I sometimes wonder if it is a little odd to get as excited as I do about dividends. Asia is about growth, people say. Why on earth would I get turned on by dividends?
"It is difficult to pinpoint any one reason as to why shareholders accepted this relentless decline in pay-out ratios"
Well, put simply, a dividend policy is what binds a company to its shareholders. It is therefore an incisive way for a company to send a message or a series of messages to its owners: how much it cares about them, what it thinks about the future, the confidence it has in its business.
But a dividend is also important because it helps determine the yield of the underlying shares. Whether you like it or not, equities, like bonds, should get judged on the basis of their yield.
Companies can do one or a combination of four things with the cash generated by their operations: keep it to reduce gearing, spend it on fixed assets, pass it to shareholders as dividends, or reduce capital through share buy-backs. A fifth use is working capital, but this is rarely by choice and usually reason for concern.
The precise mixed of these four that a company decides upon is what's known as capital management and done well it's a very powerful tool.
How much should companies pay out in dividends? Famous investor Benjamin Graham said shareholders should demand of their managements either a normal payout of earnings on the order say of 2/3 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 rather lofty though largely correct view that growth tends to get 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.
This is amply demonstrated by the many empirical studies that show value stocks significantly outperforming their growth counterparts over time.
My personal feeling is simply that priority should be given to the option that offers shareholders a higher return. When companies decide to withhold dividends, management must make a clear case for doing so. If earnings need to be retained for capital investment it would be silly to pay out dividends, then ask for them back, but managements should behave as if this was what happens.
It is ironic that Professor Graham was writing what would be his final edition of The Intelligent Investor in the early 1970s at the beginning of a period that would see pay-out ratios fall in the US as companies took a daddy-knows-best attitude to shareholders. Things only began to change for the better in 1984 following oilman T. Boone Pickens’ launch of a hostile takeover for Gulf Oil.
But although the 1980s in 1990s saw American companies become leaner and more efficient pay-out ratios continue to fall. In the early 1970s about 60% of companies paid dividends. By 1999 this had fallen to 20%.
It is difficult to pinpoint any one reason as to why shareholders accepted this relentless decline in pay-out ratios. Perhaps it was because the period was defined by high growth and low inflation in which reinvestment of earnings was an easy sell to shareholders. Moreover, equities were not judged so much, thanks to low interest rates, on the basis of yield.
But the 1980s and 1990s constituted the Internet age in which shareholders were all too happy to let companies spend their money on ever more complex technologies. We all know how that one ended.
Regardless of a tendency to let ourselves be abused by a managements, evidence in support of higher pay-out ratios is overwhelming. A study by Robert Arnott and Cliff Asness titled Surprise! Higher dividends equals 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, a finding which flew in the face of accepted wisdom.
Their explanation? On the one hand high pay-out ratios reflect extraordinary confidence in future earnings. On the other they prevent empire building in which managements with too much cash have a tendency to spend it on unprofitable acquisitions.
This brings me to Asia. In a previous era, managers here were wont to diversify, often recklessly, into non-productive assets - real estate, golf courses, and the like - in which they had no prior experience. This was a symptom of hubris and of weak shareholders.
But two things have changed. First, post crisis, companies are much better managed. At the same time, institutions, which are more rational long-term investors, are making themselves heard. The result is that pay-out ratios across Asia, while low by Professor Graham’s standards, have risen to about 40%.
For example, throughout the 1990s, Taiwan Semiconductor Manufacturing did not pay dividends. Instead, it poured all its earnings back into fixed assets, which rose from NT$10 billion in 1993 to over NT$200 billion in 2000. It then decided that it had grown enough. Over the ensuing five years it raised its pay-out ratio from zero to 70%. The change in the nature of its share price performance was extraordinary: volatility adjusted returns after 2000 with three times higher than in the 1990s.
Going forward, what might matter more than changing management attitudes, is the impact of higher inflation. In the low inflation environment of the last 20 years, dividend yield played second fiddle to growth considerations, rarely being used to measure an equity’s valuation in comparison with, say, bonds.
If as seems likely we are entering a period of higher inflation, investors will be forced to focus more on yield. Those companies that are not only able to distribute a large chunk of profits but also able to increase their dividends at least in line with inflation should get more attention. Pricing power will be a precious quality and companies able to pass on rising costs should thrive.
For the Asian investor, keeping up with inflation will be hard. Inflation-linked bonds hardly exist, and commodities investing is being touted as the only inflation hedge - a rollercoaster ride that can leave one feeling drained mentally if not financially. Perhaps this is equities’ chance to step up to the plate.
Published in the South China Morning Post
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.