A pox on dividends ::

Author: Roger Montgomery
Date: 21/09/2007
Publication: Eureka Report

PORTFOLIO POINT: Companies able to generate strong return on equity should do so, not let the money leak out as dividends.

Australia’s listed companies have long made capital allocation decisions based on the income demands of shareholders and their infatuation with franking credits. Recent changes to CGT and superannuation, however, could now allow companies to act more rationally and shareholders will be better off.

What I am about to present is heresy to legions of income-hungry, dividend fans.

Australian investors, particularly baby boomers, are enamoured with their fully franked dividends. For years investors have been swimming in dividends, blissfully unaware that they have missed out on much higher returns.

The removal of double-taxation of dividends, combined with years of advice that says retirees investors should emphasise income in their portfolios, has served to fuel a silent protest by Australian investors that has been so effective that corporate capital allocation now blindingly follows the mantra to the significant cost of the very investors the mantra seeks to serve.

Thanks to recent tax changes to superannuation and the treatment of capital gains, a long overdue return to rationality could now occur. Companies able to generate high rates of return on equity should reconsider their dividend payment policies. Sensible decision-making would result in higher returns for shareholders and greater certainty amid lower business risk.

Let’s begin by explaining why investors are selling themselves short by insisting Australian listed companies – particularly those able to generate high rates of return on equity – pay earnings out as a dividend.

Take a company with $10 of equity per share on its balance sheet. We’ll assume the underlying economics of the business and its management combine to produce a steady 20% return on equity. As is often the case in Australia, we’ll also assume that 50% of the earnings is paid as a dividend. In the first year, earnings per share will be $2 and the dividend will be $1. The retained $1, which is not paid out as a dividend, increases equity at the end of the year to $11. In year two the company again generates a 20% return, this time on $11 of equity, producing earnings per share of $2.20.

If we now assume that the stockmarket chooses to never re-rate or de-rate the shares and that they always trade on a price/earnings multiple (P/E) of 10, we discover that in year one, the shares will trade at $20 (P/E 10 x $2) and in year two, the shares will trade at $22 (P/E 10 x $2.20).

In year one, the investor received a dividend of $1, and in year two a capital gain of $2 for a total return of 15% but had the dividend not been paid, retained earnings would have been $2 and beginning equity in year two would have been $12. A 20% return on the new, higher equity of $12 would correspond to earnings per share of $2.40 in year two and had the company’s shares continued to trade on a P/E of 10 in year two, they would be trading at $24. The shareholder would have received a 20% return.

By insisting that management pay 50% of earnings as a dividend, or $1, shareholders have robbed themselves of $2 in capital gains. If the shares are held by a sixty-something baby boomer in a superannuation fund that is structured so that no capital gains tax is payable, or if discount capital gains tax treatment applies where the asset is held personally, the difference is meaningful.

For many years, it has been investment dogma that as you age, your portfolio should lean progressively away from “growth” and towards “income”. Australian companies have been beholden to the irrationality of flawed financial advice for far too long. And Australian investors have missed out as a result.

Just how serious is the opportunity cost? Just how much has it cost investors to heavily weight their portfolio with income-producing assets in retirement? Academic research could put a value on it, but anecdotal evidence is sufficient to provide some insights.

In 1965, Warren Buffett purchased shares in and took control of Berkshire Hathaway, a tired manufacturer of suit liners, for $14.75 per share. In 1967, he paid a dividend of 10¢ and then realised that as a superior manager of money, shareholders would benefit if he retained and compounded the profits rather than handing profits in the form of dividends to them to manage.

In 2007 – four decades later – Berkshire Hathaway shares trade at $110,000 each because no dividends have been paid since 1967.

Everyone marvels at how Berkshire Hathaway’s shares have appreciated over the past 40 years. But the appreciation is not remarkable in the context of maintaining a greater than 20% return on growing equity. Berkshire Hathaway trades at $110,000 because Buffett has been able to generate high rates of return on ever higher amounts of equity. Any company whose business can sustain high rates of return on rising equity should adopt the same policy towards dividends.

And financial planners who might have advised investors to sell Berkshire Hathaway in 1968 because no dividends were forthcoming, have provided flawed advice. If a Berkshire Hathaway shareholder needs income, they can sell a share and if they really want an entertaining year, they can sell two shares.

In the context of the new superannuation rules, selling shares to fund lifestyle and healthcare needs is not as silly as it first sounds. Shareholders would have greater value in their shares and would need to sell less units to fund the same outgoings.

If a company can generate high rates of return on equity, it should retain its profits. Shareholders will benefit from higher capital returns. This is why Warren Buffett noted: “growth benefits the investor only when each dollar used to finance growth creates over a dollar of long-term market value”.

Often referred to as the $1 Principle, Buffett is simply referring to return on equity. A high rate of return on equity justifies a company growing its equity by retaining earnings. Conversely, a high rate of return justifies a company NOT paying dividends. “Growth benefits the investor”.

And by retaining earnings, the company will not need to raise as much fresh capital from shareholders, thereby diluting ownership, nor will it have to borrow as much.

The idea of suspending dividends however will be anathema to many Australian companies. “Our share price will collapse”, “our shareholders expect a dividend” will be the typical cries that managers – those not behaving like owners – will be heard making. Such cries, however, are irrational and reflect concern for the short-term impact on the share price (as irrational income investors sell out) rather than the long-term benefits to the shareholders who plan on remaining owners. For as long as management resists rational capital allocation, shareholders will be missing out on meaningfully higher returns. And a further point from the coal face, many Australian chief executives and chief financial officers can tell you what their dividend policy is but few can explain why.

These directors play in the revolving door of their company’s capital allocation departments paying dividends and then raising more capital for growth by issuing shares in the very same year, diluting shareholders’ ownership stakes or borrowing money and increasing the risk profile of the business for its owners.

Take JB Hi-Fi: its debt levels are unnecessarily high. In a hypothetical scenario where it pays no dividend and instead retains profits rather than borrowing, its balance sheet would be stronger, its return on equity ROE slightly lower perhaps, but its value and share price possibly double where it is today.

In such a scenario, why do Australia’s superior ROE generators insist on paying dividends? Shareholders would receive higher returns if they didn’t and balance sheets would be less geared – just look at Berkshire Hathaway.

Now that superannuation is tax-free for most baby boomers and capital gains are discounted for investors who have held shares for longer than a year, there is no need to receive income at the expense of capital gains.

Investors in companies where management believe they can generate superior rates of returns on equity, should insist that they hang on to their earnings rather than cost shareholders returns, by paying those earnings out as a dividend.

The franking can be distributed later, when the returns, as measured against equity, plateau or decline.

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