The longer term consequences of the ‘hunt for yield’ means ...
... the ‘disappearance of growth’
With such low interest rates as currently exist, investors have understandably turned their attention to finding alternative sources of income to supplement their much reduced term deposit and interest income.
To the extent that investors have been keen to move into higher yielding equities, the companies themselves have been keen to oblige and have themselves turned on the dividend taps to red hot.
Consider this: In the past two years, earnings per share of ASX100 companies have declined by 2.2% on average, yet dividends per share have increased by around 9.5% on average in the same period. Please see chart below.
Executives are rewarded for creating ‘shareholder value’ which is typically highly aligned to the share price.
If investors want and are rewarding dividends it is in the best interests of management and boards to deliver them.
The problem, of course, is that dividends come at the expense of either debt repayment or reinvestment. Companies that pay out a large portion of their cash flow have less to reinvest back to grow future earnings than companies with lower dividends.
In fact, capital expenditure of ASX200 companies fell by 44% in FY-13 compared to FY-12. Therefore, the likely development of more dividends today is that we will get less earnings growth from companies in the future. And this will inevitably flow through directly to lower dividend growth.
The current ASX200 payout ratio is 75%, which is close to 43 year highs (industrial companies are at 80%). This compares to an average rate of 66% (since the imputation system was introduced).
History shows that the dividend payout rate can be predictive of the future dividend growth rate. Invariably after a period of higher payouts two things have tended to happen. Firstly, the earnings growth rate has begun to moderate as companies that have reduced their investment begin to see less revenue growth (new business) or higher costs (productivity is not improved as fast) than in the past. Secondly, this then typically leads to (often a new generation of) management responding by reducing the amount paid out as dividends and increasing investment to improve the outlook again.
In the three previous episodes since 1970 of payouts being at this level, they have fallen by between 23%-37% in the following years (in each case back to at least 62%). Please see chart below. Should this occur again it would require a 17% lift in company profitability in order to maintain the current dividend level.
Indeed Goldman Sachs has shown that in the past 25 years when payout ratios have been this high absolute dividend growth in the following year has averaged just 1.5%, significantly below the average long term growth rate of 7%.
Therefore, whilst companies can continue to pay high dividends based on high payouts for a while yet, eventually the dividend growth rate will be much more muted going forward as earnings slow and companies reduce payouts once again. It is highly likely that dividend growth will disappoint ‘market’ investors over the next ten years as a result.
It is important for investors to realise that whilst generating income from your equity investments is important (for the market historically it has accounted for 1/3 of your total long term return), it is actually more important for you to be positioned in companies that will also continue to grow their earnings at a good rate into the future. In the long term it is the dividend growth rate which has determined the bulk (historically 2/3) of total return in the past.
It is therefore pleasing to us that the payout ratios of the companies that First Samuel is invested in have declined from 75% in 2009 to 66% today while dividends have grown at 13% pa. It is because our companies have been investing more heavily in the past four years than previously, that we also remain confident that, on average, our companies will continue to experience similarly high dividend growth rates into the future (and still pay out high absolute dividends today).