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Why Do Dividend Strategies Tend to Outperform?

Thornburg Investment Management

Cliff Remily

February 22, 2010



In an earlier article, we addressed how we look for companies that have an ability and willingness to pay increasing dividends. We illustrated how high and rising dividends tend to outperform the market and briefly described how independent academic and practitioner research has shown that just because a company pays a dividend does not mean the company cannot grow its earnings. In this paper, we delve deeper into the supportive research and provide two specific holdings as examples. The importance of these findings is to illustrate how we look to pay a rising dividend over time. The way we accomplish this is to buy companies that are able to grow their earnings power and increase the dividend along with the increase in earnings.

One primary role of a public company’s management team is to allocate capital among various projects to maximize returns for shareholders. Unfortunately, conflicts can arise between management and minority shareholders. For instance, a ceo may have a pet project that continually loses money yet receives annual funding. Another conflict is that the highest returning projects may entail more risk than the manager wants to take, for risk of losing his or her job. This can hurt shareholders if the risk versus reward trade-off is in favor of taking the project. Finally, management teams may engage in empire building, acquiring companies at a premium in order to grow their own organizations. This occurs from ego as well as the likelihood that the management team is compensated more for managing a larger company.

The managers of the Thornburg Investment Income Builder Fund believe capital allocation decisions are one of the critical long-term driving forces for company success and, ultimately, stock performance.

How can we determine if a company is allocating capital correctly? Without perfect foresight, we have to rely on history, current decisions, and management guidance. One indication that management takes capital allocation seriously is through its dividend policy. A dividend monetizes a portion of earnings for minority shareholders, which retained earnings do not. This brings the present value of future cash flows forward, and all else being equal, raises the value of the firm. Companies with good business models generate higher metrics of profitability such as return on equity (roe) as well as cash flows. This cash needs to be deployed, and when a company has a high roe, it takes less retained earnings to grow the business relative to those with lower roe. Along with many subjective and qualitative factors, we look for these companies that have strong business models as well as the ability and willingness to allocate capital prudently.

We’ve often discussed the original study by Arnott and Asness titled “Surprise! Higher Dividends = Higher Earnings Growth?” The authors were the first to find that companies with higher payout ratios actually had higher real earnings growth over the subsequent 10-year period. This is counterintuitive, as one would expect a dividend-paying stock to translate into low growth. The table below provides the results of the study, clearly illustrating that companies paying out more cash as dividends (quartile four) had the highest subsequent 10-year eps growth.

Surprise! Higher Dividends = Higher Earnings Growth

Real Subsequent 10-year Earnings Growth

 

 

 

Average

 

Worst

 

Best

 

S&P 500 Index 1946–91

 

 

Lowest

 

Quartile 1

 

-0.40%

 

-3.40%

 

-3.20%

 

 

 

Quartile 2

 

1.30%

 

-2.40%

 

5.70%

 

 

 

Quartile 3

 

2.70%

 

-1.10%

 

6.60%

 

 

Highest

 

Quartile 4

 

4.20%

 

0.60%

 

11.00%

 

 

Source: Robert D. Arnott and Clifford S. Asness, “Surprise! Higher Dividends = Higher Earnings Growth?”, Financial Analysts Journal, Jan/Feb 2003. Data analyzed: 1946-2001.

 

In every case over these rolling 10-year periods from 1946 to 1991, the highest dividend payers had the highest earnings growth. These results were not just on average, but were robust through the strongest and weakest markets as well. We share the authors’ opinion that it is possible to have high earnings growth without paying dividends. In fact, most growth companies that have annual growth rates of 20%, 30%, or more, typically do not pay dividends since they need this capital to sustain their investment opportunities. However, we believe growth rates of this magnitude are few and far between and not sustainable over the longer term. A growth manager skilled at analyzing high-growth companies should be able to navigate this segment of the market. The point of this study is not to diminish growth as an investing style, but rather to show that dividend-paying stocks on average do indeed grow earnings over the long term at higher than average rates.

The relationship between dividends and growth is not confined to domestic companies. The same study was replicated in multiple markets, including Canada, Australia, France, Germany, Japan, Netherlands, Switzerland, and United Kingdom. The results are listed below. In Canada and Australia, the study focused on the ten-year subsequent eps growth, while the others used five-year growth rates.

