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Do you feel confident that the dividends in your portfolio are healthy? What techniques can you use to get a clearer picture of a company's long-term dividend growth prospects?
This month, Greg examines a simple 3 decision model from Aswath Damodaran to determine how companies create value for shareholders, and what it means for you as a dividend growth investor. He draws the line between companies that pay a healthy dividend and companies that are in a dysfunctional dividend mindset. As part of that, Greg gives you two simple models to employ when you're considering a company's dividend-paying capability. Later he takes a moment to discuss some of the wisdom of the late Charlie Munger.
Models used in today's Episode:
ROIC Model - (Excel download)
Excess Cash Flow Model - (Excel download)
DCM Investment Reports & Models - (Website)
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Greg Denewiler: 00:11
This is Greg Denewiler, and you're listening to another episode of The Dividend Mailbox, a monthly podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks and make each year's check larger than the last.
Greg Denewiler: 00:41
Welcome to episode 30 of The Dividend Mailbox, and today we're going to take a slightly different approach to the whole universe of growing dividends. You hear about these companies that pay very attractive dividends— they have 6%, 8%, some 12% or even higher. Then you hear about buybacks— companies are aggressively buying back their stock. Then you get into leverage— companies are borrowing money. Either they're using it partly to buy back stock or even to help bump their dividend, trying to make it more attractive to investors. But today we're going to try to just create a simple framework to figure out, “Okay, should a company really be doing what it's doing?” And what we're going to use as the base for this is we're going to look at a three-decision model on what it looks like for a company to pay a dividend and will it have a good chance of being sustainable? Then we'll just finish with— if you're not aware, Charlie Munger was the partner of Warren Buffett in Berkshire Hathaway. He died a few weeks ago, so there's been a lot written about Charlie Munger and I thought it'd be a good idea just to bring up some of the wisdom that he has said over the years, because they really do, I think, come back to the whole idea of dividend growth and companies that have sustainable cashflow growth.
So before we get into this month's episode, I just want to quickly mention that we've talked about Union Pacific in the past, and we do have our much more detailed report that we will attach in the show notes so that you'll be able to see in a little bit more detail our evaluation of Union Pacific.
Today we're going to start by going back to the basics and we're going to look at what comprises a good long-term dividend growth strategy, what a company needs to be able to sustain activity and growth. The place where we're going to start is, I have mentioned in the past, Aswath Damondaran. He's a NYU professor of finance, and he's got a really tremendous reputation. He has over a million followers and he actually offers his finance classes online, but you have to be really interested in getting into the weeds because they do get pretty technical. One of the things he did this year was he did a segment on dividends. So, looking at Damondaran and his business valuation model, basically he breaks it down into three segments. He's looking at how management decides what their investment decision is, what their financing decision is, and then finally, the third thing is their dividend decisions. These three segments, are not specifically trying to value a company, but they're more looking at how a company creates value over time and whether these decisions are really sustainable or not.
The first one is the investment decision, and here you're looking at: “Are companies investing in assets that earn more than their hurdle rate?” And the hurdle rate is pretty much— we're going to define it as more than their cost of capital.
The second component, decisions they make in regard to financing, here, they look at using equity versus debt and what that balance should look like. Because it's not necessarily all equity. It's definitely not all debt 99% of the time. There's some mix in the middle that will create an optimum strategy for the company to be able to go out, make investments, and have the lowest cost of their capital.
