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Cash flow is an important determinant of investment value. Cash flows originate from operations – turning sales into cash; investing – sales of investment securities and other property and collection of loan principal; and financing – sales of stock and debt.
Many analysts rightfully argue that cash flow from operations matters most. After all, that's the business – selling goods and services and turning those sales into cash.
I’ll take the argument one step further, though. The money that flows to me, the investor, is most important. I'll go so far to say that cash the company generates and distributes my way is the company's raison d'etre.
What I'm saying isn't controversial. Companies are routinely valued on the present value of future cash flows, and those cash flows should be dividends. A company can generate all the cash in the world, but if little of it finds its way to the investor, what does it matter?
Dividends Trump Buybacks
Arguments arise when the discussion turns to how and when that money gets to the investor. Many investors believe share buybacks are synonymous with dividends. They are not. Buybacks are actually far inferior to dividends.
Buyback proponents argue that money is taken off the books without committing it to a rigorous dividend policy, which is a good idea for growth companies. Simultaneously, buybacks reduce the share count far more than it reduces net income, so earnings per share rise, which helps propel the share price higher. There is also the tax argument: share buybacks return cash more efficiently than dividends.
The theory appears sound … until you look at the research, which shows that companies that deploy buybacks tend to deliver lower total shareholder returns over time.
Fortuna Advisors, a corporate finance consulting firm, finds that share-repurchase patterns are implemented when share prices are high. Companies rank capital-deployment strategies: capital is first deployed for organic investments, then for acquisitions, then for building cash and paying down debt, and finally for share repurchases. While this strategy seems sensible, it leads to implementing buybacks when the market value of the company's shares has increased significantly. In short, they overpay for shares.
A Monumental Myth Busted
Many investors will concede my downside observations on share buybacks; fewer will concede my observation on when a company should start paying a dividend. I say a dividend should be paid as soon as the company generates free cash flow, and I make no distinction between high-growth or low-growth companies.
Too often, companies that retain all their cash end up re-investing in too many lower return projects. Cisco Systems (NASDAQ: CSCO), which only recently began paying a dividend, hoarded cash and reinvested internally through the past decade. And shareholders have little to show for it, as Cisco's share price has been flat to lower for the past 10 years.
Here's the stunning dividend fact: growth and dividends aren't mutually exclusive. Academicians and money managers Robert Arnott and Clifford Asness published an influential 2003 article in the Financial Analysts Journal article titled “Surprise! Higher Dividends = Higher Growth.” Arnott and Asness found that when current dividends are low, future earnings also turn out to be low. And when current dividends are high, future earnings are high.
Measuring numerous 10-year periods covering the past century, Arnott and Asness found the average rate of earnings growth was 3.9 percentage points greater when dividends were high than when they were low or non-existent.
Dividends correlating with growth isn't as counter-intuitive as you might think. Dividends are “sticky,” and management is rightfully reluctant to cut dividends. Knowing that dividend obligations must be met, management is more discerning when vetting investment options.
This really isn't such a new distinction. Sixty-five years ago, the great value investor Benjamin Graham pointed out that dividends keep excess capital off the company's books; excess capital leads to lower returns on capital because more capital finds its way to lower-return investments.
My own experience supports the contention that dividends are outstanding value generators. High Yield Wealth investments McDonald's (NYSE: MCD), Community Trust Bancorp (NYSE: CTBI), and McCormick & Co. (NYSE: MKC) have long histories of getting excess capital off the books through dividends, and thus generate superior returns on capital and superior returns to investors.
Another High Yield Wealth investment, Altria (NYSE: MO), is the king of dividend payers, and a perennial value generator to boot. The maker of Marlboro cigarettes has raised its dividend for 43 consecutive years. Altria generates high returns on capital and high returns for investors, having produced an average annual 20% total return for decades.
Many investors don't need another reason to buy dividend-paying stocks. But for those who do: dividends-equal-growth is an awfully compelling one.