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If You Want Growth, Avoid Dividends

In my experience, there is one big difference between the equity markets of the UK and the US: dividends.

For example, in the UK it’s pretty easy to find a large-cap stock with a dividend yield of more than 5%. A quick screen for companies with a market cap. in excess of £5bn that yield of 5% or more returns 12 results in a universe of 2733 stocks. More than half of these are FTSE 100 constituents. The FTSE 100’s average yield is 3.9%.

A similar screen applied to a universe of 11,333 US stocks returns 19 results after removing any master limited partnerships, trust companies and mortgage real estate investment trusts, none of which tend to exist in the UK market (I also excluded Kinder Morgan, but that’s an argument for another day). The S&P 500’s average yield is 1.9%.

The figures are telling. Just under 0.5% of the UK large-caps screened supported a yield of +5% compared to just under 0.2% of the US stock universe. This is by no means a scientific study, but it does illustrate the point that yield is easier to find in the UK.

However, unless you’re about to retire these figures are troubling as they indicate that there’s a much more sinister underlying theme haunting the UK equity market.

Ex growth

Henry Singleton and Warren Buffett are considered to be two of the best business managers of the last century. Henry Singleton, who is often referred to as “the master of capital allocation,” always refused to pay a dividend to investors. Instead, Singleton reinvested the cash into his company Teledyne, which over a period of 20 years went from being a tiny defense contractor with sales of $5m to a sprawling global conglomerate with more than 20,000 employees.

Singleton knew that Teledyne was generating a +30% per annum return on capital invested. Therefore, it made no sense to pay the profits out to investors:

“To begin with he asks, what would the stockholder do with the money? Spend it? Teledyne is not an income stock. Reinvest it? Since Teledyne earns 33% on equity he argues, he can reinvest it better for them than they could themselves. Besides, the profits have already been taxed; paid out as dividends they get taxed a second time. Why subject the stockholders money to double taxation?…” — Source

Warren Buffett has followed in Singleton’s footsteps. Berkshire Hathaway doesn’t pay a dividend to shareholders as the business is able to generate a +20% per annum return on equity by investing in itself.

These two case studies illustrate the following point: A company should only return excess capital to investors if it cannot find opportunities for growth elsewhere. If a company is paying out a considerable amount of earnings to investors via dividends or other methods, it usually signals that the business in question has gone ex-growth.

Unfortunately, there’s also evidence to suggest that if a company starts returning excess cash to investors while it is still growing, the tail will begin to wag the dog.

“Reinvestors” vs. “returners”

Last week, the Financial Times took a look at the findings of a new white paper from the Credit Suisse Holt group. The white paper looked at the fortunes of “reinvestors” vs. “returners”, companies that returned the majority of their cash to investors vs. those firms that reinvested excess cash into operations.

From the FT:

“Historically, according to the Holt white paper, companies have deployed an average of 60 per cent of their cash flows in capital investment (whether organically or through M&A) and have returned 26 per cent to shareholders (12 per cent dividends and 14 per cent share buybacks). More recently, the capital invested has dropped to 53 per cent while cash returned to shareholders has increased to 36 per cent, with an increasing share going to buybacks.”

“The Holt paper follows the fortunes of “reinvestors” and cash “returners” and finds that the latter increase their sales by only 5 per cent per year over the ensuing five years on average. Reinvestors managed to grow sales at 19 per cent per year. So the critics’ picture of tired ex-growth companies, out of ideas for growth, and deciding to reward their shareholders to the detriment of the chance for economic growth, has at least something to recommend it.”

“Companies are getting less cash than they used to, they are not optimistic that they can invest it productively and so they are choosing to deploy it in a way that weakens the chances of sales growth in the future. Not encouraging.”

So, according to Credit Suisse’s data “reinvestors” have been able to grow sales three times faster than “returner” peers. In other words, if you’re looking for growth avoid “returners”.

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