And then the final thing is the dividend decision. Here, businesses have four general phases of a life cycle. There's the startup, then there's high growth, then they mature, and finally they eventually decline unless they reinvent themselves. In this case, from a dividend standpoint, a startup virtually never pays a dividend, and if they do, it's a situation we're not even going to get into because it's more private equity. Companies that are into the high growth stage, usually they have a lot of reinvestment opportunities. It just doesn't make sense for him to pay a dividend because the company is using all their capital to grow, continue to reinvest into the company and usually they create a lot more value and it just doesn't make sense for them to pay any of their cash out to shareholders. And they're certainly not going to be buying back any stock because if anything, they're going to be issuing more stock. But as a company matures, they become more profitable. This is where our whole dividend growth philosophy comes from, because here you're into companies that are starting to generate excess cash, and they just don't have an unlimited source of reinvestment opportunities, so, they begin to pay out dividends. And then in some version of decline, sometimes the dividends can get extremely attractive and unless a company reinvents itself, eventually they cannot sustain the dividend and they start to cut it or completely eliminate it. Or worst case— some of the famous names, Eastman Kodak, there's a huge list out there, you've heard of them— eventually they just die. So, one of the points that Damondaran makes is ultimately a company is owned by shareholders and the value of a company is determined by how much and when a company gets cash back out. It really comes out in two forms. It comes out in dividends and it comes out ultimately if the company is sold or it's merged with another company, and then you end up with stock with that. So, in the end, if a company is able to pay dividends, it should, because that's part of how shareholders get a return on their investment. If they can't pay dividends, if they never pay a dividend, or if a shareholder perceives that they're never going to get any cash out of a company, theoretically it's really worth nothing. So, the dividend decision, you look at, “Okay, is a company starting to pay a dividend? Should companies be paying the dividend that they are?” And this is where it's really important in what we do to figure out whether there is a sustainable dividend there or not.
So the three components of Damondaran's framework: Are they investing in assets that at least meet their hurdle rate? How do they raise the capital to invest in those assets? At what point do they start paying a dividend?
Well, there's two approaches to this whole dividend model from a big picture point of view. What we end up seeing is there are companies that have a healthy dividend strategy, and then there are companies that have a dysfunctional dividend strategy and now we're going to turn to what are some of the real things to look for that are red flags. Because in the end, you don't want a company that gets into a dysfunctional dividend mindset. Very seldom is it really sustainable long term.
A company that has a healthy dividend strategy is one that can easily maintain their debt payments. They are able to finance any growth opportunities that they have, and they're able to maintain a healthy balance of equity and debt. The payout is the residual cash that they've got after they make investments, and there they're able to, at that point, make a decision: we pay dividends, or we do buybacks, or a combination of both. The cash that's paid out to shareholders is in excess of what it takes to run the company day to day to maintain and even grow the company over time. But as we now go into the dysfunctional dividend, we're going to look at how a company takes some of these points and takes them to the extreme to where they jeopardize the sustainable growth of their dividend strategy.
The first point that I'll make there is: do they make dividend decisions based on past history or peer group? This is where this gets really tricky, because The first thing that comes to mind if a company's been paying a dividend for more than 25 years, well, it's a dividend aristocrat, and we talk a lot about that. But one of the things that you have to be extremely careful about is, are they just raising the dividend because they've always done it in the past? That alone is not a reason for them to continue to grow their dividend. Or the second piece of that is because the group that they're in, where you've got, let's just say as an example, a peer group like Coca Cola, PepsiCo, Procter and Gamble, some of these big consumer good companies, well, they mostly all pay dividends. Are they just doing it because the group does it? If they're not really growing profitability to the point that it justifies raising a dividend, what you see a lot and we've talked about it in a few of the things that we hold, is they'll raise the dividend by a penny just to keep the dividend growth rate intact. And in that case, you need to really look at, “Okay, is this temporary and are they going to get back on track to more attractive, sustainable dividend growth or, Is there a transition here where you're just not going to see the dividend growth anymore?” We did a whole podcast on Clorox and what they were going through. In that example, you had a case where they were not earning the dividend at the point where we started to invest in it, but we thought it was going to be a reversion to the mean, and that was part of our whole story. So that's where you got to really look at what is driving management. You want to see the dividend growth as a result of the company growing. What you're going to have is you're going to have earnings growth, and that's what's going to give you a good, attractive, long-term total return.
