I write the regular Dividend Hunter column for Master Investor magazine, and in the February issue I wrote about sustainable dividend growth and how to identify it.
In almost all cases, long-term dividend growth is unsustainable without earnings growth, earnings growth is unsustainable without revenue growth and revenue growth is unsustainable without capital employed growth.
In practice, this means companies can only produce long-term sustainable growth if they employ more capital to fund more factories, warehouses, vehicles, machines, robots, offices, computers and an endless array of other capital assets.
Or to put it another way, if you’re looking for sustainable dividend growth, you should start by looking for sustainable capital employed growth…
Hunting for sustainable dividend growth
- Read the article (PDF)
- Read the magazine (PDF)
- visit MasterInvestor.co.uk
“””In practice, this means companies can only produce long-term sustainable growth if they employ more capital”””
Not strictly true. One can develop IP and sell it and scale it up without additional capital growth.
Hi LR, as with everything there are a few exceptions, but in this case I think exceptions are pretty rare and narrow in scope.
Even a pure IP company is likely to need to increase the amount of IP over time, and that’s going to require capital in some way shape or form in almost all cases, even if it’s just more rented offices, i.e. leased capital.
Another exception might be tech companies where the cost of processing power and memory get cheaper and perhaps that might offset the company’s expanding need for computing power and storage, but again that’s a pretty limited case.
In 95% of cases (that’s an estimate, obviously), companies need more capital to grow their revenues, earnings and dividends.
Hi John,
I think a direct correlation exists between the nature of the business a company engages in and whether it is profitable in relation to sustainable dividend growth.
From my research I was surprised to find out that the hallmarks of a sustainable dividend growth for shareholder are mature companies free from unrealistic market expectations therefore share price at a realistic level, companies that require very little or moderate capital to operate, the management is active in share buybacks and the shareholder engages in DRIP.
Overtime this can snowball into a very big return.
Hi Reg, that sounds like an attractive combination, but of course the problem is finding enough highly profitable capital light business which are mature and growing but which are also available at a reasonable price!
Having said that, I think there are enough out there to build a diversified portfolio, as long as the UK market’s overall valuation remains relatively low.
Hi John,
Actually it doesn’t have to be highly profitable just average profit levels. This is key to share buybacks and DRIP because naturally the market would downgrade such stocks with average performance. In such situation it would allow management to generate better returns with stock repurchase and a DRIP investor.
To generate a good returns this needs to be done on a consistent basis by the management on a long term basis. In addition an investor can only fully utilise the benefits by sticking with the stock for the long run. As over the years the shares outstanding will be reduced which would indirectly increase the ownership stake of existing shares. In addition through DRIP a buy and hold investor would accumulate more of those valuable shares.
In the long run total shareholders return is likely to exceed via this approach compared to investing in a growing company because market will always attach a premium to such company. Therefore value is attached to market sentiment.
Interestingly the prime candidates for such stocks are bank stocks and insurance. Obviously I’m going to have to do more research but it really surprised me how a boring company can generate better returns then a exciting company.
Hi Reg, although I agree that share buybacks and dividend re-investment (DRIP) can add value, it depends on the price paid to buyback or reinvest in the shares. If it’s at an unattractive valuation then perhaps it would have been better to take the cash as a dividend and reinvest elsewhere.
Also, although high profitability doesn’t guarantee good returns, mediocre profitability comes with risk as well. Specifically, if a company can only generate mediocre returns on capital then it probably doesn’t have any strong competitive advantages, and the risk is that it will get out-competed by its peers and see its revenues and profits decline rather than grow.
This is why Buffett says time is the friend of the wonderful business and the enemy of the mediocre. With mediocre businesses, valuation becomes more important to offset those risks.
Finally, I agree that boring companies can often be good investments. They’re not whizzy or flash or cool, so investors that look for those features are not interested, which reduces the pool of potential buyers, thereby reducing demand for the shares and (hopefully) valuations.