Fat Tail Daily
The Dividend Fallacy

Friday, 1 March 2024

Greg Canavan
By Greg Canavan
Editor, Fat Tail Alliance, The Insider and Fat Tail Investment Advisory

[5 min read]

In this Issue:

  • Why dividends aren’t always better
  • CSL versus Telstra
  • The Nikkei breaks a high...set over three decades ago

Dear Reader,

Reporting season is a time for hot takes. New information comes out, and journo’s and analysts feel like they have to say something intelligent about the result within minutes.

Share prices swing wildly as the market absorbs this new information.

One of the hottest takes I've heard over the past few weeks is that XYZ’s share price jumped because it declared a better-than-expected dividend.

Or that ABC’s share price fell because management cut the dividend.

I know everyone loves a dividend in this country. But it’s important to understand how dividends impact a company’s valuation and its ability to grow.

For example, if an increase in dividends comes as a result of an increase in the dividend payout ratio, and not an increase in earnings, then such a policy will be detrimental to a company’s intrinsic value calculation.

A company that retains earnings is worth more than a company that pays out most of its earnings as a dividend.

A company cannot grow without retaining some earnings (and therefore paying less out in dividends). The amount retained, and the returns on those retained earnings, will determine its growth rate.

The best way to view and assess a company’s growth is by looking at its equity per-share growth, also known as book value per-share growth.

It’s no surprise that Warren Buffett opened every one of his shareholder letters (up until 2017) with a comment on the performance of Berkshire’s ‘per-share book value’.

Given that Berkshire doesn’t pay a dividend, and therefore retains all earnings, the growth in per-share book value is a good measure of the growth of the business.

With this in mind, let’s have a look at a few Aussie stocks — one low dividend payer and one high dividend payer — to show you what I mean.

CSL for growth

The top large growth stock that comes to mind is CSL Ltd [ASX:CSL]. My data only goes back 10 years, so I’ll start from 2014. Since then, CSL’s average dividend payout ratio has been around 45%. That means it reinvests around 55% of its profits. That gives it a good basis for long-term growth.

In 2014, CSL’s book value per-share was $6.60. By the end of FY24 this book value per-share should be around $37.30. That’s 465% growth in a decade. CSL has achieved this growth via acquisitions and share buybacks.

Share buybacks reduce the number of shares on issue and therefore increase the per-share book value. Provided they’re done right, buy backs increase shareholder wealth.

What does ‘done right’ mean?

As Buffett wrote in his 2016 letter to shareholders:

‘…repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value.’

Did CSL management follow this rule? I’m not sure. It depends on how they assessed the value.

Regardless, CSL’s book value per-share has still grown strongly over the decade. So, how does this growth translate into share price growth?

Let me explain…

In 2014 (at financial year end) CSL traded at a price-to-book value of 9.4 times, or $62 per-share. That’s a high multiple. The market rewards highly profitable companies that retain earnings. They’re ‘growth’ companies.

In 2014, CSL generated an excellent return on equity (or return on book value) of 44%. When you think of the compounding effect of reinvesting earnings, and generating a high return on those reinvested earnings, you can see why the market put a high price on it.

But by 2024, CSL’s enlarged size made it difficult to maintain such a high ROE. The consensus forecast for FY24 is for ROE to hit 17%. As a result, it now trades at an implied price-to-book value of 5 times, or $286 per share.

That’s a share price increase of 360% over ten years. The reason why share price growth is lower than the growth in book value per share is that CSL now trades on a lower price-to-book multiple.

Still, when you add in $17.40 in total dividends paid, it’s a solid return of 390% over the decade. 

Telstra for income

Now, let’s look at another Aussie corporate icon — Telstra [ASX:TLS]. Telstra is a well-known dividend payer. In fact, for a few years it paid out more than it earned. This meant that its book value per-share went backward!

Now, its dividend payout ratio is nearly 100%.

In 2014, Telstra’s book value per-share was $1.10. In FY24, consensus forecasts have it at $1.33. That’s about 2% growth per year. This is the low growth you should expect when a company pays out most earnings as a dividend.

So how does it fund investment in its mobile and other networks? It relies on debt. Net debt was $10.3 billion in 2014. In FY24, it’s forecast to hit $13.6 billion.

Because of Telstra’s market dominance and leverage from debt, it generates a high return on equity. At least it used to.

In 2014, ROE came in at 32%, and the shares traded on a price-to-book multiple of 4.7 times. However, profitability has declined over the past decade.

For FY24, consensus forecasts suggest ROE will come in around 13%. (This slightly understates Telstra’s profitability, as its free cashflow is higher than its accounting profit.)

Still, the point is that profitability has declined over the decade. And the market now prices Telstra’s shares on a multiple of 2.9 times book value.

How does this translate into share price growth?

Telstra’s share price closed at $5.21 on 30 June 2014. Yesterday, the price closed at $3.88. That’s a decline of 25% over 10 years. Total dividend payments over that time were $2.25, for a total return of around 18% over 10 years.

While I’m not suggesting these prices represent ‘intrinsic’ or fair value, the direction of the price over that time is consistent with how a rational investor should think about value creation and/or value destruction.

That is, if a company is paying out a high proportion of profits as a dividend, it’s going to struggle to grow per-share book value. And if profitability falls over time (as measured by ROE) the price-to-book value multiple will decline too.

That translates into a falling share price!

I hope you can see now why favouring dividend payers is not inherently a smart strategy. Sure, you want to have a bunch in your portfolio. But often what you get in income, you give up in growth. You need to be aware of this trade off.

