Hi all! Today I wanted to come back to you with the continuation of the series I call the Deep Dive into SIA. Part (1) was about debt. Today I wanted to make a few deliberations about another aspect of the SIA Score, namely S5 and S1, which are directly connected with each other (please see below for a quick reminder of how SIA looks like). We will try to answer the question on whether an investor following SIA philosophy should rather concentrate on dividends or FreeCashFlow (FCF) and what’s better for him as a shareholder.
Here’s the core of SIA again:
* „I don’t have to, I can” attitude
* no benchmarks
* cycle-adjusted portfolio allocations helping risk control
* concentration on the world’s best assets
* avoidance of debt overload
* maximization of effects with minimalization of efforts
* each stock must undergo a so called SIA Score process before qualifying into the portfolio:
S1: growing sector 1pts/0pts,
S2: incumbent or prospective global leader 1pts/0pts,
S3: growing or stable wide margins (40%+ gross; 3yr avg) 2pts/0pts,
S4: Net Debt/EBITDA <1.5 (last 3 ended FYs) 2pts/0pts,
S5: above-average cash flows (last 3 ended FYs) (FCF/MktCap > S&P500 Dividend Yield or US 10yr Treasry Yield (higher of the values)) 2pts/0pts;
MAX TOTAL SCORE: 8pts/MIN TOTAL SCORE: 0pts/MIN SCORE TO QUALIFY: 4pts
A shareholder of any company has two ways of receiving returns on his/her holdings: capital gain or dividends.
A capital gain is what a shareholder gets, while the company manages to increase the value of its equity (or its assets adjusted for liabilities it owes) by involving in profitable marginal new projects with a positive Economic Value Added (EVA). This happens when the projects’ NOPAT (Net Opertaing Profit After Tax) is higher than the company’s capital charge (the amount of money it has to pay for access to capital, be it equity or debt). The more such projects are implemented, the more value is added to the company and the higher is the value of equity owned by the company’s shareholders.
A dividend on the other hand is a periodic payment to the shareholders done by the company from its profits. It can be done via: (a) cash dividends (b) stock dividends (non-cash) (c) stock buybacks. Cash dividens are the easiest option: the company just pays out a certain amount of its profits as a dividend (usually using extrenal funding for that, which is important). Stock dividends are new shares granted to current shareholders. A 3% stock dividend would mean 3 new shares for every 100 shres currently held. This version of dividends increases the number of shares outstanding and decreases the company’s EPS (Earnings Per Share). Stock buybacks are yet a different way of giving investors their returns. In that case the company, instead of paying cash or issuing new shares, buys the outstanding shares on the market (via a tender offer at one specified price or via regular stock purchases over a specified period of time). Buybacks have an opposite effect on EPS – as after the repurchase the company usually redeems the shares, there’s more profits per one single share. Also, as the total number of shares outstanding falls, the equity base of the company falls as well and it becomes naturally more indebted (if it has debt on its balance sheet at all). Debt/Equity ratio goes up, and that’s not always good, especially for companies with and already high debt share. For unleveraged firms, this move might just as well turn out value-creative.
Modigliani-Miller dividend irrelevance theory
And here we’re coming back to our friends that helped up resolve the debt issues in the Deep Dive into SIA (1) – the Modigliani-Miller tandem (MM). Apart from all the work MM have done on explaining the meaning and impact of debt proportions in creating value of the firm, they have also made very important studies regarding dividends. Under some assumptions, which are simplyfing the world, but are essential in coming to the clue of any scientific thesis, they have proven that the dividend policy of a firm has no effect on its value (assumptions were: no taxes, no costs of information, no costs of transactions). The clue here is with the financing of dividend payouts. In the real world dividend payouts are most often financed with extrenal funding. This has to do with the complexity of the business environment in today’s world: first of all with the accrual nature of accounting (profits hardly ever match cash flows) and secondly the time lag between an end of financial year and the actual decision of a dividend payout. All this put together results in a situation where vast majority of companies have to use external funding while managing dividend policy. If you want to pay a higher dividend, you have to issue securities (most often debt securities) that will pay the buyers of those instruments future cash flows equal to the current value of the funds you’re raising. Effectively current sharholders incur additional costs only to get a cash dividend payment now. Doesn’t make much sense. The conclusion is that, if a company decides to pay higher dividends now, it does it at the expense of smaller dividens in the future (the costs the current shareholders incur is money spent now that could be put aside, increase the value of the business and allow to pay higher dividends in the future). Higher dividends now mean lower dividends in the future, whilst a decision not to pay high dividends now means higher ability of a company in the future to pay substantial returns to its shareholders in dividends.
