- The best methods of estimating future returns are based on valuation and expected earnings growth.
- When competent management teams find themselves with cash that they don’t need to grow their business, it is a wise decision to distribute it to their shareholders.
- Clearly, dividends do matter and do make a meaningful contribution to total return.
Seeking Alpha blogger Larry Swedroe recently wrote a piece titled (by the way, my article didn't have an entitlement, it had a title) "Dividends And 'The Magic Pants", allegedly designed to refute six statements from my recent article titled, as follows:
"Seeking Alpha blogger Chuck Carnevale recently wrote a piece entitled "Debunking The Dividends Don't Add Shareholder Value Myth." The following are six statements from Carnevale's article that I would like to refute."
Consequently, even though it is generally against my policy to comment on another's work unless I have something nice to say, Larry Swedroe's assault on my work has compelled me to respond in kind. Importantly, I do not take this action out of spite or meanness, instead I take this action because of the great respect I have for my readers, especially those that are retired and living off their dividends. Moreover, I have additionally responded in reverence to the powerful poem of John Keats "Ode on a Grecian urn," especially to the profound closing stanzas as follows:
"Beauty is truth, truth beauty,-that is all Ye know on earth, and all ye need to know."
The first statement from my article that Larry Swedroe alleges to refute is as follows:
1. "I believe that it is undeniable that dividend income, if any, represents an important component of the total return provided to shareholders on any publicly traded company."
Larry Swedroe first presents the following argument, that he believes refutes my above statement, but in truth, doesn't: "First, it's important to know that approximately 60 percent of U.S. stocks don't pay dividends. Thus, the total return to investors in these stocks comes solely from capital gains, with dividends playing no role whatsoever."
First and foremost, what I actually said in the body of the article was as follows (emphasis added by me): "There are simply two components of total return: capital appreciation and income. Dividend-paying stocks possess both of these components, while non-dividend paying stocks only possess the capital appreciation component. However, and this is of primary importance, both equity types generate total returns."
Therefore, the fact that 60% of US stocks don't pay dividends may be true, but this fact in and of itself in no way refutes the fact that dividends paid by a company, if any, are a second component of the total return calculation, because they simply are.
Then, Larry Swedroe goes on to allege that I made the mistake of confusing expected returns from realized returns, as follows:
"Second, this line of thinking makes the mistake of confusing expected returns from realized returns. The best methods for estimating future returns that we have are based on valuation metrics, either a current earnings yield (the inverse of the more common price-to-earnings [P/E] ratio) or the yield based on Shiller's Cyclical Adjusted P/E ratio. You'll note that dividends aren't considered."
Unfortunately, the mistake belongs to Mr. Swedroe. My article was addressing the contribution to total return that dividends have historically provided shareholders. All of my examples provided in the article were a review of historical total return performance, how they were generated and the contribution that the two components - capital appreciation and dividend income - supplied.
However, I will agree with much of the latter part of Mr. Swedroe's statement, but not all of it. I do agree that the best methods of estimating future returns are based on valuation and expected earnings growth. However, I'm not real fond of esoteric calculations, such as CAPE. Frankly, I have written extensively on the subject of where and how expected future returns come from, but I was not writing about that in this article. Instead, my article was providing real-world historical evidence that a company's earnings power provides the primary source, the bottom line if you will, of total return. And yes, dividends paid, if any, are an important and valuable contributor.
Then, Mr. Swedroe attempts to refute my argument that dividends paid do not reduce the value of the shares of the company held by its owners. My actual statement that he quoted is as follows: 2. "The primary point that this article will address is the debunking of the 'dividends don't matter myth.' This myth is perpetuated by those who contend that dividends are irrelevant, because somehow in their mind's eye a company has become permanently less valuable by precisely the amount of the dividend that they paid out to shareholders."
Here is an excerpt of the argument he presents to refute my statement: "PEP closed on March 12, 2014, at $81.80. With about 1.5 billion shares, it had a market capitalization of roughly $124B. I went back and found that just since 1992, the company has paid out about $22.5 a share in dividends. Now ask yourself, if you put $22.5 billion in cash back on the balance sheet, would the company still trade at $81.80, as Carnevale argues? Obviously, at the very least it would trade at about $104.30. Isn't $1 in cash worth $1?"
