Kick the dividend habit

Here’s a brain teaser for equity income fans: which income play could have been bought five years ago yielding 4.3 per cent, has provided an annual 17 per cent return on cash reinvested, and has grown its payout by a staggering 350 per cent over the period? 

Struggling for the answer? Given this particular income play has never paid a penny in dividends, it could be considered a trick question – but there are grounds to argue that it shouldn’t be. 

The investment under the spotlight is the shares of US software company Adobe (US:ADBE). The yield referred to is the company’s forecast next-12-month free cash flow (FCF) yield as of five years ago (forecast FCF per share as a percentage of the share price). The annual return from reinvesting cash is the average cash return on capital invested (CROCI) over the five years (the annual FCF generated by the company from every dollar invested in its operations).  

But what could possibly be the justification for talking about a growing payout from these non-dividend-paying shares? 

Well, because Adobe doesn’t pay dividends, the easiest way to create an income stream is through regular share sales. To tie in with that FCF yield figure (no need to, but why not), let’s assume 4.3 per cent of the Adobe stake had been sold at the end of each calendar year to generate income. The value of the retained shares – the asset from which income can be created – would now be 350 per cent more than the cost of the original investment. Meanwhile, the regular sales over the five years at ever higher prices would have produced income equivalent to more than two-fifths of the original investment.

The case for companies reinvesting cash

Presenting Adobe as an income investment is an example of what some people refer to as 'total return' investing. Behind the jargon is a simple, common-sense observation, which is particularly pertinent at a time when many UK dividend stalwarts have been slashing their payouts. For any company, paying a dividend is just one of several capital allocation choices it can make. The only question investors should concern themselves with is if the choices made are the best one to increase shareholder value. Other capital allocation options would include investing in organic growth, making acquisitions, paying down debt, or other forms of capital return such as buying back shares. 

Indeed, by paying a dividend, a company is simply forcing capital onto its shareholders to reinvest themselves. It’s not a free-money give away. In many respects, a dividend payment should be regarded in the same way as an edict that requires shareholders to periodically sell stock back to the company. The cost of the payout to the value of retained shares is reflected in the price fall when a share goes ex dividend; holders may still have the same number of shares, but the forced return of capital means they are worth less.

A key capital allocation focus for Adobe is investing money back into its business, especially through research and development (R&D). Investors should always applaud a company that is able to plough a substantial amount of its cash back into high-return growth opportunities. Forget dividend cheques, this is actually the true equity income dream. It represents a highly tax efficient, high-return method of reinvesting income. 

It’s worth considering Adobe again from a slightly different perspective to illustrate just what a good deal this represents for shareholders. By reinvesting surplus cash back into the business, Adobe shareholders avoid being taxed on the dividends they may have otherwise received. The depreciation and amortisation charges associated with investments also reduce future tax bills for the company while a lot of R&D spending can be treated as a pre-tax operating cost.

Meanwhile, Adobe has managed to achieve a FCF cash yield of about 17 per cent over five years for shareholders on money invested. Try getting that somewhere else. Indeed, had Adobe instead paid a dividend, shareholders reinvesting their taxed income into its shares would have got a FCF yield nowhere near – the shares current forecast FCF yield is 2.4 per cent. 

In fact, through buybacks Adobe has been locking in that lower return based on its shares' FCF yield. As we will see later, buying back shares at high valuations is often not such a smart capital allocation move. A breakdown of Adobe’s capital allocation over its past five financial years can be seen in the accompanying pie chart.

Not all companies have significant opportunities for internal reinvestment. Some choose to focus on growth all the same by recycling cash into acquisitions. This tends to be riskier and less lucrative than internal investment. However, if done right it can represent a very good use of cash, as demonstrated by the track records of companies such as distribution specialist Bunzl (BNZL) and engineering group Halma (HLMA). It has also been an important element of the Adobe growth story over the past five years.

For other companies, as we’ll soon see with the example of BT (BT.) and “the case for debt paydown”, the right capital allocation choice may be to pull a dividend in favour of paying down debt. 

