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Take no income from the best companies

Take Australia’s largest generational cohort, the baby boomers - all desperate for income - and then feed them some of the lowest interest rates on their cash in history. Before doing that, engineer a stock market crash, just a few years earlier, ensuring they have a disproportionately large amount of their remaining wealth sitting in said cash.

Now you have the ingredients for a boom in the pursuit of yield and in any asset promising one, but it’s important to take a step back from the noise to see the wood from the trees.

Unbridled pursuit of yield

Reading the share market tables last month, I realised that the plethora of PE ratios above 20 is not normal. A 20-year payback period at current earnings rates is a general reflection of hope and unbridled optimism, and while it can be explained, it’s not normal. Nor is it permanent.

The pursuit of yields through dividend-paying shares is analogous to a mindless heard of bison stampeding towards a cliff. Wall Street will sell what Wall Street can sell. Right now selling yield and income is the easiest game in town. Investors are predisposed to hearing the siren song of income and advisers and product issuers are rushing to feed the hoards. There are only a few who are willing to question the conventional thinking about pursuing yield at all costs.

My belief is that the pendulum will swing back and this time is no different to other periods of unbridled optimism. But that is not the subject for discussion today.

Should companies pay high dividends?

Rather, let’s look at a different view of dividends that suggests businesses, shareholders and even Australia as a whole are missing out by the grovelling to investors’ demands for income.

At Montgomery we love income. Don’t get me wrong; there’s nothing quite as satisfying as receiving cash without having contributed any sweat or labour. But are dividends the best way for companies to reward their investors? We have always held the view that when a business is able to generate a high rate of return on incremental equity, it behooves management to retain profits and reinvest, rather than paying them out. And shareholders are better off financially because in the long run, the share price – at constant PE ratios and assuming no capital raisings or borrowing increases - will rise by the return on equity multiplied by one minus the payout ratio. Buy shares in a company at a PE ratio of 10 times and if the company generates a return on equity of 20% per annum and you sell the shares years from now on a PE of 10 times, your return will be 20% per annum, matching the ROE of the company.

Of course a company can produce a similar result by paying all the earnings out as a dividend and issuing shares through a renounceable rights issue but if a company can generate high rates of return on equity it should be given the capital to do just that.

Assume you own a bank with equity on the balance sheet of $5 million. We will assume this bank generates an attractive return on both existing and incremental equity of 15% - not unlike some of its bigger rivals. We will also assume that if the shares were to trade between willing participants, they would price those shares at two times the equity value – again not unlike the multiple applied to your bank’s bigger competitors – giving your business market value of $10 million. With your bank earning 15% return on $5 million of equity, or $750,000 in the first year, the multiple of earnings at which pieces of your bank would change hands would be an undemanding 13.3 times.

Like many Australian listed companies the board of your bank has acquiesced to baby boomer shareholder demands for more income. It maintains a very high 80 per cent payout ratio, meaning 80% of the company’s annual return is received as dividends and only 20% is reinvested.

In year one the bank will earn a profit of $750,000 and the dividend will be $600,000 and $150,000 will reinvested to grow the future profits of the bank. These metrics will produce growth in both equity and dividends of about 3% per annum assuming no additional debt or equity.

After 10 years of these wonderful metrics, and with a bank still generating 15% returns on equity, the equity will have grown to $6,719,582. Given the willingness of investors to buy banks for two times the equity, the market value of your bank would now be a little over $13.4 million. But it is not just the asset value that has risen. Your dividends are rising too. After a decade, the dividend in the upcoming year would be $806,350, having grown by 3% per annum.

Under the scenario just described both your net worth and your income has grown steadily at 3% per annum.

Sell shares instead of taking income

The above scenario however is not the only way to derive the desired outcome. The company is forcing you to take a dividend when in fact the return you can achieve is far less than 15%. Logic suggests that if the business can continue to generate 15% on all and any incremental equity, it should indeed do so. But what do the owners do for income if the company is retaining all the profits to redeploy at 15%?

The answer is they can sell some shares. Now, before you write off the proposal as sacrilege, follow through this example of selling-your-shares-along-the-way.

Under the alternative strategy, you leave all earnings in the company and instead sell 6% of your shares in the company annually. Since the shares would be sold at 200% of the equity on the balance sheet, this approach would produce the same $600,000 of cash initially, and growing each year. As you will see shortly however the growth rate is about 8% per year.

