2023-08-24 06:00:00 ET
Summary
- A myopic focus on dividends may be costing investors 2%-4% in returns per year.
- Dividend Aristocrats and high-yielding companies have trailed the market-cap weighted S&P 500 in the past 10 years.
- Understanding the cash-based sources of intrinsic value and focusing on total return rather than just dividends can lead to better investment outcomes.
- You've bet big on equity REITs the past 10 years and underperformed the market return. Now what? This article will help put things into perspective.
By Brian Nelson, CFA
Stock prices and returns are in part a function of a company's net cash on the balance sheet and changes in future expectations of free cash flow. Stock prices and returns are not driven by the dividend payment, and as such, a myopic focus on the dividend, by itself, could be costing investors considerably, at least with respect to the average market return--as measured by the market-cap weighted S&P 500 ( SPY ). The free dividends fallacy hypothesized that a myopic focus on chasing dividends could be costing investors anywhere between 2%-4% in returns per annum. During the past 10 years, for example, high-yielding Dividend Aristocrats have trailed the return of the market-cap weighted S&P 500 by about that much per year, while even higher yielding companies such as REITs ( VNQ ), mortgage REITs ( REM ) and master limited partnerships ( AMLP ) did even worse. Based on the past 10 years, one could make the argument that the higher the dividend yield, the lower the total return.
Entities with large net cash positions and substantial free cash flow generation have outperformed not only the broader stock market, but also key high yield areas, including REITs, mortgage REITs and master limited partnerships during the past 10 years. (The respective ETF sponsors)
Though we have nothing against dividends, per se, the sorting of returns over the past 10 years makes a lot of sense to us. For example, many companies in the Schwab U.S. Large-Cap Growth ETF ( SCHG ) have tremendous cash-based sources of intrinsic value: net cash on the balance sheet and strong expected future free cash flow generation. Net cash is an add back to a company's discounted enterprise free cash flows in arriving at an estimate of its intrinsic value. As expectations of future enterprise free cash flows increase, so should the company's value and stock price, all else equal. As expectations of future enterprise free cash flows fall, so should a company's value and stock price. As shown in the table that follows, many Dividend Aristocrats, however, suffer from lofty net debt positions and huge future expected dividend liabilities that soak up much of their free cash flow, while their business models ebb and flow with the economic cycle. Remember: if you have a $10 stock and it pays a $1 in dividends, you don't have a $10 stock and a $1 in dividends, but rather you have a $9 stock and a $1 in dividends. For more on this topic, please see this article .
Company Name ($ in millions) | Symbol | 2022 Total Debt | 2022 Total Cash | Net Debt | 2022 Free Cash Flow | 2022 Dividends | 2022 Free Cash Flow after Dividends |
3M CO | MMM | 15,939 | 3,893 | 12,046 | 3,842 | 3,369 | 473 |
INTL BUSINESS MACHINES CORP | IBM | 50,949 | 8,841 | 42,108 | 9,089 | 5,948 | 3,141 |
WALGREENS BOOTS ALLIANCE, INC. | WBA | 11,674 | 2,472 | 9,202 | 2,165 | 1,659 | 506 |
STANLEY BLACK & DECKER, INC. | SWK | 7,456 | 396 | 7,060 | -1,990 | 466 | -2,456 |
LEGGETT & PLATT, INC | LEG | 2,084 | 317 | 1,767 | 341 | 229 | 112 |
Note: Total debt does not include operating lease obligations |
Source: State Street Global Advisors ; Fundamental data retrieved from individual company filings.
REIT investors tend to view the laws of valuation differently, using valuation multiples instead of enterprise valuation (i.e. the discounted cash flow model)--many investors like to use the P/E ratio, too, and it has myriad pitfalls leading many investors into value traps as referenced in this article --but doing so doesn't change the dynamics that drive share prices and values. For example, one can certainly look at a REIT's funds from operations [FFO] or adjusted funds from operations [AFFO] and throw a multiple on top of that measure, but the reality is that prices will be set on the basis of what the company holds on the balance sheet in the form of net cash and what it can generate in traditional free cash flow, as measured by cash flow from operations less all capital expenditures. This is what determines the valuation multiple. REITs tend to have tons of debt on their balance sheet and often dilute investors by issuing new equity, so their business models are often complicated by financing activities that muddy the waters in traditional valuation processes. Let's take a look at the financial statements of one of the market's favorite REITs, Realty Income ( O ) to illustrate why the cash-based sources of intrinsic value for even some of the strongest REITs aren't great.