The key is to be disciplined around valuations for both growth and income purchases, and you should do well over time.

Regards,

Greg Canavan Signature

Greg Canavan,
Editor, Fat Tail Alliance, The Insider and Fat Tail Investment Advisory

Greg is the Investment and Editorial Director of Fat Tail Investment Research and Editor of our flagship investment letter, Fat Tail Investment Advisory. Over the last 20 years, Greg has developed a unique investment philosophy that combines value fundamentals with technical analysis. The result is a portfolio solution that’s consistently beaten the market and embraces one key idea: that you don’t have to take big risks to make big returns.

Greg also runs the Fat Tail Capital Solution model portfolio, which is currently only available as part of the Fat Tail Alliance.

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Japanese Turning
Bill Bonner
By Bill Bonner
Editor, Fat Tail Daily

[3 min read]

The big news last week, The Financial Times:

Nikkei breaks through 1989 high

…this week, the Nikkei 225 finally broke through that peak…

after a 34 year wait.

Few Dear Readers will recall our first great ‘call.’ Our goal is to avoid the Big Loss. And in 1988, we noticed it shaping up in Tokyo. The sun was about to set on the Japanese Miracle, we guessed.

In the late ‘80s, nearly everybody was convinced that ‘Japan, Inc.’ – from a bombed out post-WWII shell…to export powerhouse – would go on to greater and greater glory. US business schools taught Japanese management techniques. Japanese terms, such as kaizen (continuous improvement), were worked into Wall Street analysts’ reports. Trendy high schools replaced Latin and French with ‘Nihongo’ (Japanese).

Our own son, then 6 years old, when asked what he wanted to be when he grew up, replied: ‘I want to be Japanese.’   

Time to Duck

By the end of the ‘80s the Nikkei Dow was trading at a P/E over 70. Individual growth companies occasionally merit such high prices. But for an entire stock market, it was…well…irrational exuberance.  

And the rationale for such fantasy was that Japan had more central planners than the US, with MITI (Ministry of International Trade and Industry) credited with guiding the economy to strategic success.

We knew nothing about Japan then. And nothing about it now. But we knew that a P/E over 20 is probably a bubble-in-the-making. Over 70, it’s time to duck.

We also knew that MITI was not responsible for Japan’s success. Major exporters (auto companies) ignored MITI’s advice when they entered the US market. And involvement by central planners, no matter where they are or what language they speak, always causes trouble.

In the event, the planners that caused most mischief were in the US, not in Japan. US trade warriors pressured Japan to limit the number of cars it could bring into the US. So, Honda and Toyota switched to higher priced, higher quality models…and soon dominated the entire world auto market. The New York Times explained:

‘“In 1945, Japan was decimated,” said Jon Ikeda, the vice president and brand officer of Acura. “And then in ’64 they were showing the bullet train and hosting the Olympics.” But in just two decades, “you’re talking an all-aluminum-body NSX and Honda is winning Formula 1 races,” he continued. “Acura got caught up in that energy — we wanted to show the world that Japan could build amazing products.”

‘One significant factor that aided the new nameplates was a 1981 voluntary trade agreement that limited Japanese auto imports to the United States. The restrictions on imports, which stretched into the early 1990s, and the subsequent loss of sales motivated the Japanese to create higher-priced vehicles to boost their profits.’

Our Best Book

We got onto the case (Japan’s imminent crash) a little early, as we are wont to do.  And by the late ‘80s, other financial writers were making fun of us for our persistent bearishness on Japan. Colleague Mark Skousen made a joke of it at an investment conference, awarding us a book that we didn’t write (with empty pages) – “How I Called the Crash in Japan” by Bill Bonner.

It turned out to be our best book! A few months later, Japan did crash.

Then, as now, the popular refrain was to: Buy the Dip. The Japanese were geniuses, investors told themselves. They’ll bounce back quickly.

But they didn’t bounce back at all. Investment managers had to apologize to their clients for the next 34 years. Japan, Inc. just couldn’t sustain a rally. Six times the Nikkei tried to get to its feet. Six times Mr. Market floored it once again. In 2012 – 22 years after the crash – the market was still down more than 80%.

Pity the poor investors! Their savings destroyed, they shuffled to their computer screen each morning…checking on their portfolios…disappointed again and again. Plans for vacations…second homes…retirement – delayed…and delayed again. They went broke. They went insane. Investors over 60 at the time of the crash said goodbye to their money and never saw it again. Many died penniless, cursing the day they ever decided to buy stocks.

Generational Losses

Even we took the bait in 2010. After 20 years, we figured it was time for a real bull market in Japan. We figured too that all the debt and money-printing by the Bank of Japan – in a misguided effort to stimulate the economy -- was bound to reduce the real value of Japanese government bonds. Either the bonds would fall or the stocks would rise; our trade of the decade – Buy Japanese stocks; sell Japanese bonds – was sure to be a winner.

It was not a bad trade. We made money. But we were early. Had we announced that 10-year trade 4 years later, we would have made a lot of money.  

And now that the Nikkei stocks have gone back to the future of 1989, finally stocks are paying off. Or maybe not. Have investors been made whole? Nope. They’re still down about 20%, after inflation…after an entire generation of losses.  

That’s a big loss.

Regards,

Bill Bonner Signature

Bill Bonner,
For Fat Tail Daily

All advice is general advice and has not taken into account your personal circumstances. Please seek independent financial advice regarding your own situation, or if in doubt about the suitability of an investment.

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