February 19, 2016

The Value of Dividends

 

“If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained” Warren Buffett

When a company pays a dividend, they are paying you, the owner, with cash that you already own. In theory this transaction shouldn’t create any value. But in practice companies that pay a high and stable dividend tend to get rewarded well by the market.

Numerous academic studies have shown that higher yielding stocks outperform the market over the long run. In his book “The Future for Investors”, Jeremy Siegel studied the performance of the S&P500 constituents from 1957 to 2002. The study showed that the top quintile by dividend yield produced an annualized return of 14.27% versus 11.8% for the S&P500 as a whole.

 

Why paying dividends is healthy

 If a dividend simply represents a payment of your own money to yourself, why does it appear to make a difference? There are two strong explanations here:

  1. Companies which payout a high dividend tend to be more disciplined. A high dividend enforces a policy of efficient capital allocation – with limited capital to spare, only projects with higher returns get funded and the poor return projects get dropped. These companies adopt a strong sense for the cost of capital throughout all levels of the organization. By contrast companies not paying out a dividend have a tendency to fund all projects, regardless of their return, or worse to engage in value-destroying acquisitions.
  2. A high dividend yield often goes hand in hand with a culture of shareholder friendliness and strong corporate governance. Companies with generous payouts are more likely to treat shareholders fairly when it comes to questions of corporate governance in other areas.

Unfortunately at too many companies there is an obvious conflict of interest between shareholders and management. A bigger company comes with more recognition, greater influence and a bigger paycheck. These management teams like to retain earnings to grow the business (either organically or through acquisition) regardless of the cost to shareholders. A high payout ratio can act as a check on management’s ability to engage in this type of behavior.

 

One size doesn’t fit all

While the academic research supports a higher dividend payout, a blind strategy of investing in higher yielding stocks is unlikely to be optimal. This is because the right dividend strategy will vary depending on the type of company. Where a company has opportunities for expansion and high incremental returns, naturally you would want the company to retain earnings in order to take advantage of this. These high growth companies may benefit from paying no dividends in the growth phase of their development. But as growth matures and new opportunities dry up, it makes sense for the company to transition to paying out at least some of their earnings (As Microsoft did in 2003).

“we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners” Warren Buffett

 For more on the balance of growth and ROIC, see our previous blog post “Why ROIC Matters

 

The importance of stability

 Subject to the availability of opportunities it usually pays for a company to have a stable and growing dividend. A conservative and long-term dividend policy creates an environment where management can plan for the long term while maintaining a disciplined approach to capital allocation. Of course this policy can evolve over time depending on the changes to the opportunity set, but it’s likely to represent a gradual change rather than a sudden one.

“The managements whose dividend policies win the widest approval among discerning investors are those who hold that a dividend should be raised with the greatest caution and only when there is great probability that it can be maintained. Similarly, only in the gravest of emergencies should such dividends be lowered.” Philip Fisher, Common Stocks and Uncommon Profits

“Payments…should reflect long-term expectations for both earnings and returns on incremental capital. Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distributable earnings that have been withheld by managers should earn their keep” Warren Buffett

While the academic research would argue for a strategy of selecting high yield stocks, we would recommend a more nuanced approach. A high yield is a good place to start, but it’s also important to understand the policy that drives the yield and the sustainability of that policy.  Furthermore you need to be aware of the company’s approach to capital allocation and attitude towards shareholders. Beyond any one single figure, it is these factors that are likely to determine the long-term success of your investment.

 

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