Twelve years ago, stock market investing was all about earnings growth, while dividends were boring. Now the reverse is true, with investors "reaching for yield" while growth is, arguably, under-priced. Investors need a framework for evaluating the trade-off between growth and yield.
Start with successful mid-size company XYZ Corp., which is growing profitably. Should it pay a dividend? The answer, especially in the current slow-growth environment with a dearth of good investment opportunities, is "No." So long as the return on its new, or "incremental," investment is greater than its cost of capital, it should make those investments rather than pay out capital.
Reaching for Rapid Growth: Risky
Fast forward five years. Now XYZ Corp. is 50% bigger and its growth is starting to slow, but Wall Street still considers it a "growth stock." The analysts with "Buy" ratings believe management's lofty growth targets. If the company dials down its growth strategy and starts to pay a dividend, naysayers may proclaim that it has "signaled" to investors that it is no longer a growth company; the PE may crumble and kill the stock price (not to mention the value of management's stock options). This mentality was prevalent in the 1990s. To avoid that fate, XYZ will be tempted to continue to invest aggressively for growth, perhaps in riskier areas (such as foreign markets) or by making acquisitions.
But if these investments are unsuccessful, they will destroy shareholder value and the stock will definitely collapse. A good example is Starbucks (SBUX), which in 2006-2008 was building too many stores in order to meet Street revenue growth expectations. During the recession, earnings collapsed, Starbucks ended up shutting 500 stores, and the share price dropped 75%. Oops.
Clearly it is preferable for XYZ to recognize that its business is maturing and start to pay a dividend. This does not mean it is no longer a growth company-merely that its cash flow exceeds reinvestment opportunities. For example, over the past few years many large, cash-rich tech companies (including Microsoft, Intel, Qualcomm, and Cisco) initiated dividends. Although this decision may have altered their image on Wall Street, in no case did it prompt analysts to cut their EPS estimates, secular growth rates, or price targets on the ground that the dividend would prevent the company from funding growth properly.
In effect, then, for shareholders the dividend was literally a "free lunch" - new dividend, same growth rate. This applies to most large, mature U.S. companies, not just tech. They can pay a meaningful dividend without hurting EPS growth because they generate more cash flow than they can successfully reinvest.
Intelligently Deploying Free Cash Flow - "Not Doing Too Much"
In our August 3 post refuting Bill Gross' claim that stocks were a Ponzi scheme, we highlighted the importance of companies using free cash flow to maximize shareholders' total return. First, some elementary definitions for XYZ Corp.
- Earnings per share = Net income / shares outstanding
- Net income + depreciation = cash flow
- Free cash flow = Cash Flow - (capital spending needed to maintain the growth of the business)
Free cash flow can be deployed in four ways:
- Pay a dividend
- Share buy-backs. If they actually reduce the shares outstanding buy-backs will increase earnings per share and, like dividends, are a "return of capital" to shareholders.
- Pay Down Debt
Historically, firms deployed free cash flow poorly, over-investing in plant and equipment or making dumb acquisitions. But in today's downbeat, sober and sensible financial environment, companies have become smarter in deploying cash. Capital spending is appropriately cautious. Dividends have been growing rapidly but still are only about 30% of earnings, so there is room for additional rapid DPS growth. Share buy-backs are fairly strong and are shrinking the share count of the S&P 500 1-3% per year. Because balance sheets are already strong, debt paydown is not a priority.
By intelligently deploying free cash flow mature firms with fairly slow organic net income growth nevertheless can generate high single-digit total return to shareholders. As an example, here is a possible combination:
- Organic net income growth: 4%
- Plus Additional net income growth from acquisitions: 1%
- Plus Share buy-backs that shrink share count 1%
- Equals Total EPS growth of 6%
- · Plus Dividend Yield of 3%
- · Equals Total Return to Shareholders of 9%
This is the corporate equivalent of a major league batter, who - as Yankee radio commentator Susan Waldman likes to say - "Didn't try to do too much." Like the batter who settles for an RBI single rather than trying to slam a home run (and probably striking out), managements are deploying cash in a disciplined manner. Yet a 9% total return is very attractive when 10-year treasuries offer 1.5%.
Reaching for Yield? - Dividend Policy of the Dow Industrials
To see how these principals apply today, let's look at the payout ratios, dividend growth, and PE ratios of the thirty companies in the Dow Jones Industrial Average. The key trends:
- The median dividend yield of the thirty firms is 2.7%. (The mean is exactly the same.)
- There is no evidence that the popularity of dividends is prompting companies to pay out too much. The median dividend payout ratio in 2012 is 37.5%, up only modestly from 34.0% in 2007 when dividends were less sexy. Considering that these are giant mature companies, 37.5% is still quite low. The payout ratio in Europe and Asia excluding Japan is 40-45%, and the payout ratio of the S&P 500 (which has many stocks that pay no dividends) was 40-45% in the late 1980s, at a point in the business cycle comparable to 2012.
- On the other hand, there is good evidence that investors are "reaching for yield" by paying too much for high yielders. The PE's of AT&T (T) and Verizon (VZ) are 15.6x and 17.8x, even though they have fairly slow dividend growth of 4% and extremely high payout ratios of 73% and 80% respectively. Shares of Procter&Gamble (PG) and Coca-Cola (KO) also look expensive as investors gravitate toward "defensive" stocks with nice yields.
- Of the thirty stocks, some that seem to offer an attractive combination of reasonable PE ratios, decent historical DPS growth, and moderate payout ratios include Caterpillar (CAT), Chevron (CVX), Intel (INTC), JP Morgan (JPM), Microsoft (MSFT), Travellers (TRV) and ExxonMobil (XOM). But these virtues will not prevent them from being bad stocks if their earnings are disappointing. Although intelligent payout policies can enhance total return, and are evidence that management is sensible and "shareholder friendly," keep in mind that it is earnings growth and valuation that drive stock prices, not dividends.