ByGreensKeeper:
I am constantly surprised by many investors' fixation on
dividend yields - a tendency that I believe is misguided.
I can understand the allure of receiving a regular cheque. In
fact, dividends have historically represented a significant
percentage of total investment returns. But blindly buying only
stocks with large dividends can get you in trouble.
Some high-yield stocks are underpinned by unsustainable payout
ratios - the portion of profits that is paid out as dividends. When
a dividend payout ratio is greater than 100 per cent, a portion of
the payout is actually a return
of
capital, not a return
on
capital. I don't consider getting paid back with my own dollars to
be an attractive proposition.
My view on dividends is based on the investment principles
espoused by Charlie Munger and later adopted by Warren Buffett. I
like to invest in companies with high returns on equity and on
invested capital. These are usually businesses that possess
exceptional economics. In these situations, if management can
reinvest the business's free cash flow in the company's core
business, my ideal dividend is zero.
A case in point: In October 2008, I bought shares of Starbucks
Corp. (
SBUX
). The stock was trading at $9.87 (U.S.) and did not pay a
dividend. Starbucks was shrinking its North American business by
closing stores but was continuing to expand in China and
internationally. I thought Howard Schultz, the founder who had
recently returned as CEO, could return the company to its former
glory.
Starbucks' cash was being retained and reinvested in a business
that had generated historical returns on equity in excess of 20 per
cent. By retaining all after-tax net profit in the business and
reinvesting it on my behalf at high returns, the company was
actually working for me. I avoided the tax bill that would ensue
had a dividend been paid out to me and I was also spared the
difficult task of reinvesting the money at equally attractive
rates. Starbucks closed yesterday at $48.09.
More recently, I purchased shares in Home Capital Group
(HMCBF.PK). As with my former purchase of Starbucks, the stock was
cheap for reasons that I believe were erroneous. Home Capital has
maintained a return on equity of more than 25 per cent for the past
nine years. It sports a modest dividend yield of 1.9 per cent,
maintains a very low payout ratio and at yesterday's close of
$51.35 (Canadian) is trading at only 8.9 times this year's
earnings. I'm not worried about the relatively low yield, because I
believe the company is reinvesting its profit where it should - in
its own business.
Mr. Buffett has often said that if a company can create more
than a dollar of market value for every dollar retained then the
proper decision is to retain the capital in the business. His
company, Berkshire Hathaway ([[BRK.A]], [[BRK.B]]), has never paid
a dividend despite its massive cash flows. Most, though, would
agree that it has created outstanding value for shareholders.
Unfortunately, most great businesses will eventually generate so
much cash that management is unable to reinvest it wisely in the
company's core business. Most blue chips fall into this camp. For
this reason, it is important to ensure that management is
shareholder-friendly.
Many managers are tempted to expand their business empires
through questionable acquisitions (e.g. Microsoft's (
MSFT
) US$8.5-billion purchase of Skype). Retaining capital in the
business can also make it easier for executives to increase their
company's earnings per share - and the value of their stock
options.
That's why a shareholder-friendly management team is vital. If
attractive internal uses for the company's excess cash are not
available, they will do the sensible thing and return the money to
shareholders either through dividends or share repurchases. In
these situations, dividend payments are healthy because they
prevent management teams from frittering away corporate cash.
The only way to know what a dividend truly means is to look at
factors such as the payout ratio and management's history of
creating value over the long term. There is nothing necessarily
wrong with investing in dividend-paying companies, but relying on
simple strategies based solely on dividends can get you in trouble
as an investor. When searching for yield, going a little deeper in
your analysis usually pays dividends down the road.
A version of this article appeared August 22, 2012, on page B9
of the Canadian edition of The Globe & Mail, with the headline:
Investors should seek good companies - not dividends.
Disclosure:
I am long [[HMCBF.PK]], [[MSFT]], [[BRK.A]], [[BRK.B]]. I wrote
this article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
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