The Dividend Letter: Check the cashflows
As dividend investors, we keep a close watch on how companies spend their cash, since we expect a portion of it to be paid out to us as shareholders. With high inflation ending the years of cheap money and low interest rates, spending it wisely has become important again.
Company management therefore faces a challenging decision. Should they pay shareholders now? Or reinvest the cash into the business, in order to have more to pay out in the future? Alternatively, pay down debt, to strengthen the balance sheet and create opportunities for future growth or dividends? In theory, it is simple: the return on investments made should at least be equal to the cost of capital. If not, then companies should pay out their profits to shareholders, as the shareholders can then reinvest those dividends into other companies which offer a better return on investment.
One of our core beliefs at Kempen is that dividend paying companies are more aware of this dilemma, as having to pay a regular dividend puts pressure on a company to make the right decision. In our view, this capital discipline leads to better return generation. Since it is so important, we scrutinise our companies for strong capital discipline using one of our favourite investment tools, the checklist.
The first thing on our capital allocation checklist is the dividend payout ratio. If a company pays a dividend, we check what percentage of profit is paid out to shareholders. A high level of payout can be a red flag, because when profits decline, this could lead to a dividend cut. But what level is sustainable, depends on how cyclical a business is. A car manufacturer such as BMW has a very different business profile from a utility company such as Engie. The more cyclical nature of the automotive sector means paying out everything you earn is imprudent when profits are at a peak. On the other hand, it could be reasonable when car sales are slow. By contrast, the stable cashflows of utility company Engie can support a higher level of sustained payout without too much risk, as revenue and profits are more stable and predictable. Whatever the business type, we look for companies which pay out dividends that can be sustained, and preferably grown in the future.
To grow dividends, a company needs to grow its profits. The second point on our checklist is the potential to add value. Companies need to invest in their existing, or new, businesses in order to add value. Even as dividend investors, we do not want to see companies paying out all of their profits as dividends. Paying out every euro, pound or dollar or may make a company attractive for investors now, but reinvesting in the business means even more profits can be paid out in the future. One of the most common reasons for a dividend cut is that a company has to catch up on underinvestment in the business.
Does a company add value? That can be a difficult question to answer because it involves many moving parts. While history is a good starting point for analysing investment returns, the question is whether investments can continue to be made at the same rate of return. When investment opportunities are unattractive, we believe it is better to pay out profits to shareholders, and company management’s decision plays a key role in this. Container leasing company Triton is a good example: the shipping industry is cyclical, which means there are periods when production costs for containers are low but demand is strong. During those times investing in the business is attractive. When the dynamics change and reinvestment no longer offers an attractive rate of return, management uses more cash to buy back their company shares aggressively, boosting future returns.
The final step on our checklist is the company’s balance sheet. A healthy amount of leverage can boost returns for shareholders, but the margin for error becomes thinner. The low interest rates in recent years meant it was attractive to take on more debt, but the risk is that it lowered the bar for investments. We look at the balance sheet and check if the debt load is manageable, including when interest rates rise, or whether there are any large loans that will need to be refinanced in the near future. On the other side, we look at the value of the cash, assets and investments a company owns. If debt and assets are in balance, a company is creating opportunities to invest in the business when needed, or pay out earnings to shareholders.
One of our holdings, Spanish and Latin American telecom company Telefonica, provides a good example. The company was suffering under a huge debt pile. To make it worse, it had borrowed in currencies different from those it was earning profits in, making the company vulnerable to currency swings. The company set out on a plan to tackle these issues by reducing the debt load, in part by selling infrastructure assets at an attractive price, and they aligned the currency of the remaining debt with where they earn profits. This helped to strongly de-risk the company and make it more attractive, leaving more cash to return to their shareholders.
Three simple checks, but with big implications. Companies with a high dividend are attractive only if they can sustain their payout. Companies with a lower yield can be interesting, when they reinvest the money to grow the business. These are not always easy to determine, but we believe these are key elements in a good investment case. In the long term, those companies that are deploying their cash most efficiently will end up on top.