Under this strategy, the equity of the company obviously rises faster - to $20.2 million after a decade ($5 million compounded at 15% per annum for a decade).

To receive income you sell shares each year. The perceived downside of this strategy is that as you sell more shares each year, your percentage stake in the business declines. In a decade’s time, your stake would be 53.86%. But perhaps surprisingly, the market value of your stake is actually worth more than under the first scenario. The equity, you might recall has been growing at 15% and trades at two times the equity. It now has a market value of $21.8 million. This compares favourably to the $13.4 million market value of a 100% stake in the equity of the company in the ‘take the dividend now’ scenario.

Perhaps even more surprisingly, the cash receipts from selling shares have been higher every year since the second year began. In the tenth year, the cash from selling a 6% stake is almost 78% higher than the first strategy at just under $1.4 million. Obviously, you would not have to sell as large a stake if you didn’t need the additional cash.

Many advisors and investors however would point to the fact that capital gains might be taxed at a higher rate than franked dividends but they forget two things. The first is that many baby boomer investors pay no tax at all. Even after franking credits are added back, the second scenario is a whole lot more attractive. And second, for those investors that do pay tax, the capital gains are only paid on the difference between the purchase and sale price (and subject to CGT discounts), whereas tax is paid on 100% of the grossed-up value of the dividends received.

There are many real world examples

Moving away from hypotheticals to the real world, many attractive businesses generate rates of return on equity that are much higher than 15% and the market is also willing to pay much more than two times book. REA Group currently trades for 14 times its equity value and Domino’s Pizza at nine times equity. Clearly, there is no need to sell as many shares to make up the income you might like annually.

It is reasonable to conclude that you would be much better off financially if the very best businesses – those that can retain profits and reinvest them at very high rates of return - paid no dividends at all and allowed shareholders to make up their own minds about how much income they needed.

Baby boomers demanding income are therefore stripping from companies the ability to generate even higher returns for them and therefore ripping themselves off. Perhaps ‘generation now’ is a more apt label for baby boomers after all.


Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘

December 08, 2014

Fair comment, Daman.

Even if internally generated cash-flows are the cheapest form of financing (evidence unclear to me), this is only half the story. The returns available on investments made will provide the net return, and here we are comparing the internal retention option with the infinitely many external options in terms of business, country, currency and asset structures. Its non-doability does not justify the current obscurantist adherence to retention by default.

As was pointed out, retention of franking credits (notionally belonging to shareholders, but only notionally) skews the retention option adversely, constituting as it does a conscripted loan to the ATO at zero rate of interest and subject to legal risks (see Murray report stirring up changes to franking, for starters).

The argument against paying out in full and incurring merchant banking fees seems at first sight to be rational: 'why indulge in such book-keeping antics, incurring real costs?' Note this argument would apply equally to other costs such as staff bonuses, pay increases etc. The staff could simply take all these as additional shares and if they need cash in a flash, sell in the market to liquify, can't they? The retention argument loses traction. In addition of course, those who make decisions (boards and management) are the agents telling owners to defer cashing (with market sales as a back-stop), but asymmetrically eschewing such forbearance themselves. Agency risk at its shimmering best. The need for liquidity is as much for the owner gander as it is for the agent-manager goose.

From a taxpayer perspective, increased payouts will deal with the clogged pipeline of tax revenues by removing our confected tax deferral (Joe Hockey, note). What is earned by corporates is passed to owners as taxable income, truly reflecting the intent of imputation. There are some national regimes that penalise non-distribution of profits.

This model is not unknown in partnerships etc with the concept of taxing 'present entitlements' tightly defined. Joint stock companies do need a differential approach, if well-run. If not they don't deserve it ab initio.

Is it not time that we remove the odium of blaspheming against hallowed myths from corporate finance, as we have done with civic conduct? Joans of Arc, happy to be burnt at the proverbial stakeholder are invited to apply....

December 06, 2014

By way of a contrarian approach, why not advocate that by law, all corporates should pay out 100% of each year's profits to shareholders, funding future growth through periodical rights issues (or public offerings)?

The focus on retained earnings presumes that the business you invested in somehow knows your changing investment risk- reward relationship better than you. At best if correct it could only mean an average investor: with differing risk appetites, tax positions and cash-flow needs this is unlikely to be skewed distribution. Those in favour of investor choice should allow investors to choose better options than reinvesting in the same business.

