At NAOS we invest in small and micro-cap industrial companies. Whilst the concepts of smaller stocks and sustainable dividends do not typically go hand in hand, there are plenty of companies in our universe which have demonstrated the ability to consistently pay dividends, and we hope to see this occur sustainably into the future.
In our view, the principles which create an environment for stable to growing dividends are not necessarily dependent on company size. In this article we look at a few key principles to be considered when investing for consistent, growing cash returns.
For any of the below it is important to consider the medium to long term performance record as results can vary significantly from year to year.
The quality of a company’s operations can be measured by the amount of free cash it generates. The ability of a company to ‘compound capital’ comes down to how a company utilises/reinvests a portion of its free cash, whether that be through activities such as acquisitions, debt reduction, or building a bigger cash balance.
Whilst you can pay dividends without free cash flow in the short term, over the long term this is not conducive to sustainable capital management. Put simply, a company that is extracting cash at the expense of reinvestment capital is unlikely to be growing. We like to see capital light businesses that allocate a portion of free cash to both strategic and balance sheet initiatives whilst allocating a portion to their shareholders.
A very basic way to look for sustainability would be to compare the total dividend payout to the total free cash flow figure. For the purpose of this exercise we define free cash flow as operating cash flow less ongoing capital expenditure. A company that is generating sustainable income for investors would have higher a free cash flow than dividends paid.
As a dividend hungry market, payout ratios of ASX listed companies have been on the rise and are becoming an ever-increasing percentage of total shareholder returns.
A dividend payout ratio simply measures the dividend per share to the earnings per share. By inverting the payout ratio, we know how much profit the company plans to retain. We are mindful that there are likely to be industry specific or ownership specific factors which may vary results, however as a general principle a very high payout ratio can be a sign that dividends may not be sustainable over the longer term.
Earnings that are retained within the business should be a buffer for what is expected to occur in the future, therefore a very high payout ratio is likely to provide you with an understanding of the intentions of directors. A very high payout ratio can prove to be unsustainable in the longer run as businesses which do not reinvest will likely face headwinds in the future.
Over the medium term, a capable board is one which prudently builds the retained earnings balance at a rate greater than the dividend payments. By doing so, you are giving yourself a buffer in case of unexpected losses/impairments and could allow you to generate a consistent dividend profile.
Often a company can be valued on its dividend yield, therefore a very high yield can artificially inflate a share price. If/when this payout ratio drops it can result in a significantly negative effect on the company’s share price.
The numerical increase in dividend per share often doesn’t tell us enough. We believe a better approach is that a company should ‘earn the right’ to increase its payout ratio. If previous investment decisions are compounding capital faster than a payout ratio increases, it demonstrates sustainability.
Therefore, if you notice a company’s retained earnings balance is consistently diminishing whilst dividends remain steady or are increasing, this could be a red flag.
As the saying goes, it is best to read a company’s financials back to front; the cash flow statement first and the income statement last. The reason being that a company can’t muddy the waters of a cash flow statement. Whilst all financial statements are important, the bottom section of the cash flow statement allows us to see how a company ‘keeps it’s lights on’ during a reporting period.
In our view, a warning sign for any company would be continual entries in the ‘proceeds from borrowings’ line of the cash flow statement, without any entry in ‘repayment of borrowings’. There are short term reasons such as acquisitions when this is acceptable (which in turn should hopefully generate increasing future free cash flow) but there are other, more worrying reasons.
If a company is continually living on debt and not generating the free cash to pay it off, any dividends will eventually suffer and a capital raising may be on the horizon. A quick way to interpret sustainability of the funding of dividends would be to compare dividend growth to debt growth. Artificially ‘holding up’ a dividend through debt is likely not a sustainable capital management decision.
The above three principles should not be solely relied upon, rather be considered as part of a wider analysis undertaken on any potential investment. These principles aim to provide an insight as to what may eventuate down the track to a dividend, which in theory should be the most predictable part of total shareholder returns.
At NAOS we believe in investing in businesses where the earnings today are not a fair reflection of what we consider the same business will earn over the longer term, and over time the business can pay dividends. Investing solely for income is not something we do, avoiding ‘yield traps’ is just as important as finding a good sustainable dividend.
Important Information: This material has been prepared by NAOS Asset Management Limited (ABN 23 107 624 126, AFSL 273529 and is provided for general information purposes only and must not be construed as investment advice. It does not take into account the investment objectives, financial situation or needs of any particular investor. Before making an investment decision, investors should consider obtaining professional investment advice that is tailored to their specific circumstances.