Defensive Value Investing: A 20-week course
“Each company should have a long record of continuous dividend payments.”Benjamin Graham, The Intelligent Investor
I’m an income-focused value investor, so dividends make up the backbone of my investment strategy.
That’s why I like to start the process of analysing a company with a few simple checks on its dividend history and the earnings upon which those dividends depend.
To make sure we’re on the same page, here’s a definition:
There are several reasons why dividends are central to my approach and why the process of analysing a company begins with them. The most important reasons are:
1) Efficient capital allocation
A company should only retain cash generated from operations if that cash can be used to produce an attractive return. The main uses of retained cash are:
- Maintaining the existing business
- Growing the business (e.g. buying new factories, stores or equipment)
- Paying down debt
- Buying back shares
When those options are exhausted, cash should be returned to shareholders as a dividend.
With companies that don’t pay a dividend there is, in my opinion, a greater risk that cash retained within the business will be used to expand the CEO’s empire (and pay packet) rather than maximise returns for shareholders.
2) Commitment and accountability
Companies with progressive dividend policies have made a promise to investors that they will maintain or grow the dividend each year.
This provides a public and very concrete goal for management to achieve. Of course this promise can be broken, but on average dividend-paying companies have historically performed better than non-dividend payers.
3) A helpful yardstick
A progressive dividend gives investors a gauge for the long-term progress of a company. While earnings – and to a lesser extent revenues – bounce around from year to year, a progressive dividend can give a good indication of the underlying growth rate of a company.
4) A cash income
Perhaps the most obvious benefit of dividends is that they are a form of cash income. For those investors who are after an income, either today or in the future, dividends are an excellent way to receive that income without having to sell any shares.
They also provide an always-positive return which is independent of a company’s share price. This can help reduce the volatility of your portfolio.
Why I look for a long record of continuous dividend payments
The logic behind Ben Graham’s rule on dividends (quoted at the top of the page) is simple. If investors want to buy companies that are likely to pay a consistent dividend in the future, the best place to find such companies is among those that have paid a consistent dividend in the past.
That’s why I look for companies with a long and unbroken record of dividend payments. This leads to the first of many rules of thumb that make up the backbone of this investment strategy.
Rule of thumb
I don’t mind the odd missing interim or final dividend, as long as some sort of dividend was paid in every year. If there is a year in that ten year period in which no dividends were paid then the company goes straight into my metaphorical waste paper bin.
It is important to remember that a consistent dividend record is not a magic bullet, because dividend payments are not guaranteed. No matter how good a company’s track record, you can never be sure that the dividend won’t be cut or suspended at some point in the next few years.
The banking crisis of 2007-2009 was a good example of this. A whole group of companies that were thought to be safe – i.e. the big banks – turned out to be anything but. The banks suspended their dividends, in some cases for several years.
Unfortunately, dividend cuts are a fact of life. If you invest for long enough in dividend-paying companies you will see a dividend cut in your portfolio at some point. However, this is not a reason to abandon the approach.
Instead, the risks of seeing a dividend cut can be reduced by looking at a range of additional factors such as profitability, debt levels and cyclicality. As a last line of defence, your portfolio should be widely diversified across many different companies, which will reduce the impact of the occasional dividend cut when it occurs (we’ll cover each of these points in detail later on).
Finding ten years of data
There are various ways to get hold of a company’s financial results for the past ten years. The obvious place to look would be the company’s annual reports, but that approach is very time consuming and any per share data, such as dividend per share, will not have been adjusted for share splits or share consolidations.
Share splits and consolidations change the number of shares a company has and the price of each share, but they don’t affect the value of each shareholder’s holdings. However, they do affect per share figures such as dividends and earnings per share, which means that per share figures from older annual and interim results have to be adjusted to take account of the change.
You could correct for splits and consolidations by hand, but my preferred approach is to get ten years of data from a data provider such as Morningstar or SharePad, at least initially, and to supplement that with the company’s official results documents if I decide to get into a more detailed analysis.
From now on I’ll assume you have access to all the required financial data, so let’s move on and analyse the dividend record of a company I’m currently invested in.
Consistent dividends from Ted Baker (TED)
Ted Baker is a FTSE 250 clothing retailer listed in the defensive Personal Goods sector. It is known for its quirky ‘British’ style and has more than 500 stores across the globe. It sells via three main channels: retail, licence and wholesale. Ted Baker had the following dividend record for the ten years to 2019 (shown in Table 1.1).
|Year||Dividends per share (p)|
Table 1.1: Ted Baker’s dividend record through ten years to 2019
Looking for dividend payments in every one of the last ten years is a pretty simple test. Either a company made a dividend payment in every year or it didn’t. In Ted Baker’s case it did, so at this stage it would still be a viable investment candidate.
Looking for earnings which regularly cover the dividend
Of course, dividends don’t appear out of thin air. A company first has to generate revenues and profits because without profits there can be no sustainable dividends, and without revenues there can be no profits.
Let’s nail down some earnings-related terminology:
For many years I focused on normalised EPS in an attempt to get a clearer look at a company’s core performance. However, experience taught me that adjusted and normalised earnings are sometimes consistently higher than basic or reported EPS, and paint an overly rosy picture of a company’s past. This occurs when a company repeatedly defines expenses as ‘one-off’, such as costs relating to redundancies, fines or spin-offs (e.g. when a company sells a previously acquired company and makes a loss on the transaction).
So now I use basic or reported EPS because it includes all income and expense items and gives me a better picture of how the overall company is performing, warts and all. When I mention earnings or earnings per share throughout the rest of the book you should assume I mean basic EPS.
The first thing I look for in a company’s earnings is that they consistently cover the dividend, which just means that the income from earnings was higher than the amount paid out as dividends. I do this by calculating the dividend cover ratio for each of the ten years and just count how often the dividend cover was greater than one.
I’m looking for a consistently covered dividend, so my rule of thumb for dividend cover is:
Rule of thumb
This is a pretty relaxed rule, but it should at least exclude companies with very volatile profits and dividends which are frequently at risk.
Calculating the dividend cover ratio
The calculation for dividend cover is relatively simple:
dividend cover = basic EPS / DPS
Let’s turn to the real world and see how this idea can be applied to another of my current holdings.
Consistent dividend cover at Burberry (BRBY)
Burberry is a FTSE 100 company. Like Ted Baker, it operates in the defensive Personal Goods sector. Also like Ted Baker, Burberry is a ‘British’ fashion brand selling through three channels: retail (over 400 stores, concessions and outlets, plus e-commerce), wholesaling (to department stores and other multi-brand retailers) and a small amount of licensing (just 1% of revenues). Burberry has paid a dividend in every one of the last ten years, so it passes my first rule of thumb.
To check its long-term dividend cover we’ll need its earnings and dividends for the last ten years, which you can see in Table 1.2.
|Year||EPS (p)||DPS (p)||Dividend cover|
Table 1.2: Burberry’s dividend cover, 2009-2018
Burberry’s earnings record gets off to a bad start with a loss in 2009. However, I’m not put off by the occasional loss and in this case it’s understandable as 2009 was the middle of the global financial crisis. What’s more important is that Burberry continued to pay a dividend.
As for the company’s dividend cover, the table shows that Burberry’s dividend was covered in every year except for 2009, which means its dividend cover score is nine out of ten. Nine is obviously more than five, so Burberry’s dividend was covered by earnings most of the time which means it easily ticks this particular box.
Next time we’ll turn to the subject of measuring growth, but for now, here’s a quick summary of the rules we’ve covered so far:
Rules of thumb for profitable dividends