Frankly, the assumption that Pepsi would -"Obviously, at the very least it would trade at about $104.30" - is simply fallacious and based on an assumption that simply cannot be substantiated. Moreover, Mr. Swedroe actually refutes his own argument later in his article, when he discusses what he calls "agency risk." The truth, dear readers, is that it cannot be logically assumed that PepsiCo (NYSE:PEP) would trade at a higher value if it retained its cash. As Mr. Swedroe himself points out, that excess cash is just as likely to tempt management into using it unwisely, and thereby decreasing future shareholder value.
When competent management teams find themselves with cash that they don't need to grow their business, it is a wise decision to distribute it to their shareholders, and the act of doing so does not automatically reduced the value of the company. In fact, and I contend in most cases, it can have the effect of increasing future value, because it does not dilute the returns on invested capital that the company requires to grow. But alas, modern finance today rarely teaches its students how to value a business.
Frankly, I must admit to being most disturbed by Mr. Swedroe's illogical attempt to refute my third statement, which he presented as follows:
3. "First of all and practically speaking, once I receive a dividend from a company I own, I have less money at risk precisely proportionate to the amount of my dividend check. Therefore, I understand that I simultaneously have reduced the risk of owning that stock simply because I now have less money at risk. Moreover, I did not have to sell any shares to receive that cash back, therefore, my beneficial ownership interest in the company remains intact. More simply stated, I still have all my shares."
Mr. Swedroe primarily bases his argument on assumptions that he illogically postulates as fact. Fortunately, at a young age, I was taught the dangers of assuming anything by a simple exercise. Write the word ASSUME on a piece of paper, put a dash (-) before and after the U and read it out loud. More clearly stated, just because you assume something to be true does not make it true.
Mr. Swedroe's attempts to argue by assuming that a company will have a higher expected growth in earnings simply because it has more capital to invest. Apparently, he must also be assuming that management teams are incompetently paying out capital that they desperately need to grow their business via their dividends. If management teams did this, I believe they truly would be incompetent. However, I contend instead, that truly competent management teams recognize that capital in excess of what they need to fund future growth is best used by sharing it with the shareholder passive owners of the business in the form of a much-appreciated dividend check.
Moreover, the assumption that higher expected earnings offset the lesser number of shares resulting from what Mr. Swedroe likes to call a "homemade dividend," is simply misguided. There is no evidence supporting the notion that higher retained earnings will always result in higher expected future earnings. On the other hand, there are multitudes of evidence showing that companies that retained earnings they did not need simultaneously destroyed future shareholder value. Again, Mr. Swedroe seems to be aware of this by what he calls "agency risk."
Regarding Mr. Swedroe's vain attempts to refute the fourth and fifth statements of mine that discuss how dividends provide a return bonus, I offer the following real-world examples supporting the total return contribution that dividends truly provide shareholders. Yes, I will utilize the F.A.S.T. Graphs™ earnings and price-correlated research tool to make my case. By doing so, I am offering real-life examples, just as I did in my previous article, presenting historical evidence with no assumptions preceding them.
SCANA Corp.: (NYSE:SCG)
SCANA Corporation engages in the generation and sale of electricity to wholesale and retail customers in South Carolina. The company also engages in the purchase, sale, and transportation of natural gas to wholesale and retail customers in South Carolina, North Carolina, and Georgia. It also conducts other energy-related business, and provides fiber optic communications in South Carolina. The company operates through two segments - Regulated Utilities and Non-regulated Businesses.
With my first example, I chose the utility stock SCANA Corp. because the regulated nature of this company's business creates a significant limitation on its ability to grow earnings at a high rate. Consequently, as I will soon illustrate, this low-growth utility provides a very clear example of the relevant benefit that its dividends contribute to shareholders' total returns. However, before I present the earnings and price-correlated graph, the following slide from the company's Fourth Quarter & Full-Year 2013 report illustrates that the major portion of SCANA Corp.'s earnings come from the regulated segment.
