There are many different investment styles applied by professional fund managers around the world. If you have ever bought a unit trust, you may have been confused when working through the myriad of offerings with terms like value, growth, quants based, GARP etc. Each strategy would have experienced a period of real success for it to warrant a space in a competitive landscape, but Dividend Income Strategies have long held a special place for many investors often nearing the point of retirement, and searching for a replacement to the more traditional form of income they were used to in their working career. Whilst investing for dividends can certainly form part of an income generating strategy, we don’t believe it is always the best or sometimes most appropriate strategy, if it means overlooking more attractive investment opportunities that don’t necessarily pay a dividend. It is often said the majority of returns for equities comes from the reinvestment of dividends and this is often supported with a chart like this for example:
It is not surprising when dividends are reinvested, a higher rate of return is achieved, but it is not the same as demonstrating the majority of returns come from reinvested dividends. In our view they come from retained profits.
If we use an average US listed company found in the S&P 500 we found the following:
An approximate pay-out ratio is around 53% (pre-Covid) which would mean around half of the profits are distributed as dividends.
A Return on Invested Capital (ROIC) of 15,5%
A price to book ratio of (market value divided by book value) of 3,3
So which generates more value for shareholders? Is it the reinvestment of the dividend paid out, or the reinvestment of the profits by the company? South African tax law dictates that foreign dividends (in excess of R 3,700) are taxed at a maximum effective rate of 20% which means for every Dollar you received as a dividend, you keep 80 cents. This must then be used to repurchase the shares at the prevailing market price and given the current price to book of 3.3x this means you will only get to own just 30,3 cents (100 / 3.3) of the company’s capital for every Dollar you invest. Remember though you only get to keep 80 cents of every dollar (after tax) which in fact means you only get 24,24 cents of the company’s capital (80 / 3.3). If we consider that every $ of retained income (which belongs to you as the shareholder), is not taxed and reinvested in the company’s capital at book value, you then get full value for every $ retained. In addition, each Dollar of retained earnings is then turned into $3,3 of market value as the company’s shares trade of a 3,3x book ratio. When looking at the return comparison for the S&P 500 Total Return index against a more Dividend biased index such as the FTSE High Dividend Yield (TR) Index, it is clear from the table below that you would have been in a better position investing for growth and redeeming capital in order to meet your income requirements.
Source: Morningstar Direct
* The FTSE High Dividend Yield Index is derived from the U.S. component of the FTSE Global Equity Index Series (GEIS) and includes stocks with the highest dividend yields
It seems clear that when a portion of returns that companies generate are retained and automatically reinvested on your behalf, it can create more value than you as the investor are able to by reinvesting your dividends. If we take this example a step further and consider the shares that have contributed most to our managed global equity strategy over the past 5 year (all non-dividend payers), the results are extreme as illustrated in the graph below:
Source: Morningstar Direct
Source: Morningstar Direct
It is important to mention that not all companies are always able to adequately reinvest at an appropriate return, which is why we have used the S&P as our reference point in this article. The South African stock market is a far more challenging environment to seek out companies with positive growth trajectories and opportunities to expand. This is one of the main reasons why we consider investing offshore so critical to the success of any investment portfolio long term. It is not just for the Rand hedge qualities, but the opportunity set available to the investor. We will spend more time covering this in more detail in the following article but it is important to understand we should not be limited in our thinking that dividend income is the only way of meeting expenses from a portfolio over time. Provided the portfolio is structured correctly to manage and account for periods of volatility and there is never a need to realise shares at a depressed price, it is our view that greater consideration should be given to the quality of the companies we invest in rather than just the dividend they are able to pay. When investing in a smaller emerging market like South Africa however this view may be different.
We place a strong emphasis on constructing portfolios specific to each of our client’s personal circumstances, and asset allocation at a portfolio level should be representative of the objectives the portfolio needs to achieve including income and capital growth. As we have learned over the last 3 months, things can change very quickly and it is important that portfolios are able to absorb periods of instability.