Twelve years ago stock market investing was all about earnings growth while dividends were BORING.\u00a0 Now the reverse is true, with investors \u201creaching for yield\u201d while growth is, arguably, under-priced.\u00a0 Investors need a framework for evaluating the trade-off between growth and yield.<\/p>\n
Start with successful mid-size company XYZ Corp., which is growing profitably.\u00a0 Should it pay a dividend?\u00a0 The answer, especially in the current slow-growth environment with a dearth of good investment opportunities, is \u201cNo.\u201d\u00a0 So long as the return on its new, or \u201cincremental,\u201d investment is greater than its cost of capital, it should make those investments rather than pay out capital.<\/p>\n
Reaching for Rapid Growth: Risky<\/strong><\/p>\n Fast forward five years. \u00a0Now XYZ Corp. is 50% bigger and its growth is starting to slow, but Wall Street still considers it a \u201cgrowth stock.\u201d\u00a0 The analysts with \u201cBuy\u201d ratings believe management\u2019s lofty growth targets.\u00a0 If the company dials down its growth strategy and starts to pay a dividend, naysayers may proclaim that it has \u201csignaled\u201d to investors that it is no longer a growth company; the PE may crumble and kill the stock price (not to mention the value of management\u2019s stock options).\u00a0 This mentality was prevalent in the 1990s. To avoid that fate, XYZ will be tempted to continue to invest aggressively for growth, perhaps in riskier areas (such as foreign markets) or by making acquisitions.<\/p>\n But if these investments are unsuccessful they will destroy shareholder value and the stock will definitely collapse.\u00a0 A good example is Starbucks, which in 2006-2008 was building too many stores in order to meet Street revenue growth expectations.\u00a0 During the recession earnings collapsed, SBUX ended up shutting 500 stores, and the share price dropped 75%.\u00a0 Oops.<\/p>\n Free Lunch!<\/strong><\/p>\n Clearly it is preferable for XYZ to recognize that its business is maturing and start to pay a dividend. \u00a0This does not mean it is no longer a growth company\u2014merely that its cash flow exceeds reinvestment opportunities.\u00a0 \u00a0For example, over the past few years many large, cash-rich tech companies (including Microsoft, Intel, Qualcomm, and Cisco) initiated dividends.\u00a0 Although this decision may have altered their image on Wall Street, in no case did it prompt analysts to cut their EPS estimates, secular growth rates, or price target<\/span> on the grounds that the dividend would prevent\u00a0 the company from funding growth properly.<\/p>\n In effect, then, for shareholders the dividend was literally a \u201cfree lunch\u201d \u2013 new dividend, same growth rate. \u00a0\u00a0This applies to most large, mature U.S. companies, not just tech.\u00a0\u00a0 They can pay a meaningful dividend without hurting EPS growth because they generate more cash flow than they can successfully reinvest <\/span>.<\/p>\n Intelligently Deploying Free Cash Flow \u2013 \u201cNot Doing Too Much\u201d<\/strong><\/p>\n In our August 3 post refuting Bill Gross\u2019 claim that stocks were a Ponzi scheme, we highlighted the importance of companies using free cash flow to maximize shareholders\u2019 total return. First, some elementary definitions for XYZ Corp.<\/p>\n Free cash flow can be deployed in four ways:<\/p>\n Historically firms deployed free cash flow poorly, overinvesting in plant and equipment or making dumb acquisitions.\u00a0 \u00a0But in today\u2019s downbeat, sober and sensible financial environment, companies have become smarter in deploying cash. Capital spending is appropriately cautious.\u00a0 Dividends have been growing rapidly but still are only about 30% of earnings, so there is room for additional rapid DPS growth.\u00a0 Share buy-backs are fairly strong and are shrinking the share count of the S&P 500 1-3% per year.\u00a0 Because balance sheets are already strong, debt paydown is not a priority.<\/p>\n By intelligently deploying free cash flow mature firms with fairly slow organic net income growth nevertheless can generate high single-digit total return to shareholders<\/span>.\u00a0 As an example, here is a possible combination:<\/p>\n This is the corporate equivalent of a major league batter who \u2013 as Yankee radio commentator Susan Waldman likes\u00a0 to say \u2013 \u201cDidn\u2019t try to do too much.\u201d\u00a0 Like the batter who settles for an RBI single rather than trying to slam a home run (and probably striking out), managements are deploying cash in a disciplined manner.\u00a0 Yet a 9% total return is very attractive when 10-year treasuries offer 1.5%.<\/p>\n Reaching for Yield? \u2013 Dividend Policies of the Dow Industrials<\/strong><\/p>\n To see how these principals apply today, let\u2019s look at the payout ratios, dividend growth, and PE ratios of the thirty companies in the Dow Jones Industrial Average.\u00a0 The key trends:<\/p>\n Dividends versus Share Buy-backs<\/strong><\/p>\n We prefer dividends, but both have their uses.\u00a0 We\u2019ll cover that in a future post.<\/p>\n Update:\u00a0<\/strong>You can also find this post on Seeking Alpha \u00a0http:\/\/seekingalpha.com\/article\/824551-not-doing-too-much-smart-cash-deployment-enhances-total-return<\/a><\/strong><\/p>\n","protected":false},"excerpt":{"rendered":" Twelve years ago stock market investing was all about earnings growth while dividends were BORING.\u00a0 Now the reverse is true, with investors \u201creaching for yield\u201d while growth is, arguably, under-priced.\u00a0 Investors need a framework for evaluating the trade-off between growth … Continue reading \n
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