Meanwhile, for companies with surplus cash and attractively priced shares, buybacks could be the best option to boost shareholder value. We’ll come to this in more detail when examining the concept of shareholder yield and 'the case for buybacks'. 

But behind all these potential uses of cash is the simple idea that the best way for a company to create shareholder value is by making the best capital allocation choices. Indeed, dividends can be regarded as what's left over if a company can't find anything better to do with its cash. So if the best choice is to do something other than pay a dividend, that is the right choice for shareholders. Any extra income a shareholder needs can be generated by selling shares – all things being equal, there is absolutely no difference in cash coming out this way and cash coming out in the form of a dividend payment. 

The case for dividends and dividend growth 

None of this is to say dividends can’t help identify good investments. However, the value of a dividend in identifying opportunities is not simply about the cash amount handed over. What’s important is that good dividend records can highlight good businesses; companies that regularly generate surplus cash and hold shareholders in high regard.

Few cash-generative businesses, even very successful ones, are able to do an Adobe and find compelling growth opportunities for lots of their cash most of the time. Nevertheless, management teams are easily seduced by the glamour of growth. This can lead to costly diversions into new markets, vanity projects and ill-conceived “transformational” acquisitions. When companies pursue poor growth strategies, they often end up generating returns on capital that are below their cost of capital. This destroys shareholder value. 

It is avoiding this bad outcome that makes a strong culture of returning surplus cash to shareholders important. A commitment to cash returns forces a company to be much more disciplined about the opportunities it pursues. 

Good cash returns supported by solid cash flows are also often the preserve of companies with steady businesses that may allow their shareholders to sleep more soundly at night. There are big behavioural benefits to be had for investors that are comfortable with their holdings. This can significantly reduce the chances of making emotional mistakes, such as panic selling. 

And if companies can maintain dividends come good times or bad – in practice quite a big 'if' – then shares do not need to be sold at low valuations during periods of weakness.

For investors focusing on dividend yield in the hunt for attractive opportunities, the dividend screen we run every month in our Alpha product highlights some of the key factors worth thinking about. While the criteria makes for a useful checklist, outside screening, there is no need for an approach to be quite so formulaic. 

That said, this strategy has a track record to justify itself. The screen based on this criteria that has run annually since mid-2011 in the Investors Chronicle Stock Screen section has produced a cumulative total return of 160 per cent. That’s more than three times the 50.6 per cent over the same period from the FTSE All-Share (the index the screen is conducted on).

The screening criteria are:

• A dividend yield higher than the median (mid-rank) average of all dividend-paying shares screened.
• A dividend covered at least twice by earnings; the dividend looks like it is affordable.
• Earnings growth forecast in each of the next two financial years; dividend cover is not expected to dramatically fall and earnings may support dividend growth.
• Operating cash conversion of 100 per cent or more; earnings appear to be tuned into cash with which to pay dividends.
• Interest payments covered at least five times by operating profits; interest payments on borrowings do not seem to be a significant threat to maintaining dividend cover and there is unlikely to be a debt mountain lurking in the background.
• Return on equity of 12.5 per cent or more; an indication that the business may be of decent quality. If the interest cover test is also met, this suggests high returns on equity are not overly dependent on high debt levels.
• A beta of 0.75 or lower; the shares have historically not been very sensitive to market movements, suggesting the business may have defensive qualities.
• No dividend cut in the past three years; the company appears committed to returning surplus cash.

Reflecting the financial strains of lockdown, only one stock can pass all these tests at the moment (German business and industrial park investor Sirius Real Estate (SRE). The accompanying table includes fundamentals relating to it along with details of stocks that passed all but one test. The Aim companies listed qualify on a similar basis, but based on the slightly different criteria used by our Alpha small-cap dividend screen.

Source: FactSet

One of the key things to note from the criteria is that the objective is to identify decent yields rather than particularly high ones. Of equal importance is that the payout looks well supported by earnings and the balance sheet, and that a business shows signs of being defensive, capable of growth and turns profits into cash.

