Income fund managers constantly bang on about dividends. Maybe it’s in our genetic makeup but actually dividends should be important for all equity investors. In my mind there are five key reasons for this:
1) Total returns – I can bore you by reciting data from numerous studies showing dividend yield and dividend growth make up the majority of an investor’s total return over the long run but it would be more interesting to look at a real time example. I bought Imperial Brands for the Trust 5 years ago when the stock was trading on an 11x price to earnings multiple. Today the multiple is still at 11x. The market is valuing the company at the same rating it did 5 years ago. So does that mean the company has been a bad investment? In short, No. The shares have delivered a total return of 64%, outperforming the UK equity market by over 20% in that time period. That return has been driven by the high dividend yield which has grown at 10% p.a. Message 1 – you don’t need a rerating for shares to outperform.
2) Contrarian investing - generally high yielding stocks tend to be unfashionable as either they have disappointed the market, resulting in a falling share price/rising yield, or they are mature, low growth businesses. Consequently, investors either underestimate their ability to produce decent returns or assign a too low valuation to these returns. Back in 2012 AstraZeneca had a dividend yield of 7% but was facing a patent expiry on its main drug, was unloved by analysts, was perceived to have no new drugs in its pipeline and people questioned the dividend sustainability. Not a compelling investment case. Since then the company has committed to the dividend, developed a pipeline full of exciting immuno-oncology drugs which are the envy of the industry and the shares have returned 186%. Message 2 – Just because a company is out of favour doesn’t mean it can’t change.
3) Investor discipline – Fund managers love to talk through their investment process and how it led them to buy a particular stock but frequently skip over their sell discipline. A focus on dividend yields provides a clear valuation discipline for fund managers. When the dividend yield of a stock moves to a discount to the market, through strong share price appreciation, it forces the fund manager to re-evaluate the investment. Can I still justify holding a low yielding company as an income fund manager? The answer is sometimes. Hilton Food Group now yields only 2.3% having been one of my strongest performers over the last few years, however, given the good visibility over its future growth it still has a place in the portfolio. When MoneySuperMarket’s dividend yield fell to less than 3% in 2015, the payout ratio was already high while the rate of growth was slowing. Despite being a good performer it was time to move on. Message 3 – Stay disciplined even with your favourites
4) Company management discipline – Company management’s role is to keep us shareholders happy. One way is to pay a sustainable dividend while the other way is to invest and grow the business. It’s a fine balance in capital allocation. Paying a too small dividend may lead to the cash flow burning a hole in management pockets and encourage them to spend it irresponsibly. Think Rio Tinto’s $38bn acquisition of Alcan in 2007. Paying a too big dividend may constrain investment in the business and lead to issues in the future. Bus and Rail operator FirstGroup cut capital expenditure to maintain their dividend which ultimately led to an underinvested fleet, operational problems, a dividend cut and a rights issue. Message 4 – A high dividend yield is not always attractive especially if the company can’t afford it.
5) Cash flow – companies are unable to pay dividends without sufficient cash flow. Cash flow is harder to manipulate than earnings and provides a better indication of a company’s value. Before Carillion got into trouble the valuation used to screen “cheap” on earnings metrics but the company always generated poor cash flow. This should have been the early warning signs to investors. Message 5 – Don’t ignore the phrase “Cash is King”
Dividends are very important to investors but only if they are sustainable and can grow into the future. Focusing on a well-diversified portfolio of companies that pay a good and growing dividend should help drive outperformance over the long term.
Price to earnings ratio: A popular ratio used to value a company’s shares. It is calculated by dividing the current share price by its earnings per share. In general, a high P/E ratio indicates that investors expect strong earnings growth in the future, although a (temporary) collapse in earnings can also lead to a high P/E ratio.
Discount: When the market price of a security is thought to be less than its underlying value, it is said to be ‘trading at a discount’. Within investment trusts, this is the amount by which the price per share of an investment trust is lower than the value of its underlying net asset value. The opposite of trading at a premium.