Payout, earnings quality, and valuation. Kleinwort benson investors White Paper

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1 Payout, earnings quality, and valuation Kleinwort benson investors White Paper Kleinwort Benson Investors June 2013

2 In the world of investing, Total Return is a widely recognised and accepted approach to measuring equity returns: Dividend Yield + Dividend Growth +/- Change in Valuation = Total Return It can be used to decompose historic returns or to estimate future returns. We have written two previous papers 1 focussing on these drivers at a macro or equity asset class level over the long term. We showed: the first two elements (which we collectively call payout) tend to dominate equity returns in the long term, the attribution varies on a decade by decade basis, and the cyclical benefits of focussing on these elements given the recent history of global stock markets and our long term outlook. More interestingly the formula can also be used to capture the focus of our investment philosophy at the stock-specific level. Central to this philosophy is the extent to which we believe each of these total return drivers is interconnected. Many interpreters of the above formula tend to consider each element as a standalone ingredient, as if their ongoing dynamics of return contribution were independent and discrete from each other. Our contention is that it is not a linear equation and dividends are an intrinsic measure of the long term sustainability of business profits and a central part of the way those profits are transferred to shareholders. They are not a separate or different source of return from profitability or valuation, but an intrinsic way of assessing both. Also, managing the payout policy is not a secondary element of management responsibilities but rather management s primary responsibility to its shareholders. In this paper we demonstrate the very strong relationship between a company s payout ratio and its long term valuation. All earnings are not created equally and all earnings are not valued equally Dividend growth is a key indication of how comfortable companies are with their own financial circumstances. Profit growth is not necessarily accompanied by dividend growth, but when it is, it indicates that there is a greater certainty and longevity to the profit growth. The expansion of payout in tandem with profit growth signals that there is a long-term stability to the profits and that the volatility of future earnings is likely to be lower. So while the overall rate of earnings growth may be lower, investors are prepared to pay a premium for CHART 1 2

3 the higher level of predictability (or lower level of risk) that is associated with companies that combine profit growth with payout increases. It s not just the level of earnings that counts, it s the type of earnings and how persistent they are likely to be. Or looking at it the other way around - the higher the risk, the lower the multiple, which is logical. (For example a company can generate huge profit in the short term from an innovative product launch, which is then taken away by the increasingly fast reactions of competitors. We are trying to look at a more holistic version of profit than just sales.) Our thesis is that dividend growth, or more specifically an expansion of payout, once it is being funded correctly (a very important proviso), is an indication that the broader financial health of a business is improving, which should be a positive for the multiple as well. Yes, the higher dividend payments themselves bring an extra value to shareholders but it is also indicative that there is a higher level of predictability and sustainability attached to future profits. Importantly, as several charts in the following pages will show, this durability, or quality, is something that investors are prepared to pay for. Firstly we look at the historic relationship between payout and valuation. Chart 1 (on previous page) shows the rolling year on year change in the dividend payout ratio of the S&P 500 (by measuring the change for the previous 12 months) and compares it to the change in P/E multiple over the same period. What we can see very clearly is that the relationship is very strong and that a rise in the payout ratio has historically led to a rise in the multiple. Because Chart 1 shows rates of change, we have also included the absolute level of dividend payout in Chart 2 (below). As you can see we are at all time lows, so the future direction of payout is most likely to be upwards (the reasons for this have been dealt with in an earlier paper). CHART 2 January 1871 January 1876 January 1881 January 1886 January 1891 January 1896 January 1901 January 1906 January 1911 January 1916 January 1921 January 1926 January 1931 January 1936 January 1941 January 1946 January 1951 January 1956 January 1961 January 1966 January 1971 January 1976 January 1981 January 1986 January 1991 January 1996 January 2001 January 2006 January

4 Next in Chart 3 (below) we map forward looking valuation preferences. We show rolling twelve month I/B/E/S forecasts from the start of The chart shows that the relationship between valuation multiples and payout has been rising steadily since the tech bubble, while the relationship with earnings estimates has been declining. CHART 3 This chart also captures another element of the total return nature of our philosophy: that higher payout companies tend to generate positive earnings surprises versus expectations. This is why we prefer to look at dividends and payouts. As Nobel prize winning economist and behavioural finance guru Daniel Kahneman 2 might say - it s slow data rather than fast data - but better for you in the long term. In a similar vein, John Bogle (Founder of Vanguard) in his many public addresses emphasises the distinction between the investment return on offer from equities and the speculative return. We find this distinction helpful. Unfortunately in the daily zoo of equity markets most noise and activity surrounds the short term speculative elements and not the long term investment issues, which tend to change only slowly. What we are most interested in are companies that are expanding payout. In particular we want companies that can do this because their retained earnings have been building up, and their cashflows are stronger than their competitors. Or more simply, identifying companies with a long term financial surplus, where that surplus is being shared. 4