The second major point is if a company is borrowing money and they're raising their dividend and they're somewhat aggressive in buying back stock, one of the things that you have to determine are they borrowing money just because they can and they have room to borrow more money? Are they doing it because the industry tends to use a lot of debt? And a great example here would be IBM. IBM has reinvented itself several times, I can't tell you whether it's number three or number four or where they're at as far as reinventing. But, they've gone through another major transformation here in the last decade. For quite a while, one of the things that was happening was debt continued to climb higher and higher as they bought back a lot of stock and they were aggressively raising the dividend. Well, three or four years ago, they really started to hit the wall to where they were not going to be able to raise the dividend anymore. In fact, if they didn't get the business turned around Then you had a situation where the dividend was potentially going to have to get cut. Just as kind of full disclosure, we do have a position in IBM and is not in the model portfolio. We have not added to it for several years. It was a turnaround candidate that took a lot longer than we thought and I really was not comfortable with it for a while but fortunately they may have turned the corner on that thing and the stock is starting to do better but the dividend yield on IBM got up to I believe around 6%. There was a real question there whether they had over leveraged and a big part of that leverage was really just trying to drive share buybacks. They were driving a strong dividend growth story but guess what happens in that situation? You're not getting total return because the market looks at that and they realize that the returns on the underlying business are just not there. Financial engineering always has an end game to it. When a company uses debt, they're leveraging their balance sheet and they're using that to continue to grow dividends and potentially buying back stock. What they're doing is they're taking assets off their books where they're not getting a return off of it and they're actually increasing their debt costs. So they're putting more expenses on the company's balance sheet and they don't have an asset to generate any revenue from. When they pay a cash dividend out, it's gone and it's never coming back. So, us as investors, what we have to do is figure out where that line is between they're borrowing money because, on one level it's healthy, or are they borrowing money just to manipulate their dividend and share buyback program and try to show more growth than what the underlying business can really support?
Point number three, and this is what we really try to look at: are they making investments just based on the fact that they have the capital that's available to make them? Are they making them to the degree that they're able to earn more than their hurdle rate and they're actually adding value to the business? This is a big one because a lot of companies just acquire because they're in an empire building mindset, but they're not adding value. In fact, they're destroying value as they issue more stock or more debt or a combination of both. AT& T is a prime example of this where literally they made an acquisition just to help try to support their dividend strategy. AT& T bought DirecTV hoping to get cash flow. They bought Time Warner looking for growth, but neither one of them worked out. Companies tend to pay too much for that cash flow and then those are usually not growth stories. In AT& T's case, it did decay over time. Ultimately, the dividend was cut, and they spun off DirecTV. Time Warner was just huge destruction of shareholder wealth.
So, this is really where you should spend a lot of time. If you haven't started to get a picture yet, for a sustainable dividend, you have to look at is the company making the dividend decision based on, they have excess capital, they have room to pay it, they're still able to grow the business, and they're able to do it profitably? Or are they just borrowing money to grow the dividend? Are they just borrowing money because they have the capability to? Are investments being made, but they don't really earn that good of a return? You want healthy dividends, and what you don't want is a dysfunctional dividend, but the problem is, especially on the front end, when companies start to transition to trying to financially engineer a dividend strategy over time, you really have to understand what is going on and make some assessment whether they're healthy or not.
We've looked at the conceptual side, but now we want to give you just a few simple techniques to help give you some idea of whether a company leans towards being healthy or whether you're potentially into a dysfunctional situation. We're actually going to put in the show notes a couple of spreadsheets if you want to go into this a little deeper.
