Monday, April 30, 2012
High Yielding Equity Portfolio Studies Found Biased
Introduction
The worldwide economic slowdown has brought forward a movement toward high dividend yielding equity investing. While this is typical of every such part of the economic cycle, investors, both individual and institutional, are being misled by a slew of biased research on the part of academics and money management firms.
In general, firms which, by virtue of their products, services and financial management are proven to be historically consistent above-average dividend yielding companies are also good free cash flow producing firms, and that is the reason for outperformance relative to various benchmark indexes. If these firms were to instead have deployed their free cash flows into projects above their cost of capital, their shareholders would have been further rewarded.
The Dividend Decision
The implicit assumption behind a high yield equity strategy— whose basis is by purchasing shares in a diversified portfolio of firms having high payout ratios and above-average dividend yield— is an investor can earn a higher rate of return on that cash than the entity itself.
Over time, firms which produce free cash flows have traditionally had open to them, and are presented with, opportunities which are not generally available to the public at large. For firms which are net borrowers or have limited access to capital, value-adding opportunities cannot be pursued to similar degree, if at all.
Additionally, firms which are able to retain high quality management teams possess levels of expertise superior to that of the ordinary investor and can invest in size to take advantage of the opportunities presented. They then have the financial and management flexibility to negotiate and improve upon returns of the acquired assets, or in the parlance of management consultants— can become a better owner. This can take the form of improvements to the supply chain and manufacturing process or introduce labor and technology savings, cross-selling, and conceivably lower borrowing costs.
On the other hand, firms which chose to forego available opportunities in light of a dividend policy, bypass many value creating acquisitions, capital and software additions, and joint-ventures and partnerships.
A popular refrain among executives is they cannot find such opportunities available at a safe higher cash on cash return over their weighted average cost of capital, are capital constrained, or are regulated. Firms having poor acquisition records, have a top heavy financial structure, lazy or near-sighted managements, or succumb to the desires of vocal shareholders, including those insiders who own stock, and look for the simple way out of returning the excess cash to shareholders, are generally destroying, or not maximizing, value for its shareholders. While these firms’ shares may outperform generally recognized stock benchmarks during periods of poor economic growth, their ability to continue to pay dividends must remain a function of their ability to produce long-term free cash flows.
At issue in the academic literature is the bias introduced in the comparison of firms which pay dividends as compared to firms that do not. Such bias exists as firms that pay dividends are overwhelmingly free cash flow producers. It is my contention that yield studies should only use the universe of free cash flow producers, as the real argument is how such firms could best maximize value.1 Studies must look retrospectively to see what assets and decisions involving cash were open at the time a decision on the dividend was reached, including assets that were both passed over and those that were approved.
When studying firms having high payout ratios, the analyst/investor should not restrict their summary results to stock price performance but rather present comparison between capital deployment choices of those firms in the same industry, especially drawing on those firms having chosen lower payout ratios. From that point, the investor can then estimate what the firm’s financial metrics would have been had all choices been made.
After all, it is the primary responsibility of a firm’s asset guardians—its group leaders, executives and Board of Directors— to not merely protect the assets, but seek such means to see the capital base grow such that increasing amounts of free cash flows are produced under a sound financial base. The firms return on capital and, where additional amounts of capital are not required, economic profit— as opposed to its return on equity, is the preferred measure. To see how ROIC and economic profit should be defined I refer you to chapter, 5, Security Valuation and Risk Analysis.
When undergoing such an analysis, an analyst may need an inside knowledge of the firm to account for and explain the choices which lay before the CEO. Since most acquisition candidates, including that of privately-held firms are out of the sphere of ordinary investors, only the CEO, or perhaps those on his team, may know of such decisions.
Some firms had real opportunities before them while others might have been constrained from serious investments; for example Merck, which currently has a high 4.4% dividend yield, has clearly had many opportunities over the past decades, generates substantial free cash flows, yet whose shares might be looked at as slight outperformers during a down equity markets but whose shares have vastly underperformed the S&P since the last bull market began. One can easily make the case its shareholders would have been considerably better off if the firm made an acquisition of a related industry firm such as Allergan, Perrigo, or Watson.
1 See for example, Journal of Financial Economics, The Effect of Personal Taxes and Dividends on Capital Asset Prices, 1979.
Altria, another high yielder, has been divesting assets, and should be looked at using different metrics than Merck, as would be true of any firm facing a potentially large legal settlement. Similarly, other firms which are cash generators but face a potential call on cash, such as when asbestos manufacturers were confronted with and ultimately required to pay many billions of dollars in lawsuit settlements and legal fees, would not be in a position to be aggressively leveraging the financial structure.
Clearly, the recommendations of the CEO to the Board on how a firm should deploy free cash flows begins to form the basis of valuation, as these decisions impact prospective free cash flows, cost of capital and return on capital.
Yield Objective
As for the investment objective of an income producing portfolio, and hence safety of principal is an implied consideration, high grade fixed income instruments of varying high quality maturities should be preferred rather than equities, due to their higher yield and stronger collateral cover.
If long-term capital appreciation is desired to offset inflation alongside of income, both equities and bonds should be utilized, not the hybrid stock, unless the latter’s share price is low in relation to its future income stream.
