The Tortoise and the Hare: The Case for Dividend Growth

There is a fundamental case for investing in stocks which boast growing dividends, in our view.

Introduction

The hare ran down the road for a while and then looked back at the tortoise and asked: “How do you expect to win this race when you are walking along at your slow, slow pace?” Confident of winning, the hare took a nap. The tortoise walked and walked. He never, ever stopped - until he came to finish line first.

As in The Tortoise and the Hare’s fable, we believe investments which show resilience and consistency often get rewarded.

Valuation metrics (such as price-to-earnings and enterprise value-to-EBITDA1 ratios, or free cash flow yield) are frequently used as the main argument to buy or sell a stock. However, empirical evidence suggests this approach is only relevant for investors with short-term investment horizons (Figure 1). Over the long term, trading multiples tend to revert to their mean, making valuation arbitrage (i.e. the bet that a multiple will re-rate) of marginal importance, in our view.

What, then, do long-term returns actually depend on?

The Tortoise: Dividend Growth

If the value of a company is defined by the sum of the discounted cash flows for its investors, it seems sensible to have a metric based on the company’s dividends. Rather than the stock’s dividend yield (which is itself another valuation metric, dependent on one near-term payment and therefore susceptible of being influenced by a short-sighted or aggressive stance from the Board of Directors), the dividend growth introduces an element of sustainability over time, which is more relevant, in our view. Steady dividend growth requires simultaneous growth in cashflow. Companies which can deliver both are marked in their success; it therefore comes as no surprise that the metric can be a good indicator of overall returns over a 5-year period (Figure 1).

Figure 1. Average Absolute Return Contribution from Dividend Yield, Dividend Growth and Valuation Adjustments for Different Holding Periods

Past performance is not indicative of future results. For illustrative purposes only. Source: MSCI research ‘Global Markets & Return Drivers’, Analysis for the Ministry of Finance, Norway, February 2016. The paper examines the importance of dividend yield, dividend growth, and valuation adjustments in driving global equity returns from 1994 to 2015.

In this context, we would argue that investors identify stocks with a progressive dividend approach, a policy common in Anglo-Saxon countries. This policy allows for nominal annual increases in the company dividend, which we believe gives an important signal to investors looking for long-term market winners.

We believe focusing on companies with a progressive dividend policy has clear benefits.

First, such a policy keeps investors away from the large array of companies whose business model does not lend itself to dividend payments. Because such companies are not consistent cash generators over time, cash is earmarked for reinvestment rather than distribution via dividends.

Secondly, regular increasing dividends are a guarantor that shareholders’ interests have primacy among the company’s stakeholders and counterparties, which include bondholders, unions, pension trustees, government(s) and/or the management team.

Thirdly, it works as a self-regulating mechanism, promoting discipline in the capital allocation process, thus minimising the risk of unnecessary spending in internal growth projects or mergers and acquisition activity.

In parallel, there are macro arguments in favour of a growing dividend policy. The merits of growing dividends have not fully played out in an environment of falling yields, such as the one we have lived in since the Global Financial Crisis.

However, with policymakers increasingly alluding to symptoms of monetary policy exhaustion, there are signs of a turn in the regime, with higher reliance on fiscal rather than monetary policy. Christine Lagarde’s references to “potential side effects of unconventional policies”2, Mario Draghi’s allusion to “effective and timely” action from “governments with fiscal space”3 or more recently, Luis De Guindos’s claim for “other actors … to step in”4 come to mind. There is a fair chance that this turn coincides with an increase in inflation – a context in which growing dividends become of particular relevance.

One argument against the case for regular dividend payments is share buybacks. While we do regard share buybacks as shareholder-friendly corporate action, we do not find them preferable to dividends. It is frequently the case that capital tax gains are higher than dividend taxes, making buybacks less efficient. Additionally, companies do not frequently ‘time’ their purchases well (because they buy when they can, not when they should). As for management teams, it is unsurprising to see them advocating for buybacks because short-term performance measures are frequently linked to earnings-per-share growth (which directly benefits from buybacks) and because unvested options normally do not accrue dividends.

Conclusion

There is a fundamental case for investing in stocks which boast growing dividends, in our view. Indeed, this case may become even more compelling if and when yields rebound from current multi-decade lows. Just like the tortoise, we believe these stocks – which show resilience and consistency when it comes to dividend growth – and those that invest in them, will be the ones that get rewarded.

1. Earnings before interest, tax, depreciation and amortisation.

2. https://www.wsj.com/articles/christine-lagarde-pledges-to-review-ecbs-negative-rates-11567603619

3. https://www.ecb.europa.eu/press/pressconf/2019/html/ecb. is190912~658eb51d68.en.html

4. https://www.ecb.europa.eu/press/inter/date/2019/html/ecb.in191009~59da42388d.en.html