Tuesday, July 11, 2017

Dividends Unlock Value For Shareholders

After observing companies for a decade now, I have come to the conclusion that dividends unlock value for shareholders. Let me start off with an actual example.

A few months ago, Costco (COST) announced that it would be paying a special dividend to shareholders.This event alone unlocked hidden value for shareholders.

On April 26, 2017 Costco announced special dividend of $7/share to shareholders on record from May 10, payable on May 26, 2017. The stock price rallied to 178.05/share at the opening and closed at $176.80/share on April 26, which was up from the close of $172.68/share on April 25. The stock closed at $172.64 on the ex-dividend date of May 8, and it had closed at 180.20 on May 5. In this case, the special dividend unlocked hidden value in the enterprise for shareholders.

That amount of money was locked in the business, and was not put to productive use for shareholders. This is why the company’s rational management decided to distribute the money to shareholders. This is the rational thing to do, when you are showered with cash, and you do not have a lot of high ROI projects to invest into. That $7/share were sitting in cash, but were not fully baked in the stock price, until the announcement unlocked this hidden value for shareholders.

I went back to look at the history of prior special dividends for Costco. I was stunned that every single special dividend ended up unlocking value for the shareholders. What I mean by “unlocking value” is the fact that the share price increased as a result of the special dividend announcement. So shareholders were better off as a result of the special dividend in every single case.

Those examples were discussed in a previous article, where I argued that paying a dividend does not reduce a company’s value. Here are the two examples:

On November 28, 2012 Costco announced special dividend of $7/share to shareholders on record from December 10, payable on December 18, 2012. The stock price rallied to close at $102.58/share on November 28, which was up from the close of $96.51/share on November 27. The stock closed at $98.47 on the ex-dividend date of December 6, and it had closed at 105.95 on December 5. In this case, the special dividend unlocked hidden value in the enterprise for shareholders.

On January 30, 2015 Costco announced a special dividend of $5/share to shareholders on record from February 9, payable on February 27, 2015. The stock price rallied to close at $142.99/share on January 30, which was up from the close of $140.64/share on January 29. The stock closed at $149.09 on the ex-dividend date of February 5, and it had closed at 155.92 on February 4. In this case, again the special dividend unlocked hidden value in the enterprise for shareholders.

Yes, a little before the dividend is paid, the stock will go down on the ex-dividend date. But, do not forget, the stock went up when the special dividend is announced out of the blue.

A lot of people look at the drop at the ex-dividend date, and reach out all types of crazy conclusions that dividends do not matter, or that a share buyback is the same as receiving a dividend, or that selling stock is the same as receiving a dividend.

They are wrong.

They forget to see that the stock price in between ex-dividend dates also slowly accrues the dividend payment to the shareholder. In other words, a quarterly payment of 90 cents/share would slowly accrue at a daily rate of 1 cent/share, which is obfuscated in the daily mess of stock fluctuations. When a company has a firm dividend schedule on hand, investors expect it to be paying that dividend amount (hence the regular dividend expectation is baked into the price).

A company that pays a dividend routinely unlocks value for its shareholders, by distributing excess cashflow to the rightful owners. This is money that is not needed in the business, that would have otherwise gathered dust on the balance sheet. When you have too much idle cash sitting around, the odds of it being squandered away greatly increases. Dividends on the other hand impose discipline on management, that forces them to invest in worthwhile projects that have a high chance of delivering ROI above a certain threshold. Since paying a dividend is a routine event that happens every quarter, the accretion of value is not easily noticeable for the untrained eye. A special dividend announcement is highly visible on the other hand.

In the case of Costco, this special dividend has unlocked value for shareholders. It is obvious that they are better off with the dividend, rather than without it. Paying a special dividend is superior to share buybacks, because it provides options for shareholders to allocate the money as they choose. The special dividend is also superior to share buybacks, because every shareholder receives the same amount of value per share at the same time. A share buyback on the other hand takes time to complete, management may not follow through with it all the way to completion. In addition, in the case of Costco, it would have been dumb to repurchase shares at over 30 times earnings.

A company like Costco could have bought back shares regardless of the fact that it was selling for over 30 times forward earnings, and the slowing growth in earnings per share. The problem with the share buyback is that the stock price is overvalued today.

A company that repurchases shares without looking at the intrinsic value they are receiving, for the amount of money they are giving up, could be wasting your shareholder dollars. That doesn’t mean stock prices can’t get more overvalued however. Costco could have repurchased shares when the stock was selling at over 20 times earnings in 2012, and it would have been a great decision in retrospect. The company grew net income from $1.7 billion in 2012 to $2.35 billion by 2016. Investors also assigned an earnings multiple of 33, up from roughly 24 - 25 at the end of 2012. Of course, if the valuation multiple were to shrink to 15, repurchasing shares would have seemed like a not so good idea. If retire half of shares outstanding when your stock sells at 30 times earnings, but the PE compresses to 15, you would have done nothing to add value to investors.

With the benefit of hindsight, making a share repurchase at $180/share in 2017 instead of paying a special dividend does not look like a good decision. This is because the stock has fallen by 15% after the announcement for the payment of the special dividend in 2017.