With my first graph of SCANA Corp., I present a plotting of earnings only since 1996. What is important about this graph is the 3.8% earnings growth rate that the company has historically achieved. Moreover, these historical earnings will be the primary source of this company's historical capital appreciation component and its contribution to shareholders' total returns.
With my second graph on SCANA Corp., I add monthly closing stock prices. What is important about this graph is that it illustrates that stock price correlates to and tracks earnings, which generates the capital appreciation component. But most importantly, the company's stock price tracks the full complement of the historical earnings that SCANA generated.
With my third and complete F.A.S.T. Graph on SCANA Corp., I bring in the dividend, or income component of total return. Importantly, the dividend component is expressed in two important ways. First, the light blue shaded area above the orange earnings justified valuation line represents the dividends that were paid out to shareholders. Even more importantly, perhaps, is that the pink line is also representing the portion of earnings prior to being paid out to shareholders as dividends (the green shaded area below the pink line graphically depicts the dividend payout ratio).
What this complete graph clearly illustrates is that the company's stock price tracks all of SCANA Corp.'s historical earnings since 1996. Moreover, we see that the market value applied to this company's shares over time is attributed to all of the company's earnings, regardless of the dividend paid. Consequently, the light blue shaded area representing dividends paid clearly provides undeniable evidence that the dividend component in this example provides a significant contribution to the shareholders' total return - capital appreciation and income.
The above points are further evidenced by reviewing the performance results associated with the above graph. First of all, we see that the capital appreciation component depicted as "annualized ROR (W/O Div) of 3.2% is virtually identical to the company's operating earnings growth rate of 3.8% (only minor valuation discrepancies keep these numbers from matching exactly).
Next, by reviewing the Dividend Cash Flow table of the performance report, we see that total dividend income contributed $10,098.74 to SCANA Corp.'s shareholders' total return. Admittedly, this is a rather dramatic example considering that dividends generated more return than the $7,673.11 of capital appreciation they received on the original $10,000 investment. Consequently, I emphatically contend that the evidence is too clear and compelling to deny. In this example, dividends matter - and they matter a lot. To restate the obvious, here is a clear case where the dividend or income component matters more than the capital appreciation component.
Next, I offer the following two examples in order to more clearly demonstrate that a company generates the capital appreciation component to shareholders based on its earnings achievements. In order to accomplish this, I will provide one example of a non-dividend paying stock and compare it to an example of a dividend-paying stock, where both have achieved approximately the same historical earnings growth.
ScanSource, Inc: (NASDAQ:SCSC)
ScanSource, Inc., together with its subsidiaries, operates as a wholesale distributor of specialty technology products.
ScanSource, Inc. is a small cap company that has never paid a dividend. Once again, we see the high correlation between the company's monthly closing stock price (the black line) and its operating earnings (the orange line). Moreover, considering that the company has never paid a dividend, we discover that earnings growth has averaged 9.2% since 2002.
When we review the performance of ScanSource, Inc. associated with the above graph, we discover two important facts. First and foremost, 100% of their capital appreciation came from the market capitalizing on the company's historical earnings. Second, we discover that capital appreciation again closely matches or correlates to the company's earnings growth rate.
United Technologies Corp.: (NYSE:UTX)
United Technologies Corporation provides technology products and services to the building systems and aerospace industries worldwide. I chose this example because it achieved an almost identical historical earnings growth rate to my non-dividend paying example above. Once again, we see that the market values all of this company's earnings (the orange line and green shaded area), and interestingly, quite often values this company at a premium to its earnings justified valuation (the orange line).
Since I do not assume, I can only wonder if dividends might also be a contributing factor to that premium valuation. In other words, might investors be generally awarding a higher valuation because they expect to receive a nice quarterly paycheck along with the capital appreciation that this company's earnings will generate?
When we review the associated performance (total return = capital appreciation plus dividend income) of United Technologies Corp. over the same time frame, and with a virtually identical earnings growth rate of our non-dividend paying example, we once again see the relevance of dividends. The capital appreciation component - annualized ROR (w/o Div) - of 10.9% highly correlates to the company's earnings growth rate, and includes all of the company's earnings.