The potential for steady growth is a particularly important consideration. That’s because companies with a good prospect of growing will often produce better income over the long term even when the initial dividend yield is substantially below that of shares in slower-growth companies. 

Consumer goods company Unilever (UNLV) is a very good example of this. It is a company with an incredible history of dividend growth, the past 35 years of which can be seen in the accompanying chart. 

This growth means the value of Unilever shares for income has historically been far less about today’s payout, and far more about payouts in years to come. For example, shares bought just five years ago at 2,917p on a none-too-shabby yield of 3.1 per cent would now pay a hearty 4.9 per cent yield based on the original buying price. Further growth is forecast in the coming years. Based on the buying price from 10 years ago, meanwhile, the shares would now yield 8.0 per cent.

The danger, though, for a company like Unilever is that should its fortunes deteriorate, it could prove so wed to its dividend record that it will not be able to call a stop to payouts in a timely manner. If a company’s dividend policy is not responsive to underlying trading conditions, it can seriously stretch the balance sheet and be incredibly damaging to shareholders.

Dividend dangers

Focusing on the size of a dividend yield in isolation may be dangerous, but it can also feel very compelling. The psychological attraction of buying shares with high historic and forecast yields is the feeling of tangible reassurance it brings. 

The fact a company has paid a given level of dividend in the past feels like something real as well as a commitment for the future. A cheque on the doormat seems a far more solid proposition than the potential for value creation from alternative uses of cash. What’s more, on the face of it, a dividend yield looks much like the interest offered by a bank account. Compared with the vagaries of potential share price gains and possible payout increases from low-yielding shares, a high yield looks so much more certain.

Sadly, the reality is often very different. And from a total-return perspective, it is deluded to disassociate the payment of a dividend with the value that could be created if the cash was used in another way. 

As in most walks of life, when it comes to dividends you get what you pay for. 2020 has exposed many big UK companies with high-yielding shares as providing anything but certainty. Link Group’s UK Dividend Monitor found that in the third quarter this year dividends fell by almost half to £18bn, which is as low as they were a decade earlier in the wake of the financial crisis. 

True, lots of UK companies have cut dividends for reasons that are related to the Covid-19 pandemic. However, for many cuts have simply been made under the cover of Covid and have in reality been a long time coming. So while some dividends will come back quickly, many once big payers are unlikely to reinstate payouts to previous levels any time soon, if ever.

Capital allocation decisions are difficult given no management team has a crystal ball. But it does feel as though UK investors, with our love for equity income funds and dividend cheques, have at some point started to fetishise dividends without considering the broader context and companies have not wanted to rock the boat. 

With hindsight, many companies that have recently been forced to cut their dividends may well have better served shareholders by switching focus to paying down debt several years ago.

 BT and spotting dividend danger

For some time Investors Chronicle has felt telecoms group BT (BT.A) has been paying out too much money as dividends. We even presented a dividend cut as a potentially positive catalyst for the shares when we briefly warmed to the stock as a recovery play at the start of 2019. The cut did not come as soon as we would have liked and our opinion on the stock soon changed. This year, the company finally pulled the payout.

What were the warning signs for investors, and what advantage may the company have lost by not pulling the plug earlier? One of the easiest ways to identify dividend danger is to simply look at the level of the yield. If it looks too good to be true, it normally is. BT was a shining example as we can see from the accompanying chart.

The higher the yield gets, the less secure the market views the payment to be. This is usually due to some combination of limited cash generation, poor growth prospects and  more pressing balance sheet needs. At the extremes (7 per cent plus is often used as a crude rule of thumb) the yield can suggest the dividend will soon be cut or abandoned, as with BT.

However, while a high-and-rising yield is a useful warning sign of weak prospects, there are plenty more red flags to look out for. The key question is whether a company is generating the cash it needs to fund the payout. If not, the dividend will need to be cut or funds will need to come from elsewhere, such as raising debt, issuing shares or selling assets. Often this is simply a case of robbing Peter to pay Paul. 

