A couple of weeks ago an interesting article was posted on Stockopedia:
This is a pretty bold statement and, having ruminated on it a bit, one I can’t help but disagree with. I started typing a comment by way of response on there, but having got a bit long, I figured I’d move it over here with a suitably gauntlet-laying title. My teachers always did say I was prone to exaggeration! Click through and read the article for yourself if you want to get it from the horse’s hooves, but I’ll attempt to summarise the author’s argument here as fairly as I can:
Active management is bad because it’s difficult to spot profit warnings coming, and difficult to discern future profitability. It is better to base investment decisions on a ‘fundamental measure, like dividends’.
The charge that accounts are unreliable is one that comes up quite often. I note one thing to start with; if you like investing in AIM-listed Chinese companies, or exciting little oil & gas plays, I sympathise with you – you might well find published accounts a decidedly questionable source of information.
On Tesco, though, I think the furore about the profits overstatement is the exception that proves the rule. Everyone knows that companies are flexible beasts and accounting is a science of best guesses and justified assumptions – but the proverbial ton of bricks that has been brought down on Tesco’s head says a lot about the view the market takes when the accounts lose their sanctity. In some senses, Tesco’s predicament was probably more likely than in most FTSE companies. Where does one expect the pressure to overstate profits is most prevalent? Perhaps in a company which has been battered by market forces and has lost its do-no-wrong halo in the last few years? This is to say nothing about the incentives of other participants to investigate given Tesco’s particular situation…
In most cases, markets make their views on fishy accounts quite clear – you only have to look at Quindell to see that much. The market is suspicious. You cannot avoid it. Sometimes, something really does come out from the blue – but such is life. A significant number of dodgy accounts post obvious characteristics – cash flow problems, usually, and a little digging into the numbers has a great deal of value. The real surprises on figures are part of the reason we’re paid more to be equity holders and not debt holders. We take equity risk in exchange for equity returns.
On dividends being a better arbiter
I’m not really sure what the original author is comparing dividends to when he says ‘accounts’ – in ‘dividends are more reliable than accounts’. I assume he means traditional valuation metrics like price/earnings and long term financial analysis. He does say:
Active managers claim that only by detailed analysis of the accounts, and interrogation of executives, can the true prospects for a company be discerned.
This is a worrying statement to make because, at the very least, the first one of these is one of the few ways you can make informed guesses as to the long-term performance of companies. Everybody knows that there are no crystal balls, but I continue to believe – as is evidenced by a substantial amount of academic research, as well as the experience of everyone’s favourite value investor – that if you buy good companies, with solid long-term return profiles at reasonable prices, you will outperform the market.
So what’s my problem with dividends?
Nothing I’ve said up to now puts anything against dividends. The author I linked to thinks dividends are more reliable than accounts, but I am sure that he uses both and does not invest solely on dividend yields. To do so would be trying to play snooker with a toothpick – you have better tools available to you, so why not use them?
I’ll go a step further, though – I don’t think dividend yields should even be a primary metric when it comes to investment decision making. That’s probably slightly more controversial. Private investors love their dividends. I suspect this is because they provide a source of income that feels more safe than the capital appreciation you see from rising share prices. If a company’s paying you £1,000 a year for holding it, it’s tempting to feel that the investment is somehow more reliable than a company retaining all of its capital.
I think this is a false sense of security, though, because dividends are ultimately a lever which is entirely dependent on the one key metric when it comes to valuing the company – the only thing that actually matters – the long-term cash generative ability of a business. This is the real metric every investor needs to estimate, not a dividend yield figure. Let me give you one hard example.
This is Fidessa:
Fidessa is a solid company. They provide software integral for banks and financial services; if you want an impressive stat, in their latest annual report they say that ‘$12tr worth of transactions’ went through their network last year. It is trading on a dividend yield of 3.5%.
This is Rotork:
… and that is pure chart porn for any investor. Rotork is a compounding machine; they produce flow control systems, predominantly for the oil & gas sectors. Check out their annual report for a better description than I could possibly give here. Rotork, for their part, trades on a rather less exciting 1.9% dividend yield.
The crux of the issue
Which one of these two offers better value? Here’s my problem – the dividend yield is telling you next to nothing about that question. It is a poor valuation metric. A table of other figures quickly shows why:
Fidessa is a company paying out all of its earnings in dividends. Implicitly, Fidessa is telling investors that it has no more productive use of that capital than to given it back, though they are still investing some cash in product development . Clearly, this is an admirable thing to do – far better than wasting money on acquisitions or pursuing far-fetched products. At the same time, though, it raises questions for their long-term returns. Call me stingy, but I’m not particularly comfortable paying 30 times earnings for a company which looks pretty mature, no matter how promising them bringing their formidable might to associated products might be.
Rotork pay significantly less in dividends. Is this a bad thing? It might be if you care deeply about the income, but it’s not to me. This is because Rotork is a company which has proven itself to be an excellent custodian of its shareholders’ money, earning stellar returns on capital and equity historically. By paying a relatively small dividend, they are saying to investors “let us keep the money – we’ll invest it, and we’ll compound it”.
Not only has following the dividend made a significantly more expensive (in earnings terms) company look cheaper, but it’s also intrinsically biased in selecting mature companies with fewer outlets for reinvestment of capital. For any investor with a long-term timeframe, I think that’s excluding an enormous amount of exactly the type of company you want to be investing in.
So how do I use dividends?
I’m certainly not railing against dividends. As far as I’m concerned, though, they are a secondary consideration. I don’t care where my return on capital comes from – from stock price appreciation or from dividends – and I think that agnostic approach makes sense.
There are plenty of companies that should be paying dividends. Mature companies with great cash generation and nowhere to reinvest it should target high payout ratios. Companies (like Rightmove) who need little capital to finance their growth should be paying dividends or, as in Rightmove’s case, buying back shares.
But these are sanity checks, checks of logical management and prudent capital allocation. Stand-alone, the dividend means very little.
I think if you invest in 10 companies like Rotork your performance will be meaningfully better in the next ten years than if you invest in 10 companies like Fidessa. I have nothing against Fidessa, I should note – it is just a nice example that came to mind of a blue-chip company paying out a chunky, earnings-busting dividend.
If I might even venture a little psychology, I wonder if some of that difference might come about from the reluctance of market participants to short dividend-paying companies. Shorting a company requires you pay its dividend, not receive it – making it a particularly uncomfortable affair. As I ventured earlier, I think this is a bit of a logical fallacy – a ‘devil you do know’ vs. ‘devil you don’t’ case, where market participants dislike the uncertainty of shorting into visible capital outflows, and feel more comfortable shorting companies with ‘invisible’ potential capital outflows (price appreciation)!
I’m not really breaking any new ground here; it’s the same story as ever from me. Our job, as active investors, is to value businesses and figure out – in one way or another – the discounted cash flows that business can generate in the future. It’s not easy, but shortcuts provide – if you are a simple man like me – more dead ends and clouded thinking than real value.