microsoft – are well placed, given their combined pile of cash and short term investments totalling close to $500bn.
I spent much of my career based in Asia, and recall the case of Taiwan Semiconductor Manufacturing, one of the region’s most successful tech companies. Throughout the 1990s, it did not pay dividends, instead pouring all its earnings back into fixed assets, which rose around 20 times between 1993 and 2000. The company then decided to ease back on reinvestment and, over the next five years, it raised its pay-out from zero to 70%. The change in the nature of its share price performance was extraordinary: risk-adjusted returns after 2000 were three times higher than they had been in the 1990s. Internet companies, take note.
Published in What Investment
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.