The ever-present agency risk (where those who manage the business as agents of owners might diverge from owners' interests for their own purposes) magnifies the perils of the culture of retention. One might counter this by saying that underperformance with retained moneys would be reflected in market ratings, but that would be too late for those who went along with the agent's decision to retain.

I cannot help thinking that the excessive focus on retention is another manifestation of the unhelpful attitude that derivative constructs such as joint stock companies have an inherent right to exist, almost like real beings such as individual investors. The effects are seen in mergers and acquisitions where the interests of the Board and senior management are prioritised over those of owners.

Free market advocates should vote for full distribution rather than retention.

December 06, 2014

If internally generated cash flows are the cheapest source of financing, and a business is able re-invest to generate strong returns in excess of its cost of capital, then I do not see why the business should payout capital.

Paying out 100% dividends sounds like a great idea, however likely results in advisory fees pay to merchant banks to sustain the capital base. I would prefer these fees not be paid, if there is not a need.

I believe what Roger is trying to get at is the focus on total return for Australian investors has been lost. This can be detrimental to long term returns. I do not believe Roger is implying capital retention is the one stop shop for returns. The examples used by Roger, showed businesses with strong returns on equity, and with an ability to generate these returns persistently on incremental capital. Obviously if the business has run out of opportunities to generate returns on capital, above its cost of capital the best avenue is most likely to pay cash flows to shareholders.

On agency risk, one can always seek businesses with alignment by investigating the shareholder register and by taking the time to understand the remuneration structure of management.

Capital Markets Guy
December 05, 2014

Hi Roger,

At present, most investors (whether baby boomers or not) are asking companies to regularly return most of their after-tax profits to shareholders. Companies that do so have been hamsomely rewarded on average, and those that haven't have been punished, sometimes severely. To the extent that companies are serving their shareholders, that is their job.

If you are asking shareholders, including baby boomers, WHY do they require regular cash flows, I think you would find the answer covers a wide range of responses:

* I need income to live
* companies that pay dividends are safer than those that don't
* I don't trust companies to retain big piles of cash
* successful Australian companies pay dividends

Some of these are conventions - e.g. it is now easy to sell shares instead of taking dividends of course. But paying dividends is the easiest way to distribute franking credits ***

There is some convincing research that companies often don't treat retained earnings with the respect that it deserves - e.g. Arnott and Bernstein's paper on US companies showing that - surprise! - higher payout ratios are associated with faster earnings growth.

Finally, if you are asking whether investors including baby boomers are potentially hurting their long-term return prospects by being overly focussed on an early return on capital, that is a very interesting but complex question.

*** BTW does anyone have a convincing explanation as to why there are tens of BILLIONS worth of franking credits sitting on the balance sheets of Australian companies, wasting away with the time value of money? I don't understand why more investors don't treat these as valuable assets and demand their return (and why company management effectively treats them as being of little or no value).

Chan SF
December 05, 2014

The strategy to retain capital and for shareholders requiring periodic cash receipts to sell shares is superior to the high payout strategy. It is though, still an inferior strategy to a 100 percent payout ratio with capital retained by way of underwritten DRPs. The additional benefit is upto 2.57 percent per annum being the value of the franking credits which would be fully refunded to the 'many baby boomer investors [that] pay no tax at all'. There is no benefit for a company to retain its franking credits (as opposed to capital). All other numbers are exactly the same as the capital retention strategy.

A further logical progression is that if such a company can indeed earn 15 percent return on additional invested capital then it would be an unlikely coincidence that the optimal amount of additional capital investment each year is exactly equal to retained capital from the previous year. Therefore the optimal approach would be for the company to raise additional capital from shareholders up to the point the marginal return on capital is equal to the marginal cost of capital. The problem of course is the lack of perfect foresight, and informational asymmetry between shareholders and management where it is in the interests of management to be over optimistic about the expected return on additional invested capital. Constraining additional capital to retained earnings is an arbitrary strategy but not necessarily inferior to making additional investment equal to 50% or 200%.

In all circumstances, a payout ratio that pays out 100% of Australian tax paid retained earnings each year with a DRP, underwritten if necessary to provide capital for growth, is an optimal strategy


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