Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 301

3 principles for finding dividend sustainability

A recent podcast with Robert Millner, Chairman of Washington H Soul Pattison & Company Ltd (ASX:SOL) provided valuable insights into the mindset of a long-term investment conglomerate. What started as a chemist on Pitt St in the 1870s has turned into what some would argue is the closest thing Australia has to a Berkshire Hathaway.

Today, as a conglomerate with only 10 people in head office and a market capitalisation of over $6 billion, SOL has delivered dividends to shareholders every year since 1903 and is one of only two companies listed on the ASX to deliver a growing stream of dividends over the past 20 years.

SOL is likely the ‘gold standard’ of income stability and consistency for investors. Whilst there are only a handful of companies on the ASX that can come even close to the 20-year dividend track record of SOL, one can never rely on past performance when looking ahead.

At NAOS we invest in small and microcap industrial companies. Whilst the concept of small stocks and dividends does not typically go hand in hand, there are plenty of companies in our universe which have demonstrated dividend success.

The principles which create an environment for stable to growing dividends are not company size dependent. For any of the principles below, we recommend looking at a medium to long term performance record as results can vary from year to year.

Principle 1 – free cash flow

The quality of any company’s operations can be measured by the amount of free cash it generates. The ability of a company to ‘compound capital’ comes down to how a company utilises and reinvests a portion of its free cash. This can include activities such as acquisitions, debt reduction, or building a bigger cash balance.

Whilst companies can pay dividends without free cash flow in the short term, over the long term, it is not conducive to sustainable capital management. A company that is extracting cash at the expense of reinvestment capital is likely to be going backwards. We like to see capital-light businesses that allocate a portion of free cash to both strategic and balance sheet initiatives whilst paying a portion to their shareholders.

A basic way to look for sustainability is to compare the total dividend amount to the total free cash flow amount. For this exercise, we define free cash flow as operating cash flow less ongoing capital expenditure. A company that is generating sustainable income for investors would have higher free cash flows than dividends paid.

Principle 2 – payout ratio

As a dividend hungry market, payout ratios of ASX-listed companies have been rising to become an ever-increasing percentage of total shareholder returns.

A dividend payout ratio measures the dividend per share versus the earnings per share. Inverting the payout ratio shows how much profit the company plans to retain. There may be industry-specific or ownership-specific factors which vary results, but as a general principle, a high payout ratio can be a sign that dividends may not be sustainable over the longer term.

Earnings that are retained within the business should be a buffer for future expectations, therefore a high payout ratio is likely to provide an understanding of the intentions of directors. Businesses which do not reinvest will likely face headwinds in the future.

Over the medium term, a capable board is one which prudently builds the retained earnings balance at a rate greater than the dividend payments. It gives a buffer against unexpected losses or impairments and may allow a more consistent dividend profile.

Often a company can be valued by its dividend yield, therefore a high yield can artificially inflate a share price. But if this payout ratio drops, it can have a serious negative impact on a share price.

The numerical increase in dividend per share often doesn’t tell us enough. We believe a better approach is that a company should ‘earn the right’ to increase its payout ratio. If previous investment decisions are compounding capital faster than a payout ratio increases, it demonstrates sustainability.

It could be a red flag if a company’s retained earnings balance is consistently diminishing whilst dividends remain steady or increasing.

Principle 3 - financing cash flows

It may be best to read a company’s financials back to front: the cash flow statement first and the income statement last. A company can’t muddy the waters of a cash flow statement. The bottom section of the cash flow statement shows how a company ‘keeps its lights on’ during a reporting period.

A warning sign is a continual entries in the ‘proceeds from borrowings’ line of the cash flow statement, without any entry in ‘repayment of borrowings’. There are short-term reasons such as acquisitions when this is acceptable (which in turn should hopefully generate further free cash flow) but there are other, more worrying reasons.

If a company is living on debt and not generating the free cash to pay it off, any dividends will eventually suffer and a capital raising may occur. A quick way to interpret sustainability of the funding of dividends is to compare dividend growth to debt growth. Artificially ‘holding up’ a dividend through debt is likely not sustainable.

These principles are a good start

The above three principles should not be solely relied upon, rather be considered as part of a wider analysis of a potential investment. The principles give a grasp of what might happen down the tract to a dividend, which in theory should be the most predictable part of total shareholder returns.

At NAOS, we invest in businesses where the earnings today are not a fair reflection of what we consider the same business will earn over the longer term, and over time the business can pay dividends. We do not invest solely for income, and avoiding ‘yield traps’ is just as important as finding a good sustainable dividend.

 

Robert Miller is a Portfolio Manager at NAOS Asset Management, a specialist fund manager providing genuine, concentrated exposure to Australian listed industrial companies outside of the ASX 50, and a sponsor of Cuffelinks. This content is for general information only and has been prepared without taking account of the investment objectives, financial situation, or needs of any individual.

For more articles and papers from NAOS, please click here.

RELATED ARTICLES

Chasing yields is paying dividends

Reporting season was not all doom and gloom

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.