In the case of BT, the high and rising level of net debt over the past five years has suggested dividends may not have been its best use of cash. An additional consideration here is the company’s massive pension liabilities. A change in assumptions around future pension payments did cause the reported deficit to fall considerably last year, but sizeable top-up payments are scheduled to persist.

Added to the impression of an unsustainable dividend over the past five years is BT’s relatively low free cash flow (FCF) generation. FCF represents the money left over for a company to pay a dividend or allocate to other areas of the business, such as paying down debt, buying back shares or making acquisitions. Indeed, based on our calculation of FCF, only slightly over two-thirds of the cash paid out as dividends over the past five years was covered. It should be noted, our FCF calculation is different to the adjusted numbers presented by BT, which ignore regular “specific items” costs, mobile spectrum purchases and those ongoing pension top-ups.

BT and the case for debt paydown

From a 'total return' perspective, the interesting question is what would have happened if BT had decided to use its cash differently. Specifically, given a key concern for several years has been the state of the balance sheet, what would BT look like now if it had simply spent the past five years paying down debt rather than paying out dividends. 

Thinking about BT in terms of enterprise value (EV) helps answer this. EV attempts to take account of the value being put on all the sources of a company’s funding that have claims on its assets and earnings. It’s a holistic measure of company value, which is the go to for takeovers and buyouts.

Read more about EV in our three step guide to valuation.

The simplest EV calculation is based on adding net debt to market capitalisation. That means, all things being equal, any reduction in net debt transfers directly to shareholders in the form of an increased market cap (and a proportionally higher share price). 

The implication is therefore that had BT used dividend cash to pay down debt, market capitalisation would have benefited by the amount of the dividends foregone. Based on BT’s EV at the time of writing, that would mean no dividends for five years but a market cap of about £16.8bn compared with the actual market cap of £9.8bn. In all, shareholders would be no worse off from this viewpoint, although they would not have been able to make other uses of that dividend cash.

However, this assumes that investors put no extra value on BT with a stronger balance sheet. That seems unlikely. If nothing else, the impact on earnings per share (EPS) from reducing the group’s interest bill would probably justify a higher rating (this can in part be seen as the compensation for shareholders not being able to put dividend cash in their own bank accounts). 

If the market was prepared to value a BT with a stronger balance sheet at four times cash profit (Ebitda) rather than the current disaster rating of just below three times, then the effect for shareholders would be noteworthy. Indeed, even after deducting the £7bn of lost dividends over five years, the remaining market cap element of EV would be over 80 per cent higher than it is today. 

A valuation of four times cash profits is still low and seems far from outlandish given BT’s EV/cash profit has averaged 5.5 times over the past five years, based on FactSet data. BT seems to still be hooked on dividends, though, pledging to bring back the payout at half its previous level despite its high debt and high investment needs in coming years.

The case for buybacks and shareholder yield

When a company wants to return cash, the dividend is only one option for doing so. The other most common method is through share buybacks. While cash will not end up directly in shareholders’ pockets, this form of capital return does have a direct impact on the value of shares by reducing the number of them that profits and assets are split between. Income investors can benefit from considering dividends and buybacks together rather than regarding them as a thing apart.

Read Phil Oakley’s Rightmove buyback case study here.

True, there are good arguments that certain management incentive schemes encourage the misuse of buybacks. However, from a purely technical shareholder perspective, buybacks can be considered in pretty much the same way as a dividend reinvestment programme (when dividends are used to automatically buy shares in the company that has paid the cash). 

That said, buybacks are more tax-efficient than dividend reinvestment programmes because they are only taxed once, at the corporate level. Dividends get taxed at both the corporate level (dividends are paid from after-tax profit) and at the individual level when received as income by a shareholder. In the UK, with the dividend tax allowance set at £2,000, this income actually starts being taxed much sooner than capital gains (profits from selling shares) for which there is a £12,500 allowance and flat 20 per cent tax rate.

