The Dividend Dance
Are higher dividends always a hallmark of good investment outcomes?
The Australian market has the unique distinction of having not only one of the highest dividends yields in the world, but also the highest payout ratio (that is, the percentage of companies’ net profits that are paid out as dividends).
We owe much of the credit for this to franking credits, resource companies (BHP and RIO amongst others) as well as the big four banks – towards which our market is heavily weighted.
Australia has one of the highest payout ratios and dividend yields in the developed world
A recent report published by FCLT Global (Focusing Capital on the Long Term) - an initiative established by the Canada Pension Plan Investment Board, McKinsey & Company and BlackRock looked at the factors that are associated with long-term, successful companies.
FCLT Global was born from the observation that there is undue short-term pressure placed on investors and CEOs and looks to encourage a longer-term focus in business and investment decision making.
The report “Predicting Long-term Success” looked at 85% of global investable companies and looked to identify what factors make companies successful in the long term.
The study measured company performance based on return on invested capital (ROIC) - that is the returns that a company delivers to the whole capital structure of a company. This measure was used in preference to stock prices which can be influenced by investor perception, or financial leverage.
The findings of the report are summarised in the tables below:
Source: FCLT Global
The two factors that had the greatest association with successful, long term value creation were:
- Greater fixed investment: that is companies that are investing in long-term assets
- Greater expenditure on research and development (which in today’s market may be more applicable to technology and healthcare companies)
In short, companies that are actively invested in their future create greater value over the long-term.
The factors that were most associated with lower long-term value creation included:
- Overdistribution of capital (in the form of dividends and buybacks)
- Providing short-term guidance
The first point is almost the inverse of the “positive factors” while the second is symptomatic of the companies having a short-term orientation more broadly.
What to make of this?
Intuitively, the findings make sense.
Companies that have good investment opportunities available, but pay out their earnings in preference to re-investing, should naturally be expected to underperform those that invest in the long term when opportunities present.
This introduces a common, if not patently obvious theme of the report – companies with a long-term orientation seem to add greater value.
This is perhaps also exemplified by the other highlighted negative factor: “the provision of short-term guidance”. This factor would suggest that companies that predominantly focus on short-term targets, may, in fact, destroy value.
We have witnessed extremes of this in the past, with companies often looking to meet these targets through accounting distortions (for example Dick Smith), aggressive expansion (ABC Learning) and excessive risk-taking (Enron) which have ultimately led to value destruction.
Takeaways in the current market
In the current market and with a decline in interest rates, we are seeing investors willing to pay a premium for companies that distribute a large portion of their earnings, that is, companies that pay high dividends.
The study above suggests that the capital allocation decision – that is, the decision to invest or distribute, is a delicate balance and crucial to the long-term success of a company.
This also applies to new business models in the digital age. One of the greatest Australian success stories of late, Xero, invested 25% of its revenue last year into product design and development.
Therefore, as investors, we must be aware that a company that pays high dividends today may be starving itself of the capital it needs to grow in the future.
On the flip side, it highlights that there may be value in companies that have a long-term focus and actively investing but are unloved due to this, or challenges in the short term.
We see this as a broader investment theme, which we will touch on in our Chief Investment Officer Event: Managing for a Low-Interest Rate Future.