Firms which cannot deploy cash into opportunities which earn a rate higher than its weighted average cost of capital should seek to distribute its excess cash, although far-sighted executives rarely run up against such a wall. As such, firms run by executives and acquisition teams with poor records of successfully finding and integrating acquisitions should not be looked at as a preferential income investments, given such entities would be less likely to see their dividends grow at a real (inflation-adjusted) rate.
Example
In the following example, I look at a firm deciding on a payout ratio. The firm currently produces $4 per share in adjusted free cash flows— that is including normalized working capital, capital spending and other discretionary spending, statement misclassification as well as adjustment for spending that should have taken place, such as pension underfunding, unfunded commitments, and purchase and payment obligations either related to materials or a prior acquisition. At CT Capital LLC, we routinely make such adjustments.
Understandably, while what follows is a simple analysis, it is not far from reality, as the basic analytical principles are similar to what occurs in actual practice. Also in actuality, a firm will weigh a host of financial metrics and qualitative factors in reaching a decision, including the current and expected level of interest rates(inflation), refinancing, covenants, calls on cash and expected business conditions and changes to current regulations and taxes. Presume in both instances the financial structure is similar, although the more aggressive management is likely to approve of higher leverage which could alter average cost of capital.
The distinction in the following example is that in the first instance (Decision “A”) the Board of Directors has decided to plow back all cash flows into the company to add to its capital base and expand output, which results in greater future free cash flows. They have decided to pursue an acquisition led strategy. In the second instance, its Board, after receiving a report from its consulting firm concluding its shareholders prefer cash be returned, foregoes larger-scale projects and instead institutes a higher payout ratio. Hence, its prospective free cash flows are lower.
Decision “A”
As a result of bypassing a dividend, all free cash flows are directed toward additions to capital and software, joint-ventures, acquisitions, and other related expenses, such as marketing, working capital, taxes, etc. The firm’s free cash flows are expected to grow by 8% per year for the coming 6 years and then tail off to 6%, not unreasonable, as in fact many firms in our portfolio have considerably greater normalized (four year average) rates of growth over long periods of time, including that period encompassing the worldwide credit crisis. While such growth will not occur in linear fashion, the average growth rate is not unreasonable.
Using an 8% cost of equity, roughly equal to that of the median S&P Industrial, this firm’s fair value is approximately $104.05, or 26 times its current free cash flow; in actuality, this firm might be expected to have a lower than market cost of capital. The valuation premium makes sense given the current 2% 10 year treasury yield and the firm’s prospective growth rate in free cash flows, as well as its return on capital and economic profit, both of which is superior to that of the median firm in the S&P. At the end of 10 years, presuming the firm is still meeting its historical and expected normalized growth in free cash flows, if still selling at 26 times free cash flows, fair value would have grown to $208.26, or double the initial investment for a compounded annual return of 8%, which logic would dictate would match the growth in free cash flows.
Decision “B”
The firm’s Board has instead decided to pay a higher percentage of current free cash flows in the form of a 4% dividend yield, and so future cash flow growth is limited to 2% per year. The current fair value now equates to just $63.43, assuming the same cost of capital, 8%. At the end of year 10, fair value rises to just $77.22, or just a 2.2% compounded annual rate of growth, again equal to the growth in free cash flows.
In reality, it would be difficult to estimate the two firms cost of capital unless additional information was known, especially with regard to financial structure, inflation rate, expected cash flow stability, sovereign risk, etc. Let us assume the 8% cost of capital accounts for these other factors. Also, a 2% growth rate in free cash flows is so close to the flat line one could presume its inflation adjusted free cash flows were near zero, inducing a higher cost of capital and lower fair value.
Thus, the results show that even for the investor who relied on the “Decision B” dividend for living expenses, he/she would have been placed in a superior position under “Decision A” had they merely sold shares from year to year. Again, in reality results are not linear, yet one can presume in some years the valuation multiple will be higher than average as shares are sold for income or other purpose.
Dividend Reinvestment
Further presume the investor under “Decision B” is able to earn the rate on current 10 year treasury bonds, or 2.2%, and all interest income were to be reinvested at that rate to purchase additional bonds. The total value of a $1000 bond, assuming all reinvestment of interest at the current coupon rate, at the end of year 10 would be $1,491, or a total annual return on the bond of 4.5%, which shows the power of interest on interest. Of course, if interest rates were to rise (fall), the interest on interest were to be substantially higher (lower). Yet, even with the investor reinvesting all of the interest income, the total value does not approach that of the company’ stock, which was compounding at 8% and then 6%.
If the investor consumes the cash dividend, his total return would of course be negatively impacted, as the cash on cash return from the dividends would be zero. In the above analysis, I presume the absence of taxes on the dividends and interest income—as opposed to preferential capital gains—which would have further penalized the income-seeking investor relative to the capital gains outcome. For example, Florida, Maine and Texas have a zero state tax rate while Hawaii taxes a high as 11%, California, 10%, DC and Vermont, 8.95%, and New York, 8.82%
Conclusion
Popular studies purporting to prove the relative superiority of investing in a high yield portfolio are biased as they include firms that are not consistent free cash flow producers as well firms that burn cash. The relative superiority of a high (payout) dividend strategy exists only as such firms are generally free cash flow producers; had such entities chosen to deploy excess cash into value-adding projects, their total value to shareholders would have been enhanced. Only if the investor is capable of earning a higher after tax return than the firm is capable of, would it serve the investors pecuniary interest such cash be distributed.
Kenneth S. Hackel, CFA
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