Realty Income's latest Balance Sheet. (Realty Income)
Realty Income's latest Cash Flow Statement. (Realty Income)
First, let's start with Realty Income's net cash position, or rather its net debt position. As of its latest quarterly report, it held roughly $17.55 billion in net debt, which within the enterprise valuation process is a reduction to a company's discounted present value of its future enterprise free cash flows in arriving at a fair value estimate. To avoid the discussion between maintenance and growth capital spending at this point--both of which are a reduction to operating cash flow in arriving at free cash flow--let's just use operating cash flow in this valuation exercise to get a sense of the company's leverage. Let's say Realty Income does not have to spend money improving its buildings at all, using an annualized rate of its operating cash flow during the first half of this year, the company is on track to generate ~$3 billion in operating cash flow (~$1.5 billion x 2), which isn't too shabby.
Growth and maintenance spending is not free, however, and the cash going out the door with respect to these endeavors is shareholder capital, and therefore must be captured within the context of enterprise valuation (i.e. the discounted cash flow method), too. Said another way, the ~$4.69 billion the company spent in 'investment in real estate' so far in 2023 represents new buildings that ultimately serve to drive operating income higher. To ensure balance in the valuation process, if one is expecting operating cash flow to increase as a result of these new investments (and this is a part of one's valuation method, even using a multiple of future FFO), then one must also deduct these new investments from operating cash flow in arriving at an intrinsic value estimate (or within the valuation process). Not only does the timing of these cash outflows matter with respect to valuation (a dollar today is worth more than a dollar tomorrow due to inflation), but giving credit in incremental operating cash flow without accounting for the cash the company spends to generate that incremental operating cash flow is a valuation no-no. Subtracting these investments from operating cash flow results in our measure of adjusted traditional free cash flow generation that isn't very attractive, in our view.
Now, you might say that REITs are different, and we're not looking at things correctly. But the reality is that every company has maintenance and growth spending from industrial entities that must fix or update existing property, plant and equipment to retailers that may need to invest in older stores. Most every company has growth capital spending. One shouldn't ignore it for one group and account for it in another. Some companies, for example, may invest in a new product line to generate incremental operating cash flow, while others in the REIT industry may buy new buildings to generate incremental operating cash flow. The most important dynamic with respect to valuation is balance, and ignoring growth and maintenance capital spending, while including incremental operating cash flow that is driven by growth and maintenance capital spending is just a flawed way to look at valuation. From our perspective, some of the best companies are net-cash-rich, capital-light operators that generate tremendous free cash flows without having to invest much in their businesses.
Microsoft’s free cash flow continues to be phenomenal. (Microsoft)
Since many income-oriented investors may not have compared the financials of their high-yield holdings with other lower-yielding stocks on the market, let's look at Microsoft ( MSFT ) and Alphabet ( GOOG ) ( GOOGL ), by comparison. For the three months ended in June, cash flow from operations at Microsoft surged to $28.8 billion, while capital spending came in at $8.9 billion, good for free cash flow generation in the quarter of $19.8 billion (see image above). For Alphabet, cash flow from operations at Alphabet jumped to $28.7 billion in the quarter, while capital spending was $6.9 billion, resulting in free cash flow generation during the period of $21.8 billion. At the end of June, Microsoft held $111.3 billion in total cash and cash equivalents, exclusive of $9.9 billion in equity investments, and short- and long-term debt of $47.2 billion--good for a very nice net cash position. For Alphabet, at the end of June, total cash and cash equivalents stood at $118.3 billion, while long-term debt stood at $13.7 billion--again, a very solid net cash position. Microsoft and Alphabet are net-cash-rich, free-cash-flow generating secular growth powerhouses and make up a good percentage of the S&P 500.