All this doesn’t mean of course that dividends have no influence on a company’s value. They do! The Dividend Discount Model (most commonly known as the Gordon Model), which is a version of a Discounted Cashflow Model, uses exactly the dividends as the value-determining factor:
But, what’s most important to understand is that it’s the choice of the dividend policy (higher now vs. lower later or vice versa) that is ignorant to the firm’s value.
On top of all the deliberations about dividends, most market practitioners (and MM as well), agree anyway that the very most important factor determining a firm’s value is the regular stream of Free Cash Flows (FCF) it generates to the shareholders.
How does that relate to SIA philosophy? Read on….
The choice between Growth and Value
Now as we have already presented, in short, what kind of options every shareholder has while owning a stock, we need to figure out what is really the right balance between those two basic kinds of returns (dividend+capital gain). It is especially important to understand not only the direct “dividend or capital gain” choice (quite often these two can persist alongside each other), but rather the choice of what kind of stock we hold and what’s currently best for this stock from a shareholder’s perspective.
What I mean here is that, as most of you know, all stocks belong to certain sectors. Different sectors are at different stages of their life cycle. Sectors at Start-up phase have totally different characteristics than the ones at their Growth, Shakeout, Maturity or Descent phases. In general the five basic sector lifecycyle stages show the following characteristics of a firm’s most important business determinants: cash/financing, revenues and profits:
Start-up: The market for the firm’s product is very limited or does not exist yet, customers do not yet often realize they might have demand for the product, there’s no set up channels of distribution and no complementary products. Start-ups have massive need for external financing to grow their idea or product, but they have no or hardly any revenues to cover the costs. Cash flows are constantly negative.
Growth: The market for the company’s product starts to evolve and grow. Demand is growing and so do sales and revenues. Profits are rising and margins on the product are very wide at the start, but as competition grows they later show a falling tendency. The product is constantly being improved. Demand keeps growing as the product’s prices fall with growing competition. Lower prices have positive effect on maginal demand on the the product. The companies in the growth stage show rising revenues, positive cash flows, and rising profits. –> Vast majority of stocks qualifying into SIA portfolios will come from sector currently in this stage of their life cycle. More on this in a moment, but this is absolutely crutial to our deliberations on question “higher dividends now or higher dividends later?”.
Shakeout: This stage is mostly characterised by increased consolidation and elimination of weakest entities from the market. M&A activity is plenty and the fight for market share is pretty harsh. The companies in the shakeout stage usually start feeling some growing pressure on revenues, margins and profitability.
Maturity: The sector is mature and mostly consolidated, the number of companies within the sector is smaller than in the growth and shakeout periods, major players in the sector (so called incumbets) make sure that smaller competitiors do not grow too much too fast (often taking them over to weaken competition), market saturation for the sector’s products is high. Products are widely used, cheap and very accessible. During the maturity period revenues often experience their cycle peak, as do profits and cash flows.
Decline: Demand for the sector’s products is falling, the market is contracting, causing weakest firm’s first to drop out ot the race, more and more companies divest or change their profile to another sector. There’s an ongoing deterioration of business conditions within the sector and all three major determinants (revenues, FCF and profits) are falling.