The other problem with buybacks is the fact that their amount and timing is never really as certain as the amount and timing of a special dividend. Typically, when a company announces a share buyback, they do not always go through with it. There is always the possibility that a big buyback is announced with fanfares, but only a limited number of shares even end up being repurchased. In the meantime however, the company’s leaders change their minds and do not follow through. Unfortunately, this is not unseen before. Even if a buyback is completed, it may take the company several months to complete it. I have looked at an actual buyback schedule from a Fortune 500 company, where a certain number of shares was being purchased for several months in a row. This was done in order to make sure that the amount of repurchases is low enough relative to the daily volume of transactions, in order to avoid influencing the price too much. So share buybacks are different than dividends.

Companies receive a “safe harbor” from market manipulation liability on stock buybacks if they adhere to four limitations:

1) not engaging in buybacks at the beginning or end of the trading day,
2) using a single broker for the trades,
3) purchasing shares at the prevailing market price, and
4) limiting the volume of buybacks to 25 percent of the average daily trading volume over the previous four weeks

One of the reasons why corporations favor share buybacks over dividends is because CEO bonuses are tied to earnings per share. Hence, share buybacks are a preferred method for distributing cash to shareholders over special dividends, since they improve the odds of higher executive compensation.

The investors who prefer buybacks operate under the logical fallacy that selling stock is the same as receiving a dividend. They forget that when a company pays a dividend, everyone receives the same amount of cash.

When you sell shares on the other hand, the amount of shares you need to sell and the amount of money you have will vary due to timing of your sales. If you sell shares when their prices are low, you may run out of shares to sell. If you retire at the end of a bull market, you may experience this sequence of returns risk firsthand. Of course, if prices increase in percentage terms by more than the proportion of shares you are selling, you will never run out of money. The question you have to ask yourself next however, is how good are you at predicting future stock prices?

You can see that the amount you receive for selling your shares will vary from person to person. It makes sense that the price at which you sell, and the number of shares you need to sell will vary due to timing. It seems risky to have a retirement plan that is dependent entirely on share prices to rise over the time period that suits your needs. Perhaps the people who plan to sell stock in retirement believe that they are above average or luckier than everyone else. Or perhaps they own too much fixed income in order to reduce the damaging effect of sequence of return risk.  (Which smooths out short-term volatility at the expense of reduced forward returns. Fixed income is expected to return nothing after inflation over the next decade )

In addition, the price at which you sell will vary, because market participants assign different P/E ratios to different companies based on their expectations, moods, etc. A company may be doing all the right things, but its investors may not make money if they pay too high of a price, and the P/E multiple shrinks from there. In other words, if you pay 30 times earnings for a company that reinvests all its earnings back into the business and it doubles earnings over the course of a decade, you can still end up not making any money. This could happen if the market ten years from now is less optimistic about the perceived value of the enterprise, and thinks it is only worth 15 times the doubled earnings.  If that company instead became more efficient and distributed half that money to shareholders in cash, while doubling earnings per share the stock, it would have created more shareholder wealth than the first company. As we all know very well, there is no guarantee that plowing all the money in your business will deliver the returns you hope for. Being efficient with your resources, be it money or time, is smarter than just throwing everything at it. And of course, if everyone in a given industry reinvests every cent in profit back into the business, pretty soon the excess capacity from this investment would have eliminated all profits due to increased competition.

So why doesn’t Costco simply reinvest all that money into the business?

Successful companies by default should be generating more cash than they know what to do with. Some companies are able to reinvest that money back into the business at high rates of return. A select few are able to reinvest that money at high rates of return, until they get too large, and hit a ceiling point. Those are extremely difficult to identify in advance. After all there is only one Buffett, but more than 100 dividend champions. Taking risks to get into other lines of business is fine, but it is also possible that you lose money in the process. Unfortunately, there is a limit as to how much can be profitably reinvested back into the business at high rates of return. There are marginal constraints to growth. For example, if you are Costco, you can’t simply invest all money back into the business and expect things to magically deliver returns. You may cannibalize your sales or alienate customers if you open too many locations, too quickly, and your service deteriorates. Surprisingly, a research I read found that companies that reinvested the least amount of money back into the business delivered the best returns.

Long-term readers of dividend growth investor website intuitively understand this. A great dividend growth company with a great brand will earn a lot more money than it needs. This is similar to a frugal person who saves 50% of their income.

It would be extremely stupid  silly and wasteful under most scenarios to tell this person to reinvest all of that money in themselves.

There are limits to growth. This is similar to eating pizza. When you are hungry, you can afford to eat a whole pizza. But once you are full, there are limits to how much additional pizza you can consume. It would be stupid silly to tell someone who is full to eat another pizza.

The same laws of diminishing returns apply to reinvestment in businesses.

Ships will sail around the world but the Flat Earth Society will flourish.

Relevant Articles:

- Dividends versus Homemade Dividends
Why I am a dividend growth investor?
Why should companies pay out dividends?
Does Paying a Dividend Reduce a Company’s Value?
Dividends versus Share Buybacks/Stock repurchases

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