5 A less plentiful earnings environment While there are contentious views about the best tactics to employ to maximize returns when growth is slower, we are increasingly interested in two total return drivers that are often overlooked. To us, they take on more importance and should be utilised for advantage. 1. The impact of the price paid for each individual unit of earnings 2. The extent to which the value of the earnings that do exist are transferred to shareholders 1. The impact of the price paid for each individual unit of earnings It is clear that investors pay a premium for certain types of earnings. As we have already shown, companies that can deliver dividend growth can really distinguish themselves. This is not just because of the immediate benefits of the growth in the dividend itself but also because the broader financial and profitability characteristics that are required to sustain dividend growth become very attractive. CHART 4 We have already established that investors pay more on a per-share basis for some types of earnings over others. We show this effect again in a different way in the chart above. At a macro level, when the absolute level of profit growth is plentiful this effect often can t be seen, or is deemed to be unimportant. However, when earnings are generally more moderate or disappointing this source of value becomes more influential. 2. The extent to which the value of the earnings that do exist are transferred to shareholders When earnings are more scarce, maximising the extent to which ordinary shareholders participate in those earnings has a bigger impact on the return that they get (what we call total payout). We focus on companies where the transfer of company earnings to shareholders is not diluted through an increase in the number of shares available, and where possible that the transfer becomes more concentrated through a reduction in the number of shares circulating in the marketplace. 5

6 CHART 5 Global Strategy MSCI World When trying to maximize their exposure to growth, equity investors should remember the basics. Economic growth does not equal earnings growth, and earnings growth does not equal shareholder return. This is a particular concern when considering their pursuit of emerging markets, where the transfer mechanisms are considerably weaker. Not only are rights issues more prolific, but discretionary capital investment still exceeds depreciation (replacement capex) by a rate of two to one despite slower economic growth 3. This reinvestment rate is double the rate of the developed world and has remained unchanged in ten years. In aggregate the combination of declining growth and continued overinvestment has led to steadily declining ROIC. Avoiding these dilutions, which often go unnoticed, can help improve investment returns from an ordinary shareholders perspective and avoid impending profit disappointments 4. Conclusions: Applying this to stock selection Going back to the equity growth equation at the top of this paper, while the yield of a specific stock can be considered current, changing on a day by day basis, the second two (dividend growth and changes in valuation) happen in the future. Together they combine to make up the total return that is achieved by an investor. Maximising this combination is how we approach adding value. Again our thesis is that investors don t just benefit from the direct impact of the dividend metrics (the yield and growth that is delivered) but also from the overall matrix of financial requirements that are needed within a business to maintain them. Corporate decisions around increasing dividends and payout are rarely a simple, singular, mechanical, financial metric. The constant production of dividend growth requires many elements of profitability to be maintained. It s this overlapping matrix of elements that we find most attractive and these are the financial characteristics that we endeavour to capture in our investment process. 1 A changing environment as equity payout returns to centre stage Kleinwort Benson Investors, Dividend Growth: the key to real investment success Kleinwort Benson Investors, Daniel Kahneman was awarded the Nobel Prize for Economics in He is a Senior Scholar at Princeton University, and Emeritus Professor of Public Affairs, Woodrow Wilson School of Public and International Affairs. This is a reference to his recent book Thinking, Fast and Slow. 3 The Asian investigator: EM Fundamentals Citi Investment Research Earnings growth: the 2% dilution, William Bernstein and Robert Arnott, Financial Analysts Journal,

7 Global Equity Strategies Team David Hogarty Head of Strategy Development Ian Madden Portfolio Manager Gareth Maher Head of Portfolio Management James Collery Portfolio Manager Name of Firm: Office Location: Kleinwort Benson Investors Headquarters 3rd floor, 2 Harbourmaster Place, IFSC, Dublin 1, Ireland Website: Contact: Tel: (+353) Fax: (+353) info@kbinvestors.com 7