As I mentioned above, most of the SIA-style stocks that will become part of the equity allocations in the Global Leaders Portfolio (GLP) will naturally be Growth stocks. Only fulfilling the SIAScore will by algorithm mean most of their characteristics will be typical for the growth phase described above. Some of them might be mature enough to be at the break of growth and maturity phase and might have more characteristics of a value stock rather than growth, but will still have long time ahead before reaching their peak. It’s nicely depicted in the structure of the GLP equity part (as of GLP’s inception):
Accoring to the Morningstar Style Box methodology only slightly less than 14% of the equity part of GLP was Value stocks (namely Intel/INTC and Biogen/BIIB). Intel still gets 8pts in the SIAScore though, so can easily still be in late Growth or early Maturity phase, given it operates in the rapidly growing sector of semiconductors, it possibly still has a long long time before it reaches its peak of revenues, FCF and profits. Similar case with Biogen: 7pts in SIAScore and a prospective pharma sector. Rest of the stocks in GLP at inception were either large-cap or mid-cap growth stocks or the ones with a mixture of growth and value characteristics (mid-cap core, large cap core).
Free Cash Flow
And finally we’re slowly coming to the point where I wanted to convey the clue of this post. We know the follwing:
* SIA aims to chose the world “best assets” as we call it. This means that in the equity part of GLP a Smart Investor will look to have mostly the kind of stocks that will give him the additional long-term Beta (outperformance vs. wide market) driven by future dynamic growth of shareholder value, as a result of the fact that it fulfills the assumptions of SIA (growing sector, leaders in the growing sector, wide margins, etc.)….
* …This is mostly because SIA attitude concentrates on maximization of shareholder returns. While value stocks are usually (as per definition) cheaper than the market and their intrinsic value, there’s usually good reasons for that. The main reason is that most of these names operate in sectors that are already in mature (or decline) phase of their economic cycle. And this is the main reason why value stock’s future upside potential is much more limited than in the case of growth stocks…
* …Yes, the value stocks are mostly rich in revenues, FCF and profits, but they are much closer (or already post) their peaks in that regard than the companies in their growth phase, which still have the perspective of further rise of revenues, FCF and profits ahead of them. This limits the shareholder’s future returns, as the capital gains will not be easy anymore. Hence value (maturity/decline) stocks concentrate on returning money to their investors by increasing dividend payouts instead of concentrating on delivering capital gains…
* …But, from MM work, we know that a dividend policy of a firm is nothing more than a choice between “higher dividends now, but smaller later or smaller dividends now, but higher later”, which means that it is effectively indifferent to the firm’s value…
* …Higher dividend payouts now, especially in case of growth stocks, is effectively producing additional nonsense costs that current shareholders need to incur, instead of the management of a firm concentrating on maximization of FCF, which is (as we also know) “the absolute value-creating driver” for every company…
* ..And that’s why in SIAScore’s S5 point we’re looking for companies with above-average cash flows measured by FCF Yield (FCF/MktCap) and we prefer these stocks over dividend paying value stocks (measured by S&P500 Dividend Yield) and we use the US 10yr Treasury Yield as the absolute relative benchmark to which we compare the yields in FCF and dividends. Hence the following must hold for a company to join a SIA portfolio: FCF Yield > Dividend Yield or 10y Treasry yield (higher of the two).
Ufffff…I hope I haven’t bored you to death! 😉
All the best and take care of yourselves!
Disclaimers: None of the ideas, views and thoughts presented here shall ever be taken as a recommendation to buy or sell stocks,bonds,FX,commodities or any other financial instruments as stated in REGULATION (EU) No 596/2014 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 16 April 2014 on market abuse (market abuse regulation) and repealing Directive 2003/6/EC of the European Parliament and of the Council and Commission Directives 2003/124/EC, 2003/125/EC and 2004/72/EC or the Regulation of the Polish Minister of Finance of 19 October 2005 on information constituting recommendations regarding financial instruments, their issuers or exhibitors (Journal of Laws of 2005, No. 206, item 1715) or the Polish Act of 10 February 2017 amending the act on trading in financial instruments and some other acts. The article is for educational reasons and purely presents private views of the author, thus the author shall not be claimed eligibile for any losses of a third party resulting from trading activities based upon this article. The author uses his best knowledge and data from sources believed to be reliable, but makes no representations as to the accuracy of the data.Full Disclaimers&Liability Limitations page.