One of the simple ways to do it is you start with net income. The reason why we're starting there is because that's the number that flows to shareholders, after everything is settled, debts paid, taxes are paid, we're to the bottom line. So, you start there, you add back depreciation and amortization. These are non cash expenses. And then what you do is you subtract out capex and acquisitions. And then you subtract out a change of non-cash working capital. A simple explanation I'll give you on that is just inventory. If you've got growing company and they have to buy more inventory because their business is growing, hen that means they're adding to the balance sheet and that takes capital. So you need to subtract that number out because that's what the company needs to go out and spend to build the business. And then the last thing is debt. If they're borrowing money, you add that in. If they're repaying debt, you subtract that out. This one, you’ve got to be a little careful with because if they're increasing their capital from borrowing more money, they can only do that for so long. So what you come up with is a number that is what's left that can be paid out in a dividend or share buybacks. This is a simple little model that should give you some idea whether a company is really generating enough excess cash flow to pay a healthy dividend and is there a little bit of margin of safety built into it? So if a company has $2 billion of excess cash flow and they only pay out $500 million in a dividend, you could say, well why aren't they paying out more? Well one of the things that you don't know is Management's long-term vision. But what it does do is give you a margin of error, that's what you want. Some years are going to have a lot of excess, some years they may have very little, or maybe even go negative. It is subjective, but the key thing is you're trying to come up with some conclusion of what is sustainable. And to what extent do you think that that dividend is going to grow by?
Just kind of continuing along that same line of thought, you want a company that is at least earning their hurdle rate. There's a simple way to figure out whether a company is really successfully growing their business at a good rate of return. So, another thing that we will add is a worksheet on return on invested capital. There's return on assets, there's return on equity, I mean there's no model that's perfect but the one thing about the return on invested capital model is it does account for the entire asset base of the company. It helps take into account how, how it's financed. You're starting with operating income, and the reason why you start with operating income on this model instead of what we talked about just a minute ago with net income, here, we want the number before you take into the expense of debt of whether the company is leveraged or not. And then we just take the after tax rate. So if they earn $100 million and they have a 20% tax rate, then you just take $100 million times 80%, so the net after tax is $80 million. Then you take that number, and that's going to determine the level of profitability. You look at total assets, you subtract current liabilities, because what we're looking for here is how much money has been put into the business as they bought all these assets? But you take out accounts payable, that's considered really free financing. That’s their vendors giving them free financing, giving them 30 day terms, but you add back short term debt because there they have to pay for that. You come up with a number of, let's just say, simple explanation— the company is earning 13% on their capital. Well, a simple round number that you can use is 10%, and that's basically the cost of equity. The cost of debt is a little bit lower than that unless they're more of a junk rated company, but anyway, we'll just use 10%. Well, if they're earning 13%, then over time they are building shareholder wealth. But as you look at the company and the asset base continues to grow, and if that 13% drops to 12%, then it drops to 11%, then it drops to 10% over the next several years, what that's telling you is they are not either organically or making acquisitions that are as profitable as their core business. And there you start to get into, is this company really long term going to be able to sustain their dividend growth? This model, even though it's relatively simple, is a piece of what makes the Union Pacific story so compelling.
So another thing that we're going to put in the show notes is, we've gone through and we've tried to apply this entire concept to Union Pacific and it was one that we spent a lot of time on I'm not going to rehash that. However, what I am going to tell you is if you want to look at how we went through and evaluated Union Pacific and tried to determine “is this a long term dividend growth story?” I would invite you to look and pull up the report that we did. You’ll see how we came to the conclusion of: Yes, it is something that we want to buy at the price that we feel is attractive. In this case, Union Pacific, they use leverage and they were buying back a lot of stock there for a while and they were aggressively raising the dividend. If you're going to be buying individual stocks and you're going to hold them long term and you want to see some dramatic compounding over time, you really have to know these stories. So, I would really encourage you if you feel like looking at it to take a look.
But now we're going to go from Damondaran where you're looking at the numbers and now we're going to move to Charlie Munger and you may be thinking, well, what's the connection there? Well, the reality is investing as a mindset and that is one of the things that Charlie Munger seemed to have a really good handle on. In fact, he's rumored to be one of the great business minds of the last several decades. And although he was fairly blunt and I didn't always agree with him, after reading some of the stuff that was put out on him over the last several weeks since he's died— I have to say, if you adapt his mindset, it's going to help your investing success.