Do Higher Dividends Lead to Higher Earnings Growth? By K.C. Parker

Real Subsequent 10-year Earnings Growth

 

 

 

Average

 

Worst

 

Best

 

TSX Composite Jan-56 to Sep-05 (Canada) 

 

 

Lowest

 

Quartile 1

 

-4.1%

 

-16.7%

 

5.8%

 

 

 

Quartile 2

 

-0.1%

 

-17.0%

 

7.9%

 

 

 

Quartile 3

 

3.2%

 

-16.2%

 

7.1%

 

 

Highest

 

Quartile 4

 

6.3%

 

-21.0%

 

34.6%

 

 

S&P 500 Jan-56 to Sep-05 (United States) 

 

 

Lowest

 

Quartile 1

 

-0.3%

 

-3.4%

 

4.1%

 

 

 

Quartile 2

 

1.4%

 

-3.0%

 

6.0%

 

 

 

Quartile 3

 

2.5%

 

-1.0%

 

6.6%

 

 

Highest

 

Quartile 4

 

3.2%

 

0.9%

 

7.1%

 

 

ASX Composite Jul-69 to Sep-05 (Australia) 

 

 

Lowest

 

Quartile 1

 

-3.0%

 

-10.2%

 

-0.9%

 

 

 

Quartile 2

 

0.6%

 

-5.3%

 

6.2%

 

 

 

Quartile 3

 

1.3%

 

-6.6%

 

6.7%

 

 

Highest

 

Quartile 4

 

3.3%

 

-2.8%

 

12.7%

 

 

Source: K.C. Parker, “Do Higher Dividends Lead to Higher Earnings Growth?”, Simon Fraser University, 2005.

 

International Evidence on the Payout Ratio,
Earnings, Dividends, and Returns

Real Subsequent 5-year Earnings and Dividend Growth

 

 

 

Earnings

 

Dividends

 

France 1973–04

 

 

Lowest

 

Quartile 1

 

6.2%

 

2.9%

 

 

 

Quartile 2

 

8.7%

 

18.1%

 

 

 

Quartile 3

 

9.7%

 

8.9%

 

 

Highest

 

Quartile 4

 

20.1%

 

14.8%

 

 

Germany 1973–04 

 

 

Lowest

 

Quartile 1

 

3.5%

 

-0.8%

 

 

 

Quartile 2

 

-0.6%

 

6.7%

 

 

 

Quartile 3

 

9.3%

 

6.1%

 

 

Highest

 

Quartile 4

 

17.1%

 

18.2%

 

 

Japan 1973–04

 

 

Lowest

 

Quartile 1

 

-6.5%

 

-2.3%

 

 

 

Quartile 2

 

3.1%

 

-2.6%

 

 

 

Quartile 3

 

7.4%

 

9.2%

 

 

Highest

 

Quartile 4

 

12.3%

 

12.1%

 

 

Netherlands 1973–04

 

 

Lowest

 

Quartile 1

 

3.8%

 

2.5%

 

 

 

Quartile 2

 

9.0%

 

19.2%

 

 

 

Quartile 3

 

15.3%

 

14.4%

 

 

Highest

 

Quartile 4

 

21.3%

 

8.9%

 

 

Switzerland 1973–04

 

 

Lowest

 

Quartile 1

 

0.7%

 

-0.7%

 

 

 

Quartile 2

 

2.2%

 

8.2%

 

 

 

Quartile 3

 

14.5%

 

7.4%

 

 

Highest

 

Quartile 4

 

17.0%

 

19.4%

 

 

United Kingdom 1973–04

 

 

Lowest

 

Quartile 1

 

5.8%

 

-1.4%

 

 

 

Quartile 2

 

11.4%

 

13.6%

 

 

 

Quartile 3

 

8.6%

 

11.9%

 

 

Highest

 

Quartile 4

 

13.0%

 

14.6%

 

 

United States 1973–04 

 

 

Lowest

 

Quartile 1

 

7.7%

 

6.6%

 

 

 

Quartile 2

 

6.1%

 

5.0%

 

 

 

Quartile 3

 

3.3%

 

10.9%

 

 

Highest

 

Quartile 4

 

16.8%

 

11.4%

 

 

Source: Owain ap Gwilym, James Seaton, Karina Suddason, and Stephen Thomas, “International Evidence on the Payout Ratio, Earnings, Dividends, and Returns”, Financial Analysts Journal, Jan/Feb 2006.

 

The results were consistent with the original Arnott and Asness study, providing very robust evidence that this is a phenomenon worthy of attention when analyzing the long-term expectations of stocks. They validate our pursuit of companies that have an ability and willingness to pay dividends.