REITs have not performed as well as one might have thought. (Vanguard)
On the other hand, one has one of the strongest and most popular REITs Realty Income, which instead has a massive net debt position, and inclusive of its 'investment in real estate,' a REIT's growth capital investment, isn't generating the type of traditional free cash flow that we would find very comfortable, when it is expected to shell out a couple billion each year in dividend payments. Realty Income is very capital-market dependent, in our view. Simply in the context of a financial assessment, it becomes clear to us why REITs have significantly underperformed the market-cap weighted return of the S&P 500 the past many years. Understanding the cash-based sources of intrinsic value--net cash on the balance sheet and future expected free cash flow--would have led many investors away from investing in REITs and to more attractive parts of the market. Unfortunately, many investors continue to focus solely on the dividend or the dividend yield and this continues to cost them. We talk about the profound implications of understanding the structural dynamics of the dividend on one's potential investment strategy in this article :
Understanding how the dividend is tied to the stock price--that it is not independent of it--may help investors better understand what they are trying to do in the stock market, and it may influence how they may seek to achieve their goals. For example, many investors may have income as the primary goal and suggest that capital appreciation is a secondary condition. However, with the understanding that the dividend can be viewed as capital appreciation that otherwise would have been achieved had the dividend not been paid, would investors pursue a different strategy, knowing they can sell off a portion of shares, much like in similar fashion how their capital position in a name is reduced by the amount of the dividend when a company pays a dividend?
In this regard, income and capital appreciation are tied at the hip, and a total return focus becomes much more important, as capital can be sold to meet income requirements. Looking at year-to-date performance so far in 2023 has shown that dividend-paying equities have lagged the market considerably, and those that only focus on the dividend may have overlooked many strong net-cash-rich, free-cash-flow generating equities such as those found in big cap tech and large cap growth.
Okay, let's say that you weren't aware that the stock price is adjusted downward by the amount of the dividend on the ex-dividend date, and that you didn't understand the cash-based sources of intrinsic value within the enterprise valuation process (i.e. the discounted cash-flow method), and you missed out on achieving the market return during the past decade or so, what to do now? This is a difficult question and is different for everyone, of course. Some may not care about considerable underperformance as long as they continue to receive the dividend payment. Their minds may probably never be changed, but as we show below, this view is a potentially hazardous line of thinking, especially with respect to high yield dividend investing. For example, high dividend yields are often stiff headwinds to a company's share price, given that the stock price is adjusted downward by the dividend when it goes ex-dividend. Did you think, for example, that the share price potential of mortgage REITs and master limited partnerships was equivalent to other areas that pay lower or no dividends? If you did, it may have cost you big, as shown in the image below.
Energy master limited partnerships and mortgage REITs have destroyed the accounts of retirees, necessitating them to chase higher and higher yields as their capital positions have eroded. (TradingView)
But let's say that you understand that the dividend is capital appreciation that otherwise would have been achieved had the dividend not been paid, and that you may be looking to make a change to your investment approach, particularly in light of rising interest rates, which have put many share prices of dividend payers against the wall. Cool. For starters, we think it's important that income and dividend growth investors don't let the dividend "tail" wag the "total return" dog. You'll get your total return whether you like it or not. Most important to all investors should therefore be total return, as the dividend yield should be viewed as being "paid out" of total return, not a driver of it. We think enterprise valuation (i.e. the DCF model) is the key driver behind the total return profile of equities, as the process does a great job explaining the magnitude of market capitalization variations, while changes in key levers of the DCF, including changes in interest rates and future expectations of financials such as free cash flows drive changes in share prices. The reduction of net cash on the balance sheet when a company pays a dividend also explains why the share price of a company is adjusted downward by the amount of the dividend on the ex-dividend date.
There's nothing wrong with striving to generate an income stream with equities in retirement, and we've written a number of articles that could help retirees that are looking for ways to diversify away from REITs and high-yielding areas to other stronger areas of the market. If you believe, for example, that we may be in a new bull market, this article outlines five ideas for consideration. We're huge fans of Microsoft, and this article walks through why. We're also not concerned about Apple's ( AAPL ) valuation, and we make the case why we like shares in this article . As one can probably tell by the referenced articles, we are huge fans of big cap tech and the stylistic area of large cap growth, and we think these two areas will continue to power the markets higher this decade.
It seems like things should be simple: One can seek out total return (and then consider income) or instead run the risk of betting on the dividend alone and potentially face disappointment, as in the latest popular saga on Seeking Alpha with respect to Medical Properties Trust ( MPW ), which recently slashed its payout . As we ask in this article , why spend so much time analyzing the risks of potentially unsustainable payouts when the end result is often underperformance, as has been for most groups of dividend payers the past 10 years? Investing is supposed to be easy, but a lack of understanding of the structural dynamics of the dividend while overlooking the cash-based sources of intrinsic value has hurt many an income investor. There's a better way to achieve investment goals, but it may require that income investors pursue a reboot to their processes.
For further details see:
You Trailed The Market Betting On REITs, Now What?