Moreover, we also see by looking at the Dividend Cash Flow table that dividends contributed an additional $4,797.73 of total cumulative cash, which expands the total annualized rate of return from 10.9% to 12.1%. Clearly, dividends do matter and do make a meaningful contribution to total return.
Another important point that can be gleaned from studying the above performance results is the fact that the total number of shares held did not change in either of the above two examples. In other words, shareholders did not have to manufacture any so-called "homemade" income checks. And even more importantly, the rational dividend growth investor didn't have to manufacture those "homemade" dividends during the throes of the Great Recession of 2008. Instead, they continued to receive their dividend checks in spite of any market price drops their wonderful dividend-paying businesses were experiencing.
I Love My "Magic Pants"
Frankly, and with all due respect, I find the following "Magic Pants" analogy so gleefully referred by Mr. Swedroe to be not only fallacious, but bordering on the absurd: "You have a pair of pants. In the left pocket, you have a $100. You take $1 out of the left pocket and put in the right pocket. You now have a $101. There is no diminution of dollars in your left pocket. That is one magic pair of pants."
First of all, the pants in question are not worn by the dividend growth investor/shareholder. Instead, the pants are worn by the company, not the shareholder. And, they truly are a magical pair of pants that is continuously filling their pockets with fresh cash, at least the good ones are. And, when their pockets are fuller than they need, they take some of that cash and give it to the shareholders so that they can put it in their pockets. But most importantly, sending out that cash that the shareholder can put in their pocket in no way diminishes their ability to continuously refill their pockets with fresh new cash.
Summary and Conclusions
I have been in the investment business sense 1970. Most importantly, my beginnings in this business were prior to the industry being hijacked by the academics. Today, the academics call this Modern Portfolio Theory (MPT). But what I originally learned, I referred to as Ancient Portfolio Reality (APR). More clearly stated, what I was originally taught were time-tested and sound principles of business, economics, and accounting. These early teachings included lessons on how to value a business based on earnings and cash flows. How to read a balance sheet and income statement when analyzing a business, private or public. Consequently, I take exception with another of Mr. Swedroe's comments and contentions. In his article he stated, and I quote "Finally, the preference for cash dividends has long been considered an anomaly in finance."
Once again, he is in error. To be precise, his statement should have read as follows: the preference for cash dividends have only recently been considered an anomaly in modern academic finance. Moreover, cash dividends have only been considered an anomaly by Modern Portfolio Theory practitioners and their love of statistical inferences and "four factor models." In my opinion, the true prudent investors of old, such as the venerable Charlie Munger, so once aptly put it in these terms: "these academics are armed with their fancy mathematical formulas full of Greek letters, that amount to nothing more than dementia and twaddle."
In my mind's eye, the so-called academically-oriented modern practitioners are fond of looking at the forest without acknowledging the trees. However, I contend that if they look more closely, they would discover that all the trees in the forests are not the same. Some might be redwoods capable of growing to amazing heights, others might be birch, elms, or maples. There may even be some fruit trees (dividend payers) growing in the forest. Looking at the forest without acknowledging the unique nature of all the various trees seems like an insult to their unique qualities and characteristics.
Total return is calculated by adding up the two relevant components - capital appreciation + income. If there is no income being generated, then total return will be solely comprised of capital appreciation. However, when income is present (with common stocks when the dividend is paid), to argue against its contribution seems silly and even naïve to me.
I respect anyone and everyone's right to have and to express their own opinions. However, if they are going to attack the opinions of others, they should in turn have the respect to base their argument on facts, instead of innuendo or unsubstantiated assumptions. I would never have written this article if it weren't for the fact that my work was challenged. However, it was not that challenging of my work that bothered me; instead, it was the lack of substantiated evidence to support the challenge that I most objected to.
In the future, I will continue to present articles representing my views on investing matters, and as I always have, provide as much supporting evidence as I can. Moreover, as a professional courtesy, I will refrain from commenting on any of Mr. Swedroe's past or future work. I would hope that he would extend the same professional courtesy back to me. Furthermore, I will not be participating in the comment thread that might follow this article, and instead, will let this article and my previous article stand on their own merits, representing my positions on this subject.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: Long SCG, UTX at the time of writing. I am long SCG, UTX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.