These studies were built off the Arnott and Asness research and were tested to ensure statistical validity (e.g., accounting for high payout due to temporary earnings weakness, which could result in earnings recovering faster than the market). Although history is not a perfect indicator of the future, it is comforting to have the above studies support our belief that capital allocation and payout policy matter. This goes to the core of our investment philosophy in the Thornburg Investment Income Builder Fund.

Two examples of companies in the portfolio that exhibit strong capital discipline are British Petroleum (bp/ ln) and Sysco (syy). Although these are in two vastly different industries, they both have a history of displaying a willingness and an ability to pay dividends. In fact, over the previous five years, bp has increased its dividend by 19% annually and Sysco by 12%. These types of investments help support the Investment Income Builder Fund’s goals of paying an attractive dividend today and increasing the annual distribution over time.

bp is an integrated oil company with global operations. Most integrated oil companies do not pay attractive dividends and are not widely recognized as being prudent users of capital. bp’s average payout ratio is 36%, placing it in the top quartile of its peers. Its current yield exceeds 5.5%, it trades at a 2010E pe of 9.5x, and it had a reserve replacement ratio (rrr) of 116% in 2008. The rrr means that every barrel produced and sold is replaced with 1.16 barrels of reserves. Therefore, bp is illustrating that it is possible to increase oil production, pay an attractive dividend, and grow oil reserves while being prudent with its capital. Over the previous decade, bp’s earnings have grown at a 15.5% compounded annual growth rate (cagar) and management has raised its dividend at a 10.1% rate over the same period.

Sysco is a food distribution company that provides food to restaurants, hospitals, education facilities, and other health facilities. The company has increased its dividend at a 10-year cagar of 15.6% while growing earnings at a 9.0% rate over the same period. This is a true consistent earner that certainly feels the effects of the current downturn in consumer spending; but due to its low cost of capital and debt levels, Sysco takes advantage of buying smaller competitors. This accelerates growth rates as the economy recovers from its naturally occurring recessions.

The Investment Income Builder Fund paid a $0.50 per share dividend in 2003 and for the year ending 2009, $1.04. This is a 13% cagar rate over six years. We could not have achieved this increase without investing in companies with growing earnings. We scour the globe looking for the companies that we believe can balance the goals of paying an attractive dividend and finding future growth projects. Other unsustainable means of generating income include 1) writing covered call options; 2) buying companies with increasing payout ratios, which will come to an end once the average payout reaches 100%; 3) constantly trading up for higher-yielding investments. All of these are unsustainable in our opinion and are not how we manage the Thornburg Investment Income Builder Fund. Fortunately, there are historical studies that support our view on the importance of capital allocation in meeting the long-term goals of the Fund. n

 

Following a dividend-focused strategy does not assure or guarantee better performance and cannot eliminate the risk of investment losses.

Data presented are the most recent available. Inclusion of subsequent periods could change the results.

The views expressed by Mr. Remily reflect his professional opinion and should not be considered buy or sell recommendations. These views are subject to change.

 

Thornburg Investment Income Builder Fund
Class A Share Performance as of 12/31/09

                                                        Average Annual Total Returns

                                               1-Yr                 3-Yr              5-Yr            Incep.

Without sales charge      36.60%          1.81%          7.35%        11.88%

With sales charge            30.42%          0.26%          6.36%        11.15%

Blended Benchmark*     24.04%         -2.43%          3.03%          7.18%

S&P 500 Index                 26.46%         -5.63%          0.42%          5.30%

30-Day SEC Yield: 5.31%

Performance data shown represents past performance and is no guarantee of future results. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than quoted. For performance current to the most recent month end, visit thornburg.com. The maximum sales charge for the Fund’s A shares is 4.50%. The Fund’s A shares carry a 30-day redemption fee of 1%.

 

There is no guarantee the fund will meet its investment objectives.

Not FDIC Insured • May Lose Value • No Bank Guarantee

Before investing, carefully consider each Fund’s investment goals, risks, charges, and expenses. For a prospectus containing this and other information, contact your financial advisor or visit thornburg.com. Read it carefully before investing.

*75% MSCI World and 25% Barclays Aggregate Bond Index.

Thornburg Funds are distributed by Thornburg Securities Corporation.®   •   2300 North Ridgetop Road   •   Santa Fe, NM 87506   •   877.215.1330  •   thornburg.com

(c) Thornburg Investment Management

www.thornburginvestments.com

 

 

 

 

 

 


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