A lot of content that's out there is all about trying to find the next idea for the next three months. But one of Charlie Munger's quotes is: “The big money is not in the buying and selling but in the waiting.” So what exactly does waiting mean? Well, the first thing is maybe you're just waiting to find an asset that you can buy at an attractive price because what you're buying is a long-term cash flow stream. And what you pay for that is a big driver in what your long-term returns are going to be. Waiting for an attractive price is just the first step. Waiting for the cash flow to compound over time, that is probably the one concept that very few people truly understand, because back to the Union Pacific story, it's a slow, boring business, it doesn't have big growth numbers in it, but just waiting for that cash to compound has generated some extremely phenomenal returns over several decades. But you don't get it by buying the stock at $24 and selling it at $48. Part of waiting is the company has a strategy and you have to wait for it to develop. A lot of times you'll see these quarterly announcements, or you'll see comments from analysts, but if a company is showing discipline, you really have to wait until they can execute their strategy. Sometimes it gets interrupted by specific industry problems or things that are happening in the broader economy. You can't even predict to the end of the day, let alone what's going to happen to the end of the year. But in the overall economy, you're virtually guaranteed that if you wait, the economy is going to grow by 6% a year. And here, you're going to create wealth by waiting for the cash flow to compound, not by just waiting for the stock price to go up.
He goes on and another quote of his is: “All investing that is successful comes from getting more value than what you pay for.” And what is embedded in that is you have to know what you're buying and you have to come up with some idea of what the value is. If you've got good, strong cash flow, even if you overpay for it a little bit, eventually that will bail you out, and that's part of the waiting game.
Another great quote that I saw here recently from Munger was: “It takes character to sit with all that cash and to do nothing. I didn't get to the top where I am by going after mediocre opportunities.” So I thought that was kind of fascinating, especially in a situation like we are right now, where the market's up 20%, but it's come from a handful of companies. It tests your character a little bit. The broader market has started to move here recently, but for most of the year, it was flatter down except for that handful of mostly all high tech stocks. Character is really just another word for discipline, knowing what you're trying to achieve, and having the confidence that long term, the market will deliver the returns. Character is about being wrong for a while, but that's part of why the opportunities with investing are so great. There is no simple, single answer.
Another thing that I think is kind of fascinating, one of the things that came up, this is more paraphrased, I don't remember the exact quote, but Munger says: “He doesn't know any successful person that has succeeded to any degree that doesn't read a lot.” The point there is, reading gives you a much wider perspective of what's going on in the world and it helps you to create a little better framework of how the economy interacts, what's going on globally. It helps you get a little better foundation of how things fit together and it also gives you some idea about how technology is evolving. But if you don't read anything about it, you really have no idea what's going on.
So in conclusion, I think as you look at dividend growth, the important thing is to figure out how you're going to treat this from a mindset. Am I really willing to hold something for 10 years or longer and do I have the conviction that the compounding capability is there? What you don't want is dysfunctional dividends unless you're just trying to find something where you're going to trade it and you're looking for a quick gain. What you want is healthy dividends. The only way you get that is you have to wait for them, because over time, the healthy dividend is going to grow.
And I would end with a quote from William Durant, who started General Motors. He said: “I think the ability of the average person could be doubled, if it were demanded. If the situation demanded, a man or woman is either rising up or shrinking down from the demands of their situation.” So I would just say, another thing that kind of comes top of mind, and this came out of another podcast that I listened to recently, about a guy that had returns over the last several decades of roughly 20% a year. Part of that podcast was just about just setting the higher demand on yourself. 20 years of 20 percent returns— what you're really saying is, “Okay, you know, what do you have to do to achieve that?” And instead of listening to that podcast and just trying to pick up a few ideas as far as, Ooh, wow, maybe I should buy Microsoft right now, or maybe I should buy XYZ widget company. There are no shortcuts. Just like William Durant said, what are you going to demand for yourself? If you're just looking for silver bullets, you got to be honest, you're really not demanding enough.
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Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risk involved. Stocks, including dividend stocks, are volatile and can lose money. Denewiler Capital Management may or may not have positions in the publicly traded companies mentioned herein.