8 DISCLAIMERS: Kleinwort Benson Investors refers to Kleinwort Benson Investors Dublin Ltd and its affiliates, including Kleinwort Benson Investors International Limited. USA/CANADA: Kleinwort Benson Investors International Ltd. is a registered investment adviser with the SEC and regulated by the Central Bank of Ireland. Kleinwort Benson Investors International Ltd. is a majority-owned subsidiary of Kleinwort Benson Investors Dublin Ltd. Form ADV Part 1 and Part 2 are available on request. IMPORTANT RISK DISCLOSURE STATEMENT This material is provided for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase any security, product or service including any group trust or fund managed by Kleinwort Benson Investors International Ltd, or any of its affiliates (collectively, Kleinwort Benson Investors ). This introductory material may not be reproduced or distributed, in whole or in part, without the express prior written consent of Kleinwort Benson Investors International Ltd. The information contained in this introductory material has not been filed with, reviewed by or approved by any United States regulatory authority or self-regulatory authority and recipients are advised to consult with their own independent advisors, including tax advisors, regarding the products and services described therein. The views expressed are those of Kleinwort Benson Investors International Ltd. and should not be construed as investment advice. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. The products mentioned in this Document may not be eligible for sale in some states or countries, nor suitable for all types of investors. Additional information will be provided upon request. All MSCI data is provided as is. In no event shall MSCI, its affiliates, or any MSCI data provider have any liability of any kind in connection with the MSCI data. No further distribution or dissemination of the MSCI data is permitted without MSCI s prior express written consent. AUSTRALIA: Kleinwort Benson Investors International Ltd is exempt from the requirement to hold an Australian Financial Services licence in respect of the financial services it provides to wholesale investors in Australia and is regulated by both the Central Bank of Ireland and the Securities and Exchange Commission of the US under US laws which differ from Australian laws. Any services provided in Australia by Kleinwort Benson Investors Dublin Ltd or other affiliates will be provided by the relevant entity as representative of Kleinwort Benson Investors International Limited. This material and any offer of investments is intended for and can only be provided and made to persons who are regarded as wholesale clients for the purposes of the Corporations Act of Australia and must not be made available or passed on to persons who are regarded as retail investors. It may not be reproduced or distributed, in whole or in part, without the express prior written consent of Kleinwort Benson Investors International Ltd. The information contained in this introductory material has not been filed with, reviewed by or approved by any Australian or United States regulatory authority or self-regulatory authority and recipients are advised to consult with their own independent advisors, including tax advisors, regarding the products and services described therein. This material is provided for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase any security, product or service including any group trust or fund managed by Kleinwort Benson Investors International Ltd, or any of its affiliates (collectively, Kleinwort Benson Investors ). All MSCI data is provided as is. In no event shall MSCI, its affiliates, or any MSCI data provider have any liability of any kind in connection with the MSCI data. No further distribution or dissemination of the MSCI data is permitted without MSCI s prior express written consent. The products mentioned in this Document may not be eligible for sale in some states or countries, nor suitable for all types of investors. The views expressed are those of Kleinwort Benson Investors International Ltd. and should not be construed as investment advice. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. Additional information will be provided upon request. Kleinwort Benson Investors International Ltd. is a majority-owned subsidiary of Kleinwort Benson Investors Dublin Ltd. Form ADV Part 1 and Part 2 are available on request. ASIA: Kleinwort Benson Investors Dublin Ltd. is regulated by the Central Bank of Ireland. The views expressed in this document are expressions of opinion only and should not be construed as investment advice. IMPORTANT RISK DISCLOSURE STATEMENT This material is provided for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase any security, product or service including any fund managed by Kleinwort Benson Investors Dublin Ltd, or any of its affiliates (collectively, Kleinwort Benson Investors ). All MSCI data is provided as is. In no event shall MSCI, its affiliates, or any MSCI data provider have any liability of any kind in connection with the MSCI data. No further distribution or dissemination of the MSCI data is permitted without MSCI s prior express written consent. The products mentioned in this Document may not be eligible for sale in some states or countries, nor suitable for all types of investors. This introductory material may not be reproduced or distributed, in whole or in part, without the express prior written consent of Kleinwort Benson Dublin Ltd. The information contained in this introductory material has not been filed with, reviewed by or approved by any securities regulatory authority and recipients are advised to consult with their own independent advisors, including tax advisors, regarding the products and services described therein. The views expressed are those of Kleinwort Benson Dublin Ltd. and should not be construed as investment advice. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. Additional information will be provided upon request. EUROPE: Kleinwort Benson Investors Dublin Ltd. is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Conduct Authority in the UK. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. IMPORTANT RISK DISCLOSURE STATEMENT This material is provided for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase any security, product or service including any group trust or fund managed by Kleinwort Benson Investors Dublin Ltd., or any of its affiliates (collectively, Kleinwort Benson Investors ). The views expressed in this document are expressions of opinion only and should not be construed as investment advice. All MSCI data is provided as is. In no event shall MSCI, its affiliates, or any MSCI data provider have any liability of any kind in connection with the MSCI data. No further distribution or dissemination of the MSCI data is permitted without MSCI s prior express written consent. The products mentioned in this Document may not be eligible for sale in some states or countries, nor suitable for all types of investors. Kleinwort Benson Investors March 2013 KBIPAYOUT120814