The best way to take a rounded view on cash returns, whether buybacks or dividend, is by looking at the so-called 'shareholder yield”. This is a yield based on dividend per share plus net buybacks per share. Net buybacks per share deducts money raised through share issues from the value of share repurchases during a year and then divides that by the number of shares in issue.

Net buybacks per share = Money spent on share buybacks - money raised from share issues / shares in issue 

Shareholder yield (%) = Dividend per share + net buybacks per share / share price x 100

Jim O’Shaughnessy, founder of quant firm O’Shaughnessy Asset Management and author of best-selling investment classic What Works on Wall Street, has extensively investigated the returns from stocks with high shareholder yields. His firm's research into large US stocks has found that $1 invested into the highest tenth of shares by shareholder yield between 1981 and 2013 would have grown to $157 compared with $35 for an investment in the S&P 500.

However, in the same way that dividends can represent a poor capital allocation choice for a company, so too can buybacks. Mr O’Shaughnessy has identified three key warning signs that buybacks may be a bad use of cash: 

(i) Companies buying back shares at high valuations can destroy value. Among the fifth of companies with the highest shareholder yields, Mr O’Shaugnessy found a massive 10.2 per cent difference in annualised returns between those buying back shares with the lowest fifth of valuations and those buying back with the highest fifth of valuations.

(ii) Buybacks are also of less benefit when companies have weak balance sheets. 

(iii) And when buybacks are made to boost EPS growth of companies with weak earnings quality, the activity should also be viewed with suspicion. The factors Mr O’Shaunghnessy uses to identify low earnings quality include high accruals (uncollected cash), and low depreciation charges relative to annual cash investments.

So when companies are returning large amounts of cash through buybacks, investors should want them to have high-quality earnings, strong balance sheets and reasonably cheap shares (extremely cheap is a danger sign, though). 

A virtue of buybacks when they are used well, is that management is likely to feel much less compelled to treat them as a long-term commitment than is the case with dividends. This gives companies more flexibility in what use they make of cash, as well as reducing the chances of becoming enslaved to an unsustainably lavish payout. 

Online comparison site Moneysupermarket.com (MONY) is a good example of a company that has historically been very cash-generative and generous with cash returns while keeping its options open. 

Staying flexible especially makes sense for Moneysupermarket because its trading history shows it is prone to encounter setbacks that are outside its control. Regulation in its end markets, recessions, and even changes to the Google search algorithm have all had noteworthy impacts on its profits in the past. It is currently experiencing one of these rough patches (hopefully it will also prove temporary) with revenues hit by Covid and a clampdown on insurance pricing recently announced by the Financial Conduct Authority (FCA), which may reduce incentives to shop around. 

It’s therefore fortunate that during the good times it has not pegged its colours too firmly to the promise of a massive basic dividend. Instead, while providing a decent base payout, it has alternated between spending cash on acquisitions, buybacks, special dividends or simply building up its cash balances.The chart below shows this in action. So while trading may now be grim, both its balance sheet and dividend policy affords it some welcome wriggle room.

Don't wait for income to come to you

Over the years UK investors may have come to see dividends as something independent of the other capital allocation decisions companies have to grapple with. One benefit of the distressing market events this year is that the experience may have helped shake this blinkered perception. 

Paying a dividend represents a choice to forgo other ways of creating shareholder value; whether shoring up a balance sheet, going for growth or returning cash by another method. While dividends feel tangible, there is no reason to consider them superior to other forms of capital allocation. Indeed, the tax treatment of dividends and the implicit admission by dividend-payers that they lack opportunities to reinvest cash, means these payouts should perhaps be seen as among least desirable uses of capital.

That said, dividends can help identify relatively stable, cash-generative businesses, while a strong culture of returning surplus cash disciplines management teams that may otherwise be tempted to waste money on ill-conceived growth strategies. Importantly, investors do not need to rely on dividends for income. Income can be generated by selling shares. From a total return perspective, the payment of a dividend is better viewed as management forcing this sell-up option on shareholders as opposed to some kind of free gift.